Investing in Good Businesses
The investing environment over the last three years has been marked by unprecedented volatility and significant challenges. The global economy has grappled with the profound impacts of the COVID-19 pandemic, leading to market turbulence and shifts in consumer behavior. Additionally, geopolitical tensions, such as the Russia-Ukraine conflict, have introduced further uncertainty, affecting global supply chains and energy markets. Regulatory landscapes have also evolved, with heightened scrutiny on businesses in China and increased regulation in various other markets, including Mexico. Inflationary pressures and changes in monetary policy have added another layer of complexity, influencing interest rates and investor sentiment. In this relatively unpredictable environment, we believe that the time-tested principles of investing in well-run businesses with strong fundamentals at attractive valuations will hold.
Investing in good businesses is the bedrock of our approach. We seek companies with enduring competitive advantages that allow them to generate returns on invested capital (ROIC) well above their cost of capital, coupled with robust free cash flow (FCF) generation. Yet, our criteria extend beyond these fundamentals. We look for businesses with compelling reinvestment opportunities, enabling them to deploy capital effectively for future growth. Resilience is another characteristic that we favor: companies that we believe can weather economic downturns and emerge stronger, reflecting their inherent robustness and management acumen. Our perspective is decidedly long-term, and we confine our investments to our circle of competence, which broadens gradually as we expand our understanding of newer areas or geographies. We do not invest in companies facing stiff competition and significant disruption through innovation. The majority of our portfolio is invested in businesses that are inherently predictable over five to ten years such as European financial markets infrastructure companies London Stock Exchange and Deutsche Boerse, consumer franchises such as luxury conglomerate Moet Hennessy Louis Vuitton (LVMH), UK kitchen manufacturer Howden Joinery Group and global alcoholic beverages company Diageo, business services companies like Wolters Kluwer, Rentokil Initial and Compass Group and industrials such as aerospace businesses Safran, Swedish industrial compressor maker Atlas Copco and Finnish elevator company Kone Oyj.
“Investing in good businesses is the bedrock of our approach."
Nuanced Valuation
Valuation is indeed a subtle art, and even the most stable businesses can find themselves mispriced by the market for extended periods. Some of our early missteps stemmed from overpaying for outstanding businesses that subsequently experienced significant drawdowns as they failed to meet the market's elevated expectations. However, the reality is more nuanced than merely avoiding companies trading at high multiples. Relying solely on near-term shorthand multiples can be misleading and may result in significant errors of omission by missing out on exceptional businesses that continue to improve over time. This experience has reinforced the need for disciplined valuation while appreciating its complexities. Our process begins by asking whether we can determine the intrinsic value of the business with a high degree of confidence, informed by a clear vision of what the company might look like in five to ten years.
In our experience, estimating the value of businesses at a relatively early stage of their lifecycle, or those operating in rapidly changing environments with tenuous competitive positions, is particularly challenging. Consequently, we have eschewed investing in such companies.
For businesses that meet our investment criteria, we strive to uncover ideal entry points where the risk-reward equation is heavily skewed in our favor. New opportunities often arise from temporary market concerns, such as economic cycles or short-term underperformance against elevated expectations, presenting us with favorable investment prospects. Many of our investments have come to us in this manner, including UK alcoholic beverages company Diageo, French aerospace business Airbus, and Canadian railroad company Canadian National.
Once a company enters our portfolio, position sizing is driven by the upside we foresee over five years, the potential downside risk, and our likelihood of success. Additionally, we have not hesitated to sell businesses at less compelling valuations, such as Swiss chemicals company Sika, which we believe remains an excellent business but currently offers lower returns compared to other investments in the portfolio. We would gladly repurchase it at a more attractive valuation. Thus, valuation plays a critical role throughout the lifecycle of an investment within our portfolio.
Importance of Governance
Governance is a critical pillar in our investment philosophy. We have always placed a premium on the quality of management in our investment criteria. Management's role is pivotal, as they are responsible for allocating the vast majority of the capital generated by a firm over a five to ten-year period. That said, many of our portfolio companies operate in geographies that have very different corporate governance or regulatory frameworks compared to what we are familiar with in Europe or North America. Although our strategy is still in its early days, we have already navigated significant challenges, including the Russia-Ukraine crisis, geopolitical tensions in Taiwan, regulatory crackdowns on businesses in China, and increased regulation in Mexico. In general, we have viewed these events as a source risk and sold out of investments that had significant exposure such as the Taiwanese chipmaker, Taiwan Semiconductor Manufacturing Company (TSMC), Chinese internet company Tencent and Mexican airport operator Grupo Aeroportuario del Pacifico. These events underscore the importance of a company’s operating and regulatory environment. Today, we delve deeper to grasp the unique risks associated with these markets such as regulatory complexities, geopolitical risks, and diverse market dynamics. We remain focused on risks that are particular to specific markets and how we can minimize our exposure to them e.g. through higher hurdle rates for investment such as in emerging markets or refusing to lower our investment standards to gain exposure to a particular market or theme. By maintaining stringent governance criteria, we aim to mitigate risks and bolster the long-term sustainability of our investments.
