In the latest investment soundbite from Fund Calibre, Bertrand Cliquet, co-manager of the Lazard Global Equity Franchise fund considers what makes a good economic franchise and how market conditions influence the long-term value of a company. With examples from Kate Spade to medical devices and the National Grid, there’s something for every investor.
(Recorded 20 April 2023)
You’ve got a very eclectic mix of companies within the top 10, including a luxury fashion holding company, a firm that makes slot machines in Las Vegas, a high street Pharmacy, eBay, a kidney dialysis company, Japanese security company, Spanish infrastructure firm … what do they all have in common?
Yes, it might seem indeed quite eclectic at first sight, but what they have in common is what we call a source of economic franchise. Our philosophy – and what we want to deliver for investors – is really trying to find a way to minimise the risk of error around forecasting the future earnings and cash flows of our companies. And the benefit of that, in our view, is that it can enable us to be more assertive on valuations. For example, if you have a company where the future’s really uncertain, it might make £10m or £100m profits in the next five years, how do you ascribe a valuation to this? And how do you assess how this compares to the current share price and therefore your investment decision? So, what we are looking for is those companies with a source of economic franchise.
They can be a natural monopoly. For example, Ferrovial S.A. is a Spanish-listed business that owns a network of motorways in North America, so it’s a monopolistic situation with a really robust business.
They can be businesses with scale, where the scale gives them an edge. So, CVS Health Corporation has a large pharmacy benefit management business. They buy in bulk from the big pharma companies on behalf of healthcare plans in the US, and the size and their ability to process this gives them an edge.
You can have network effects. Probably eBay falls into that, where the wider adoption of a product or a service creates some, let’s say, virtuous circles, and these virtuous circles give significant barriers to entry.
They can have brands or switching costs. When you have to think about removing or changing a provider of a service, you have to think about it twice because it’s costly and potentially disruptive to your business and may actually not yield much cost advantage for you.
So, that’s what those companies all have in common. They have this source of economic franchise, which we think will enable us to forecast their cash flows and profits more accurately.
And the second thing they have in common is valuation. We’re convinced that the price investors pay to invest in a company is a crucial success factor or risk.
And we think that those companies have been faced either with disruption from Covid – for example in the case of motorways, where people were not allowed freely to go about their business and therefore are still recovering from a traffic standpoint – or with Tapestry, where the company is in the process of implementing a very deep rationalisation of its value chain management, in order to deliver its product – in the right quantity, at the right time, to the right audience, which means that they won’t have to discount and therefore the margins they get on every single product will be significantly improved.
Out of the 41,000 global stocks you could possibly invest in, how do you go about finding the gems that go into your portfolio?
There is a very thorough filtering process. Our investable universe is composed only of 220 stocks, so it’s a very, very select club of companies. What we look for is companies that have a high degree of financial productivity; we want companies with a high return on capital or consistent returns.
And then we want companies that have exhibited this consistency in profitability over time, even within a tougher economic environment. And what we think that will provide is a range of companies that will really help us defend capital as well, so, not compromising on the upside capture – and, indeed, our upside capture has been around 100% since we started – but also protecting capital on the way down, as we saw in 2022. That’s the first filter.
And then we go much deeper in understanding individual securities’ characteristics. What’s the length of the product cycle? How big are they versus their competitors – which means are they able to generate economies of scales that their competitors might not be able to? Do they have barriers to entry? Is it easy to step into their markets or challenges, in terms of free substitution? I think it’s very important as value investors that we are aware that the world can change, and innovation can introduce a risk of substitution.
You also use behavioural filters in your investment process, how do these help you to manage the fund efficiently?
I think emotion is the big enemy of investors. The last thing you want, when you are entrusted with people’s money, is to have knee-jerk reactions. And having a very strong emphasis on analysis is crucial, and a decision around valuation is important.
The way we build the portfolio – after setting up all these filters – we end up with a set of 220 really interesting franchise businesses, and the premise is very simple; we would be very happy to invest in any of those businesses, provided the valuations were compelling..
And the way we approach the forecasting and valuation of our companies, really relies on two principles.First is being conservative. We’re not the best economists but we do recognise that, although we feel our companies are better protected than most against inflation, they will still be affected. So, on the one hand, we take a conservative stance when it comes to the operations assumptions.
And on the other end in the valuation, there are a set of discount factors that always assumes normalisation in interest rates. Believe me, about 15 months ago, we felt very, very alone in assuming that interest rates would, as they did in the past, convert to a level that was consistent with long-term GDP growth, long-term inflation, and we suggested that investors should discount cash flows at a much higher discount rate than they were used to over the previous 10 years. And I think these two parts, create a high degree of conservatism.
The way we remove the emotion when we build the portfolio is we take this intrinsic value that is built conservatively, we compare it to the share price, and for every single stock, we rank the companies in order of valuation appeal. So, the bigger the gap between our view of intrinsic value and the share price, the bigger the position we want to have in the portfolio. And what that means is a lot of these very good companies, they will be expensive. We simply have to be patient.
Why are you steering clear of the financials, banks and real estate sectors? And does this change at all when value investing is more popular?
We certainly describe ourselves as value investors. We want to buy stocks at a discount to their intrinsic value. But we are not value investors in an index sense. When we look for these franchise companies, let’s say, a bank; well banks have low returns; they have a very, very high degree of financial leverage, and, as we’ve seen recently, I’m afraid, very low switching costs. So, if people want their money back, well, they go elsewhere, and if they can’t get their money back, then the bank has a bigger problem, again, as we’ve recently seen. We’ve never invested in banks because they were structurally unappealing as businesses. Again, if we’re looking for those very forecastable, very high return businesses, they don’t fit the situation.
And if you look at the pattern of the fund performance we’ve had, our performance was very strong in the first half of last year, despite the fact that we didn’t own any of those big value sectors – no banks, no commodities, no oil and gas. And I think that truly speaks to the fact that this is a strategy that has outperformed value indices very consistently, despite the fact that it doesn’t own those classic value sectors.
The advantage of the approach we have, I think, is really not compromising on the upside. So, we’ve been able to not only outperform value indices, but in the long run, even outperform growth indices.
[Main image: pawel-czerwinski-eybM9n4yrpE-unsplash]
