Ken Wotton and Brendan Gulston look in depth at the year ahead Read more
Ken Wotton and Brendan Gulston - July 2022
Ken Wotton and Brendan Gulston - July 2022
Five rules for resilience amid choppy markets
Stocks are facing a barrage of headwinds – but this is nothing new for UK markets. After Brexit, Covid-19 and the war in Ukraine, investors may be thinking UK equities are forever ill-fated.
We believe now, more than ever, is the time to double down on British businesses. There are many high-quality resilient companies to be obtained for reasonable prices.
Our private equity approach to public markets has proven over the last five years of turmoil that it is possible to find companies that look to be able to pay a sizeable dividend regardless of the macroeconomic environment.
Simply by prioritising certain quality metrics, investors may be able to access strong income streams while reducing their portfolio risk.
Below, we outline five measures to guide investors in selecting stocks that can ride out the storm.
Margins of safety
As a rule, we invest in businesses with high and sustainable margins – our top ten holdings have EBITDA margins of 21%1 on average, and the majority have margins in the double digits.
This creates a cushion allowing businesses to absorb cost inflation and other setbacks caused by the prevailing environment – in addition to powering growth and potentially increasing shareholder returns.
Companies with a competitive advantage or operating in a structurally growing market, which affords them a degree of pricing power, often boost elevated gross and net profit margins.
We also look for companies with inherent operational gearing as they will be able to grow revenue without having to grow costs at the same rate, and this should lead to expanding margins. Meanwhile, strong business fundamentals are critical for ensuring the consistency and sustainability of these elevated margins.
EMIS Group provides a patient management software to GP practices in the UK. Due to its mission critical nature and lack of competitors – as NHS approved suppliers must pass rigorous testing – the company has substantial pricing power and high margins of 30%2.
As a leader in its area, with more than 58% market share in the UK, these margins are on track to expand further.3
Cash is king
Another indicator of resilience is a business’ ability to generate cash.
Cash is important, as it ultimately drives shareholder returns through reinvestment into growth as well as distributions to shareholders.
Asset-light businesses are typically more cash generative, as they do not have to expend capital on physical assets, such as machinery or factories, which often require ongoing repairs and upgrades. More than 80% of our portfolio consists of services or software businesses that have modest capex requirements, and 90% is invested in companies that we consider to be low capital intensity, with a capex-to-sales ratio of less than 10%.4
XPS Pensions Group is an actuarial consultancy with low capex and high cash conversion as a result of being a people business. The technology-led platform is gaining market share in the pensions market, where top-tier firms have failed to invest in technology and services to trustees.
The business should also demonstrate operational gearing, and should continue to grow fast enough for wage inflation not to impact profits.
Low levels of leverage
Investing in companies with net cash positions or little leverage is an indicator that they can continue to grow sustainably – whereas businesses that rely on leverage to grow are inherently higher risk as they have less margin for error when things do not go according to plan
We like companies that are not consuming cash too fast, and growing at breakneck speed, but rather those that are targeting manageable growth, and can continue to reinvest in the business while generating additional cash for shareholders.
On average businesses in our portfolio have a two times dividend cover – or 50% pay-out ratio. This means they are reinvesting 50% of profits into the business and 50% is being returned to shareholders providing a margin of safety to maintain dividend payments even in uncertain economic times.5
This is much easier for asset-light companies, such as antibody licensing business Bioventix, whose value resides in its intellectual property. The business has a net cash balance sheet, and keeps £5mn aside for a rainy day, paying out anything beyond this as a special dividend.
As a result, the company has seen impressive dividend growth over the last five years. A small company with only twelve employees, it reinvests the remainder of profits into R&D.
The quality of a company’s earnings is paramount to surviving turbulent times. It is important to assess both visibility and predictability of future income streams by unpicking a company’s revenue line.
Recurring or repeat revenue is ideal, as opposed to transactional business, which can be less predictable.
However, we can also obtain comfort by examining a company’s customer base and concentration of revenue across particular clients, demographics, sectors and geographies. Diversified revenue streams are important to mitigate unexpected events.
Something else we seek to understand is a company’s cost base capacity.
If, in order to grow, a company needs to add an office or new facility this could represent a material step up in fixed costs, which would reduce cash generation for a period. Therefore, we look for companies with ample capacity in their existing business wherever possible.
Smart Metering Systems (SMS) exemplifies the type of contracted, long-term visible income streams we look for.
Backed by the government’s 2024 target for installing smart meters in every British home and the country’s net-zero aim, we are comfortable the smart meter business can continue to grow over the next five years.
On top of this, SMS revenues are typically generated from inflation-linked contracts, providing further comfort in the current climate.
Management makes it
A high-quality management team can make an enormous difference in a company’s ability to navigate macro headwinds.
For this, we use our judgment, honed over many years of investing, and underpinned by independent references sourced through our extensive network.
Primarily, we look for a track record and a skill set that aligns with the business strategy. Every leader has different qualities, and not every CEO of a previously successful company will be able to navigate the choppy waters ahead. Additionally, alignment of interests is crucial.
The incentive structure should motivate the management team to also meet our expectations as shareholders.
This is an area where we can add value for our investee companies. For instance, we regularly engage with the chair of the Remuneration Committee at companies where we hold a material stake.
We believe it is essential that any long-term incentive plan for the executive team incentivises genuine outperformance in line with attractive shareholder returns, clearly aligns with the business strategy and offers a competitive package to reain top talent and appropriately reward success.
1. as at 31 May 2022
2. Source: Bloomberg
3. Source: EMIS Group plc, 17 March 2022
4. Source: Gresham House, 20 June 2022
5. Source: Gresham House, 20 June 2022
Ken Wotton and Brendan Gulston are Fund Managers for the LF Gresham House UK Multi Cap Income Fund.
All opinions expressed are their own and not necessarily those of Gresham House.
Managing Director, Public Equity
Director, Public Equity
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