Investing with tailwinds

Fixed interest and equity markets continue to trade at high valuations as a consequence of the extremely loose monetary policies being pursued by all major central banks. Such an environment makes it more difficult to find high quality companies that are trading at attractive long-term valuations. We characterise investment opportunities for quality companies according to a number of differing types. These are:

Beta Effect

All companies in a certain market fall (including high quality ones), giving a generalised investment opportunity. On a global basis the last such opportunity was in 2009 / 2010 post the global financial crisis.

Persistence

This is where companies that durably grow at a moderate rate (so not typically considered ‘growth’ companies) continue to grow at that rate for a very long time and are undervalued as many investors under-appreciate the value of persistent growth through compounding. Unfortunately in today’s low-growth environment even minimal consistent growth is highly sought after by investors making these companies richly valued as a consequence.

Fallen Angel

A high quality company that has come across difficulties in the business but where over time it is likely the company will recover. This type of investment typically relies on arbitraging shorter-term investors who do not have the patience to wait for a recovery. This type of investment can arise in any type of market environment.

Genuine Investment Insight

Situations where a substantial change in the fortunes of the company is envisaged which has not been widely recognised by investors. These tend to be very rare but hugely profitable when successful.

Accordingly with few attractively valued investment opportunities from either the Beta Effect or Persistence, we are left with identifying opportunities that are Fallen Angels, or where we have Genuine Investment Insight that is not widely acknowledged. These tend to be rarer and more difficult to identify than the first two categories. However, in the recent past we have invested in Rolls-Royce and Amex, both of which we believe are Fallen Angels.

Rolls-Royce

Rolls-Royce operates in an industry we know well through our longstanding investment in Safran (another major aero engine manufacturer). The industry itself has become highly consolidated with the next-generation wide-body engines effectively a duopoly that Rolls-Royce share with GE. With increased sole-source positions for engine makers on newer wide-body aircraft, there are tangible signs of meaningfully increased discipline at both airframe integrators (more on this later) as well as engine makers.

The company has had a disappointing few years with poor capital allocation (diversifying into non-core areas) and weak accounting (effectively pulling forward profits from the future) combined with the high upfront development cost of new engines leading to a multitude of profit warnings. However, the underlying aero engine business is very long term with sales today making no contribution to profit.

On a positive note, Rolls-Royce is now taking substantial market share in new aero engines even though these sales are weighing on profits today (one of the reasons behind the profit warnings). However, these sales represent substantial future profits as the engines require regular servicing over their lifetimes. While most investors do not have the patience to wait for this (almost guaranteed) uplift in profitability we believe it represents an excellent long-term opportunity to invest in a high quality company at a very attractive valuation.

In periods where there is a scarcity of investment opportunities in high quality companies (at attractive valuations) another alternative is by investing in average quality companies where we anticipate that over our investment horizon of five years the quality of the company (and possibly the whole industry) is going to rise substantially. Investments benefiting from these tailwinds are also difficult to identify in advance and there are many times when a company or industry promises to improve but subsequently fails to deliver. However, we believe we have identified some of these opportunities in the past couple of years such as in selected US Cable Companies.

Comcast and Time Warner Cable

The cable industry in the US has been considered to be of average (but deteriorating) quality in the recent past as a consequence of changes in the habits of consumers. US Cable companies tend to offer three products: TV (called video in the US), telephony and high speed internet access (broadband). Over the past few years consumers have increasingly baulked at spending $80+ per month on their video subscription when they can build a video package over the internet for c.$20 - $30 per month including Netflix. This has led to declining video subscribers for the cable companies and is recognised in lacklustre revenue growth for most cable companies as video is the highest revenue product for the companies. However, demand for faster broadband continues to grow rapidly and the cable companies have huge incumbent advantages here as the cable is already laid and with software upgrades (Docsis 3.1 being the latest) speeds of up to 1GB/s are possible. In any geographic area there is only one cable provider (it is uneconomic to overbuild cable in a geography where it already exists) so the only competition comes from the telcos. Unfortunately for the telcos, their legacy hardware is twisted copper pair and while there are many ways to increase the speed over this (from DSL through ADSL to GFast) it will never have the capability in terms of speed and capacity of cable.

As a result, the telcos are laying fibre although this is extremely expensive with estimates of the cost per home passed running between $1,000 and $2,000 depending on factors such as whether the cable is trenched, the density of housing, and so on. If the telcos were lucky enough to win a 40% market share in the areas that they put this fibre, then the cost per home subscribed would be between $2,000 and $5,000 (including home connection cost). This compares with cable where the cable is already connected to the house (so the marginal cost is almost zero). Fibre is therefore largely uneconomic and while the telcos have committed to regulators to certain minimum penetration levels it is unlikely that they will roll out fibre widely.

This leaves cable largely a monopoly in the provision of genuinely high speed internet access and over time the cable companies have managed to push prices up to reflect this. As consumers increasingly demand the ability to stream video to multiple devices simultaneously cable will be the only option and will have substantial pricing power. Already broadband generates the most profit at many cable companies as there is minimal associated cost so it is an extremely high margin product for the cable companies. As the impact of declining video subscriptions reduces and the benefit of growing broadband subscriptions and pricing dominates we will see the perceived quality of the cable companies improve in the eyes of investors. This will lead to not only strong growth but also a re-rating as investors increasingly value the qualities of these companies.

These examples above serve to illustrate that despite the difficulty in finding high quality companies trading at attractive prices there are still ways for us to identify investments that match our style (quality bias) and are attractively valued.