Being Well-Behaved
The impact of cognitive biases on decision-making is well-documented, and we are acutely aware of these influences. We rely on a structured process for screening and conducting due diligence for every investment that makes it into the portfolio. Our process helps us to break down a complex decision into a series of simpler sub-judgments, which we believe helps reduce noise in our decisions. Furthermore, we have put in place guidelines to address behavioral biases. These include employing devil's advocates to counteract confirmation bias and re-evaluating the investment case on drawdowns to address endowment effect. We also consider multiple scenarios such as bull, base, and bear case to minimize framing errors. Our overarching goal is to ensure that the bulk of our capital is allocated to our highest-conviction ideas. There are several methods to rank investments within the portfolio – we focus on potential upside, potential downside, and the likelihood of our assessments being accurate. We enlisted an independent consultant to analyze nearly three years of data for our strategy, ensuring impartial insights. Our observations, though spanning a relatively brief period, indicate that our larger-weighted investments have generally outperformed, while the smaller-weighted ones have generally lagged. This suggests that our capital allocation process is functioning as intended.
Corporate Governance & Japan
When considering corporate governance within our diverse investment universe, it's evident that a country's legal and regulatory frameworks, coupled with its historical and cultural nuances, significantly influence the effectiveness of these systems.
Japan is a market where we have continuously sought to identify promising opportunities, however, we have often been challenged with corporate governance practices. Earlier this year, some of the team travelled to Japan, a visit that coincided with a period of rapid transformation in corporate governance within the country. This evolving landscape has spurred a notable increase in shareholder activism, which in turn has driven substantial changes in corporate strategy, leadership, and governance practices. Engagement, proxy voting, and even legal actions have emerged as pivotal instruments of change, compelling companies to become more transparent and accountable to shareholders. As international investors, this is an exciting change in one of the largest international markets, in which we currently own two companies, Shimano and Keyence.
Because of such developments and nuances globally, the importance of engagement cannot be overstated. Direct conversations with management and on-site visits enable us to gain a comprehensive understanding of the companies we invest in, their governance practices, and their cultural dynamics with aim to mitigate risk and bolster the long-term performance of our investments. A prime example is Keyence, the Japanese manufacturing automation company, where historically gaining access to meaningful conversations has been challenging. However, over our investment holding period, our differentiated efforts in research and engagement have allowed us to delve deeper. This has enabled us to recognize the significant emphasis their customers place on sustainability, thereby uncovering greater opportunities within this space.
Industry Leadership Matters
As we’ve talked about already in this letter, quality matters, a lot. But there’s lots of nuance to what quality means and how to measure and identify it. One area to look at is market share, the cream rises to the top as they say and over long periods of time, those business with truly sustainable and enduring competitive advantages should begin to dominate their industry and take market leadership. We invest in business for the long term, and for compounding to work in our favor we need patience to see this through over multi year, and indeed multi decade time periods and for this we need competitively advantaged businesses that, as a byproduct of these inherent business characteristics, will gain market share.
Market share, or change in it, is one true quantitative metric that can point to the highly subjective and qualitative area of company moats. When you invest in a market leading company, its ability to take share provides a powerful tailwind to compounding as they win more when demand is strong and lose less when its weak. And it’s this enduring ability to compound that can create real value for investors over long periods of time.
One example where this lesson has been hard to learn is with our somewhat short-lived investment in Shiseido, a leading, but crucially not the leading beauty and cosmetics company. In fact, they are one of the top companies behind the global powerhouses L’Oreal and Estee Lauder. Whilst Shiseido had many strong characteristics that attracted us to the business, like its strong market position in the fast-growing Asian Premium Skin beauty market, a brand portfolio being rationalized to double down on this core competency and brand power, and a self-help opportunity to improve its margins vs peers, its position as the 2nd, 3rd or 4th tier player, and the consequential lack of scale it had vs the leaders, meant it was hard for them to execute on this self-help and left them highly exposed to the inevitable demand cycles that exist in that industry. We exited our position in Shiseido with a small loss on our capital invested, but with these important lessons learned.
