Hello and welcome back to the Quality Compound.
It’s been a while since my last piece of writing, so here, I’ll be providing a general update, some market thoughts and an all-important update on trading activity.
A couple of months ago, I decided to halt the subscription service on my Patreon. In all honesty, the subscription business model is difficult to fulfil as a part-time writer. Subscription fees create pressure, even more so when more content is demanded of you than you can produce, resulting in the dreaded unsubscribe notification!
After a year or so of content production, I decided to take a break. Time away from the computer and markets has been great. I have taken up a few new hobbies such as roller blading (I am currently training up for my Hyde Park roller debut!) and recently bought a metal detector (inspired by the Netflix show Pirate Gold on Adak) to start hunting for coins in the local fields. Alas, with the current heatwave, digging an inch below the earth’s dusty surface seems quite the chore. Hopefully the rain will come soon so I can start to cash in on the Anglo-Saxon bounty waiting to be found.
Newly refreshed, I intend to get back to writing more for the website. I have also been writing on a weekly basis for the great publication that is The Armchair Trader. My Armchair Trader articles are somewhat shorter than what you would find on this site. However, they still explore stocks that catch my interest on that given week, with each pick still within the confinement of ‘quality investing’. Spending more time working with the team at The Armchair Trader, I do think it is a great resource for private investors. I particularly like the ‘Three Quick Facts’ updates, which I use as a morning brief on market activity.
Markets and Macro
You could say there is never a dull moment in markets, and this is certainly the case at the moment. Central banks continue to be stuck between roaring inflation metrics and improper tools in the fiscal policy kit to tame what is, really, a supply-side issue. No amount of quantitative tightening can resolve a Chinese zero-Covid-19 policy or prevent Russia from re-directing Ukrainian grain exports back to the motherland. In a piece of recommended reading, Terry Smith aptly discussed the ‘blunt tools’ of interest rate mechanics during his Fundsmith note to investors in July.
Fiscal tightening can, of course, tip us into recession, which is arguably what the markets have been pricing in as of late. You can see this phenomenon playing out with both the Swiss franc and the US dollar strengthening (flight to safety) and the price of copper falling significantly, as waning future industrial output is drawn into concern.
However, it is important to reflect on the fact that the word ‘recession’ carries significant recency bias for many in the market today. The meltdown in 2008 is still pretty fresh in people’s memories, and it is worth considering that not all recessions are made equal. In fact, each recession, and subsequent bear market, is likely to have its own winners and losers. Who would have thought some of the biggest winners from the 2020 bear market would be Winnebago Motor Homes Inc and the online real estate company Zillow.
In some good news, commodity prices seem to be cooling. We know the consumer price index is a lagging indicator, and thus, it will take some time for these lower prices to filter down to the petrol pump and to your favourite no frills cereal. However, commodity prices are only a contributing factor to inflation. Other factors, such as shipping time and labour scarcity, are also driving inflation. You only have to look at Fever-Tree’s latest results to see that there is a severe constraint on labour capacity, which will indeed impact the pricing of finished goods.
Whilst the outlook remains cloudy, share prices have already taken a significant beating. The S&P 500 is still hovering between -18% to -24% from its peak, and the NASDAQ is down -26%. Of course, the notable strength in the dollar will have helped those like myself – a British investor holding dollar denominated stocks. But this pendulum could swing the other way pretty easily, especially if the conservatives can restore some trust in the UK. The FTSE 100 has barely nudged -5%, buoyed by the resurgence of the resource groups. I’d expect GBP weakness to be playing a role in the performance here too, given many of the large FTSE 100 companies earn more in dollar revenue than they do in pounds.
With this current dynamic at play, it can be tempting to follow the money and buy value stocks, such as those on offer in the FTSE 100. I certainly have deliberated upping weightings to tobacco holdings and adding the odd dividend dynamo, such as an insurer. However, given the cheaper valuations (on a relative basis compared to six months ago) of outstanding companies, I think now is the time to double down on quality, locking in some great prices in assets you may not have had the chance to buy previously.
Funnily enough, even once-considered quality growth shares are starting to yield some pretty nice dividends. The last time I looked, Games Workshop (GAW), which is about as good quality as it gets, is now yielding 4%, the same as Unilever plc. The five-year share price return for GAW and Unilever is 436% and -8% respectively. You may not have to sacrifice growth to get a decent dividend check.
Another key attribute to my bias for quality comes from many a lesson learnt in the market, with one such lesson repeating itself in recent weeks. With quality comes conviction. With conviction comes a significant reduction in fear. My first real understanding of this was holding London-listed Network International through a significant drop back in 2019. Waking up to a 30% drop in the share price, I scrambled to the news to find out what had happened. No news had broken. Maybe someone knew something I didn’t? NMC, the Dubai-based operator of private hospitals, had recently been exposed for fraudulent behaviour – could this be the same? Of course, the drop was the result of a meaningless broker downgrade, but with the onset of panic, I sold my entire holding. I didn’t really have a clue as to the health of Network International’s operations – I wasn’t a customer in North Africa and there was scant research available on the business. This lack of conviction ultimately cost me money, as the shares rebounded after the initial broker note lost its potency over time.
