Fundamental analysts spend an inordinate amount of time trying to gauge the magnitude and direction of the future cash flow evolution of a company with detailed projections around revenue, margin and earnings trajectory. Yet over time, the lesson one learns in Mr Market’s ‘hard knocks school of investing’ is that more often than not it is what is not in the spreadsheet that counts.
Our belief has always been that companies exist in an ecosystem, and understanding and analysing that ecosystem gives the best chance of making accurate judgements around the future earnings trajectory. However, with the fast pace of technological disruption changing the landscape and ecosystem in every industry, the work of a long-term investor has become more difficult. The moat for most companies seems a lot leakier than it once did. Take a step back and ask yourself whether it is even possible to imagine what an industry or company will look like ten years from now, let alone try and predict their cash flow and earnings for that time period?
We would posit that analysts buried in spreadsheets would have scarcely had the imagination to predict how Netflix, Amazon, Apple, Facebook and Google would change the world. And they would have been hard pressed to forecast that in one of the best bull markets in history (2009-2018), GE, the largest industrial company in the world and original uninterrupted member of the Dow Jones (for over 120 years), would be a shadow of its former self in just under ten years.
How to benefit from changing times
So how does an active investor capitalise on these changing times?
- Time horizons - Paradoxically, while disruption and uncertainty have increased, the importance of investing with a medium to long-term horizon has never been greater. Albert Einstein called compounding the eighth wonder of the world (‘he who understands it earns it…. he who doesn’t pays it’). Long-term investing gives our money more time to stay invested. This gives greater opportunity for compounding and growth, and reduces the importance of fortuitous timing. From an active investor’s perspective, one must also recognise that the game and its rules have changed; the battle for short-term investing is already lost to algorithms and high-frequency traders. However, these depend on the quality of data inputs and once you extend time horizons, less-frequent data means less ability to make probabilistic judgments and decisions. Hence patience and compounding are your friends over time, and it is only over time that artificial intelligence yields to natural intelligence.
- Play to our human strengths - Creativity and empathy make us human and differentiate us from machines which are generally products of strict rules and instructions. To differentiate ourselves we need to focus more on what makes us unique. Consequently, in our process we find the importance of personal interactions, be they company meetings, site visits or regular interactions with management teams, has only grown. (I have yet to see an AI join us at the table with senior corporate management or at a mine visit - when that happens I will keep you posted!)
- Importance of management - When moats are shrinking at a fast pace, the importance of great management teams only increases. Investing is all about searching for those leaders and sticking with them as they evolve their strategy to fight against growth and economic headwinds with constant innovation. If your choice is right, compounding will again be your friend.
Good management is hard to find
The constituents of what makes a great management team are numerous and constantly evolving. Even though our horizons are long, it is important to observe and evaluate these changes regularly. Below are a few thoughts on things to look out for when judging management teams:
- Culture eats strategy - The Peter Drucker quote ‘culture eats strategy’ captured it all and has proved timeless. Great management teams understand that ‘constant change’ (a necessity in the age of disruption) is not possible without having the right culture in place. However, some leaders have modified this quote to ‘culture breeds strategy’. To give an example, Satya Nadella’s vision for Microsoft was well articulated in his first few ‘emails to employees’ (and well elaborated in his book ‘Hit Refresh’, which is highly recommended). He wanted to re-energise the organisation and make it a tool for employees to achieve their ‘purpose’. In 2015 the organisation changed its mission statement from ‘a computer on every desk and home’ to ‘empower every person and every organisation on the planet to achieve more’. Through meetings with various senior employees and leaders in Microsoft, it became clear to us that these were not just high-sounding statements but were energising and guiding every level in the organisation. As a result, under Nadella’s tenure as CEO, Microsoft has seen its share price grow from $35 to $93 in contrast to the previous ten years when it essentially stayed flat. This mission statement demonstrated that to be successful in the new age, it is essential to have - a) a sense of shared purpose for the entire organisation, b) a recognition that companies must strive (through their products and services) to consciously improve the lives of everyone they impact, and c) a culture which will re-energise and constantly breed innovative ways to win
- Capital allocation and incentives - The ‘holy grail’ of active equity investing is to find an excellent business, trading at a discount to fair value with a management team that allocates capital well. Capital allocation (choosing between reinvesting in the business, buying a competitor or returning capital to shareholders) is by far the most important decision that managers take. How they make those decisions is in no small part driven by the incentives that drive them. We look for incentive structures that promote long-term thinking (in sync with our investment horizon). We also prefer to see more returns-based incentives with metrics tailored to the company/industry, rather than blunt metrics based on growth in earnings per share or total shareholder returns which often incentivise poor M&A activity or are more or less out of management control. Lastly we are fans of high management ownership and avid followers of how insiders treat their stock. A good anecdote to illustrate this is from February 2016, when investors were worried about a global recession and markets were in turmoil. Jamie Dimon of JPMorgan Chase backed up his messages of reassurance by buying $26 million of stock with his own money at $53 a share. As of end of March 2018, with the stock trading at $110, he and all those who followed him, had doubled their investment in two years. Managers who ‘get’ capital allocation are a rare breed; the stocks of the companies they run should be treated as family silver in any portfolio.
- Confidence and paranoia - Strong management teams exhibit a high degree of duality. Nothing captures this better than being confident about your strategy and execution yet consistently paranoid about everything that could impact that equilibrium and throw you off that high horse of success. Most management teams we meet display a high degree of confidence. Paranoia is not often on display and therefore we seek more of it. Put simply, if the management team is always paranoid, investors can sleep more easily. A good example of this was our meetings with Facebook in 2017 which suggested to us that the company and the market were not paranoid enough about privacy issues and the risk of government regulation. Recent events showed that even for a fantastic management team like that at Facebook, a degree of paranoia would have helped.