On the flip side, our investment in Howden has proved the opposite. They are a leading provider of kitchens in the UK and have steadily and sustainably taken share from small independents and large players alike. Based on Brown Advisory calculations they now have an estimated 20% market share, over 1.5x the scale of the next biggest player with that gap ever widening. Due to their trade only business model, superior scale advantages and lean supply chain (again a function of their scale) they can offer their trade customers stock on demand and a lower price than competitors. Consequentially the customer is incredibly loyal. Despite the UK kitchen market being cyclical, with meaningful current near term demand issues, Howden has continued to grow organically in this declining market – losing less in a weak market – and we fully expect them to gain more when demand inevitably turns more positive.
As the strategy’s name suggests, we invest in companies that are leaders in their industry, and it’s easier to stay a leader than become one, and market share evolution is an important metric in assessing the qualitative moats that allow a business to command this market dominance, which provides protection on the downside, but also opportunity on the upside.
Scrutinizing M&A
Since the strategy’s inception, we have had a few companies that completed transformative mergers and acquisitions (M&A). Reflecting on our experiences with companies undergoing mergers and acquisitions, several key lessons have emerged that are critical to our investment process. These lessons underscore the importance of maintaining a disciplined approach, particularly in the face of the inherent complexities that come with combining two distinct businesses.
First and foremost, it's vital to ensure a sufficient margin of safety when underwriting companies undergoing M&A. The process of integrating two businesses is fraught with potential challenges, many of which are unforeseeable and can significantly deviate from projected financials. HDFC Bank's merger with parent company HDFC Ltd. completed at the height of the US interest rate hike cycle made it difficult for Indian banks to gather deposits. This short-term macro situation resulted in a temporary funding shortage for HDFC Bank, slowing lending activities and EPS growth. By demanding a margin of safety, we seek to protect our investments against these uncertainties, helping to ensure that even if some synergies fail to materialize in the given timeframe, the investment can still meet our return expectations.
The quality of governance and management becomes critically important during the integration process. As two entities consolidate, financial reporting becomes complex, and comparability with previous periods is reduced. Any temporary issues that arise during the merger can easily be misinterpreted due to the added complexity. This requires management to provide a high level of transparency and clearly communicate the nature of any issues that arise. When things deviate from a plan, management plays an essential role in navigating the company through any turbulence and keeping the strategic vision intact.
Rentokil's merger with Terminix, to create one of the largest pest control companies in the world, ran into some integration challenges while facing a temporarily weakened demand environment. Through this turbulent period, management has made an incredible effort to increase transparency of the integration process, helping us maintain long-term conviction in our thesis. Additionally, proper corporate governance is needed to ensure that no conflicts of interest arise with management, particularly with large shareholders who might exploit a weakened share price to take the company private at an undervalued price at the expense of minority shareholders.
Lastly, it is imperative to maintain a long-term perspective when assessing the outcomes of M&A. The immediate aftermath of a stumbling merger can often involve significant volatility. However, the focus should remain on the ultimate competitive advantage and moats that the combined entity will possess once the integration process is complete. By understanding the long-term potential, we can build conviction in the investment, allowing us to hold through short-term fluctuations and reap the benefits of sustained competitive strength. In HDFC Bank's case, we believe the combined entity post-merger will have the strongest branch network among Indian private banks allowing the bank to maintain a sustainable funding advantage when compared with competitors. A well-executed merger can create a more dominant player with stronger market positioning and superior economies of scale which are key drivers of long-term returns.
Shortcomings of Multiples (Multiple Shortcomings?)
As equity investors, we spend a significant portion of time understanding a company’s fundamentals – It’s customer offering, barriers to entry, expected growth rates, margin trajectory, balance sheet and management quality, in order to derive our long term free cash flow (FCF) forecasts. But what is often less rigorously challenged is the multiple (or rating) that investors should apply to those cash flow streams, in the context of other potential equity investments, other asset classes or staying in cash. Simplistically, price returns for an equity investment are driven by long term cash flow growth and the change in cash flow multiple that investors apply (total shareholder returns then include the dividend yield).
Whilst the two exercises are often looked at in isolation, in reality they are joined at the hip, with both quantitative and qualitative characteristics of a business, alongside exogenous market-based factors, feeding into a ‘fair’ multiple to pay for future cash flows and derive a market value of a company’s equity. There are many shorthand ways to ascertain a fair multiple to use; Peer group averages, historical averages, premium / discount to the broader market, among others. However, these approaches typically neglect to incorporate the primary fundamental factors that determine how ‘valuable’ a company’s cash flow streams are; Return on Incremental Invested Capital (ROIIC), Weighted Average Cost of Capital (WACC), Competitive Advantage Period (CAP) and expected future growth.