I could replace Network International with many value shares or companies exposed to exogenous shocks, the result would, for the most part, be very similar – scrambling for the sell button. But with companies that enjoy favourable market dynamics, secular tailwinds and high returns, a wobble in the share price gives you a nice opportunity to add to your holding, if, and only if, your thesis for buying is not busted.
Speaking of thesis busting, I wanted to start with my only sell from the Family Portfolio over the last couple of months. My big idea for 2022 (set out in Q4 2021) was that the off-price US chains such as TJX (T.K Maxx) and Ross Stores would receive a great windfall from consumers willing to trade down in tough times while also benefitting from snapping up lots of inventory on the cheap, as other stores over-ordered inventory during the pandemic.
Some of this occurred as imagined, with inventory levels at retailers such as Target causing massive problems in Q1 and Q2 2022, as they over ordered and were left lumped with excess goods.
However, remember how I said not all recessions are made equal… Inflation and the cost of living crisis should have created the perfect environment for Ross Stores and the other discounters to clean up. However, on this occasion, the off-price consumer in the US is coming down from a stimulus-induced high, where the prior year they received $1000 checks through the mail to purchase discretionary items like discount clothing. Unfortunately for this consumer segment, typically a low income individual, the ability they now have to spend so ferociously at the discount stores is reduced. Tough comparisons versus the prior year have stacked up against the discounters. As such, growth in 2022 is largely off the cards.
With the above situation at play, I view my initial thesis for buying Ross Stores as broken. Despite its long term quality prospects, I thought it would deliver medium-term gains, which isn’t that likely going forwards. The strong dollar has resulted in less of a loss here than I would have expected, giving a good opportunity to sell.
Source: Earnest Insights
With such a weak pound, I couldn’t bring myself to add to US holdings within the portfolio, given the Family Portfolio probably has 60% US exposure already. Despite this, I saw a good opportunity to top up the holding in Experian, the UK-listed, credit-reporting business. Experian recently reported results ‘in-line with expectations’, which the market seemed to like. Experian is a resilient growth business, providing a ‘sticky’ service to the financial services market. Here is Nick Train commenting on the June activity at Lindsell Train, a shareholder of Experian.
Experian is one of the UK stock market’s biggest companies. It owns an unmatched collection of data on 1.3bn individuals and 166m companies worldwide; data which it can deploy to help its customers grow more quickly at less risk of default or fraud. Experian has grown its sales at a steady 6%pa compound since it listed on the London stock market in 2006 (perhaps not exciting, but pleasingly persistent). Growth this year may slow a bit on that of 2021 but is still forecast to be above that 6% average of the last 16 years. Meanwhile, Experian’s shares are down 17% over the 2nd quarter and 34% year-to-date. I am not complaining. Perhaps the shares had got ahead of themselves in 2021 and the weakness has given us an opportunity to add more to the holding. But Experian is precisely the sort of technology-advantaged company for which UK investors have been clamouring for years and this recent share price setback provides a wonderful opportunity to buy a globally significant growth company on attractive terms.
Latest results show the Experian model is working well. The company has three main geographical elements that it is exposed to – the UK, which is the mature but reliable cash flow provider; North America, which churns out consistent growth; and lastly, its exposure to Latin America, which is the growth supercharger. Combining all three segments, as Nick says, Experian has managed to grow revenues at a steady rate of 6% since 2006. Experian is also a significant US dollar earner, which will prove helpful in the current climate.
My earlier interlude on conviction was not without reason. The next move I made across both portfolios was a swift reaction to market events in one of my favourite companies. This move was in Fever-Tree, the UK-listed premium mixer business. Fever-Tree suffered a profit warning during July. The business has struggled to manage costs, as it grows the business on both sides of the ocean. Labour shortages in the US have crimped Fever-Tree’s ability to get its product on the shelf, and shortages of glass bottles have led to higher costs and reduced margins. The knock-on effect of these issues have reduced Fever-Tree’s final year EBITDA expectations buy some £15 million, which is disappointing, considering the business has already issued guidance on profit margin pressure this year.
But, back to my original thesis. Why do I own Fever-Tree? I certainly don’t own this business in expectation of near-term profits. I view Fever-Tree as a power brand – a brand I believe will be alive and fizzing 50 years from now. That is a bold statement, I agree. However, the great Warren Buffet has suggested a competitive moat can be assured by a company’s ability to withstand a well-capitalised competitor entering the market. Fever-Tree managed to withstand Coca-Cola’s premium mixer gambit, eventually witnessing Coca-Cola pull the posh version of Schweppes off of the market. In the UK, we now have tonic water competition from three to four other brands, as well as supermarket own-brand mixers, yet Fever-Tree UK revenue grew 6% in the last six months to £53.5 million. I see no sign that Fever-Tree’s brand equity is diminishing.
Sticking to my thesis of planning to drink Fever-Tree well into my eventual retirement, one must ask, is management doing the right thing by forsaking short term profits to continue growing Fever-Tree’s brand presence across the globe? In this particular instance, Fever-Tree will be producing bottled tonics here in the UK and shipping these finished goods to the US, where they can be sold at various locations, potentially at a loss. In my view, this is doing whatever it takes to get the brand at eye level with consumers and ensuring a newly acquainted customer has reliable access to the product. If you are to build a brand able to withstand decades of competitive entry, this is what you must do to succeed. On the day of Fever-Tree’s sell off, I used excess cash in both portfolios to add to the holding.
Thank you for reading,