- Positive difference to the world - Strong management teams try to not lose sight of their raison d’ être - to try and leave their company, customers, employees, and the world in a better place than they found them. This trait is one of the most difficult to evaluate given it is virtually never black and white. Thinking about the long term necessitates that we evaluate company strategy and execution through the lens of their impact on the world. This is an area where active managers can make a positive contribution to the discussion and provide an accurate reflection of investors’ and society’s evolving demands.
Shades of grey
Focusing on this last point, an active manager can incorporate ESG (environmental, social, and governance) ideas into portfolio selection in a number of different ways. Even when the choice seems straightforward, there are many ways management teams can make a positive difference. Here are some examples:
The easy red lines: Tobacco, defence and Russia - My simple view is that strong returns can be generated even when avoiding investing in companies that make products which have a high likelihood of harming people (in spite of tobacco stocks having excellent yield characteristics and defence stocks obviously doing well under regimes that fuel turmoil). However there are occasions when excluding these types of stocks presents a dilemma. Take e-cigarettes - are they good because they can help people stop smoking or are they bad because they are still harmful to people’s health? Research into their effects shed little light on the conundrum (much of it is funded by the tobacco industry) and investment managers are left to make their own minds up in a particularly grey area.
The rule of law within a country and high corporate governance standards within a company - These are extremely important to us. Emerging markets do offer challenges in judging governance standards and require regular and close monitoring and possibly higher margins of safety on the initial investment. The exception is Russia, which strikes us as one market where it is difficult to gauge where the apple falls when it comes to both governance and more importantly the rule of law, making it very difficult to estimate downside risk. Consequently, as a rule, we have so far avoided investing in this market and continue to wait for some positive change before committing investor capital.
Clean fun - Nintendo, Activision Blizzard, E.A., Ubisoft, are all software companies which make popular games like Pokemon, Call of Duty, Battlefield etc. These have been great investments in the past due to the digitisation of the distribution channel (the move from CD/DVD to online downloads) which has led to strong earnings and cash flow growth. With e-sports and the potential for e-gaming their moat also seems strong. Whilst there is little to differentiate these companies on valuations and growth prospects, the one difference is that Nintendo’s games are all clean and family-fun oriented. For the other developers, this holds less true. This view was framed during a site visit to a gaming show and development facility where, while extremely impressed with the creativity and energy on display, we were also very disturbed by the content of some of these successful games. Most successful games and those in development seemed to be some version of armed warfare, sniper or shooting games. While these games are extremely addictive (hence their characteristics of strong pricing power), they also desensitise violence and are not something we would like to see our kids play. We even observed a game under beta development of how to be a crack cocaine dealer. An appraisal of media output, not just in the gaming industry, is something that must be a part of any portfolio manager’s ESG strategy.
Climate change and the ecosystem conundrum - When looking at a fund through the ESG lens, the names which score the worst are often investments in energy or mining companies. Our opinion here is slightly contrarian to current thinking on ESG - our analysis focuses on seeking to understand companies’ place in the ecosystem and the value chain and then looking for the best management teams in that field. Upstream companies are often unfairly tarred with negative ESG marks. We believe in climate change and the negative impact of fossil fuels on our planet. Yet fossil fuels remain at the core of how we power our economies whether they be developed or developing, and will continue to be for some time to come. Reducing (or asking companies to reduce) investments in this area could cause oil shocks which in the past have been big contributors to economic recessions that cause untold misery to the poorer sections of the population, especially in developing economies (and in fact would not be in keeping with the UN 2030 sustainable development goals in terms of reduction of poverty). Oil and its derivatives are present in every part of the value chain of our daily consumption items, from the plastic packaging around anything you buy from your grocer or online to the laptop/iPad that you are may be reading this note on.
The discussion on energy needs to be wholistic and not focus solely on the upstream part of the chain, which we view as part of the solution rather than the core of the problem. Having said that, we absolutely believe that companies need to have a strategy for a world without fossil fuels and a strategy of how to make use of limited resources without causing undue harm to the ecological ecosystem and the communities they work within. Indeed, Shell recently published its Energy Transition report on how it plans to navigate away from fossil fuels over the next 50 years.
For mining companies operating in tough environments the same principles apply - it is difficult to envisage a world today without steel or aluminium or iron ore and the mining companies are extremely important parts of the global industrial value chain. We keep an open mind on investing in these sectors while at the same time maintaining a high degree of engagement with our investee companies on issues of worker safety and security, and environment and ecological management.
Healthcare and the ethical dilemmas - Probably the most fascinating sector with its ethical dilemmas is the healthcare sector. A prominent sell-side research house recently put out a note suggesting that from an investor perspective the best-case scenario is to be invested in chronic-care drugs (i.e. those which, once you are on, you need to take for the rest of your life) rather than drugs that cure (great for the patient). This is for the simple reason that chronic-care drugs guarantee a long-term earnings stream while cure drugs are a one-off treatment which the market does not value highly due to lack of future growth. Gilead’s hepatitis drug is considered a prime example of this. Gilead stock has paradoxically done worse the more patients it has cured, as demand for its products has fallen and is likely to be lower in the future . A classic ESG conundrum for the entire sector, worthy of an engaged debate.
Human touch still has value
Disruption, management quality, pricing power, moats and the societal impact of the companies that we invest in are all issues we are passionate about. The world we live in is complex and appreciating these nuances is one way in which active management can add real value for clients, whether they are aiming to increase returns or do the right thing. Finding a balance between the two is not always easy, especially as investors’ attitudes are constantly evolving. But in world where we are increasingly encouraged to outsource decision making to algorithms, there are still plenty of situations where a human touch can make all the difference.
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