ROIIC, CAP & Incremental Change
In qualitative terms, Return on Incremental Invested Capital (ROIIC) is the profitability or operating efficiency of a company’s marginal invested capital. ROIIC is a core driver of the multiple that we should be willing to pay – Simply put, to achieve a constant level of future growth, a business with a higher ROIIC will have relatively more residual cash to return to shareholders than a business with a lower ROIIC, thus creating a more valuable cash flow stream over time.
The Competitive Advantage Period (CAP) is intrinsically linked to ROIC yet is the most subjective part of a fundamental research process. The CAP is defined as the period where a business can earn a return on capital ahead of its cost of capital, generating economic value and all else equal, the longer the CAP, the higher the fair multiple. Standard economic theory would dictate that where businesses earn a ROIC materially ahead of their cost of capital, where there exists perfect competition, we should see economic returns eroded such that the ROIIC compresses towards their WACC (following which firms should exit the industry as they are not generating economic value). There is empirical evidence that where companies have demonstrated a positive spread between their ROIC and WACC, this is persistent into the future, indicative of durable competitive advantages which can deter these economic forces.
Importantly, given these competitive advantages are both qualitative and dynamic in nature, and as bottom-up investors, the most fruitful opportunities are where we can identify emerging changes in a company’s competitive advantage period and associated ROIIC, which should be reflected in an uplift in multiple. In a world of endless data, identifying factors (low multiple, higher growth etc) that have outperformed, has become increasingly accessible and it is where we can identify these changes that drive idiosyncratic outcomes over time. One example of this has been our recent investment in Airbus, the European aircraft producer. We believe Airbus’ competitive position (and CAP) is being extended due to the well-publicized issues with their primary competitor Boeing’s production, alongside their newly launched A321 platform with superior range and fuel efficiency vs peers. In addition to this, we expect Airbus to be entering a cash flow harvest period (leading to a higher ROIIC) as they have front loaded investments in the labor force and manufacturing lines in the US and China. As a result, we believe Airbus’ cash flows in the future will be valued more highly as the above factors translate into a higher ROIC for the business.
Thank you for your support
Priyanka and the Sustainable International Leaders Team
Sources:
1 FactSet®. All returns greater than one year are annualized. Past performance is not indicative of future results and you may not get back the amount invested. The composite performance shown above reflects the Sustainable International Leaders composite, managed by Brown Advisory Institutional. Brown Advisory Institutional is a GIPS Compliant firm and is a division of Brown Advisory LLC. Please see the Brown Advisory Sustainable International Leaders Composite GIPS Report at the end of this presentation.
Disclosures
Past performance may not be a reliable guide to future performance and investors may not get back the amount invested. All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
Sustainable investment considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. Sustainable investment analysis may not be performed for every holding in the strategy. Sustainable investment considerations that are material will vary by investment style, sector/industry, market trends and client objectives. The Strategy seeks to identify companies that it believes may be desirable based on our analysis of sustainable investment related risks and opportunities, but investors may differ in their views. As a result, the Strategy may invest in companies that do not reflect the beliefs and values of any particular investor. The Strategy may also invest in companies that would otherwise be excluded from other funds that focus on sustainable investment risks. Security selection will be impacted by the combined focus on sustainable investment research assessments and fundamental research assessments including the return forecasts. The Strategy incorporates data from third parties in its research process but does not make investment decisions based on third-party data alone.
The strategy’s benchmark is the MSCI ACWI (All Country World Index) ex USA Index. The MSCI ACWI ex US Index captures large and mid-cap representation across Developed Markets (DM) countries (excluding the US) and Emerging Markets (EM) countries. The index covers approximately 85% of the global equity opportunity set outside the US. All MSCI indexes and products are trademarks and service marks of MSCI or its subsidiaries.
Factset ® is a registered trademark of Factset Research Systems, Inc.
Terms and Definitions
Return on invested capital (RoIC) is a measure of determining a company’s financial performance. It is calculated as NOPAT/IC; where NOPAT (net operating profit after tax) is (EBIT + Operating Leases Due 1-Yr)*(1-Cash Tax Rate) and IC (invested capital) is Total Debt + Total Equity + Total Unfunded Pension + (Operating Leases Due 1-Yr * 8) – Excess Cash. ROIC calculations presented use LFY (last fiscal year) and exclude financial services.
Free Cash Flow (FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.
Earnings per share (EPS) is a company's net income subtracted by preferred dividends and then divided by the number of common shares it has outstanding.
Return on Incremental Invested Capital (ROIIC) is the profitability or operating efficiency of a company’s marginal invested capital.
Weighted Average Cost of Capital (WACC) is a company's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. It represents the average rate that a company expects to pay to
finance its business.
Competitive Advantage Period (CAP) is the period where a business can earn a return on capital ahead of its cost of capital, generating economic value and all else equal, the longer the CAP, the higher the fair multiple.
Dividend Yield is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.