Weather-proofing

In my last post, I decided it was time to start taking some evasive action in response to increasing signs of impending trouble for more highly-rated growth businesses. I sold off some of my most expensive holdings, converting about a quarter of my portfolio into cash. Since then I’ve been thinking more about what my next move should be.

Not a lot has changed since my last post, though there was news last week from the Fed’s latest monetary policy meeting. This went largely as expected – although there continue to be signs that the US economy is rebounding a bit more quickly and strongly than expected, the Fed is still signalling that it’s going to keep its foot on the gas until it’s clearer the recovery will be sustained. This is probably a sensible course of action given the risks of a post-pandemic slump are more of an immediate concern for the economy than subsequent over-heating and inflation. However, the consequence is that there is some risk that inflation is ultimately more likely and harder to control.

I still believe this will likely take some time to play out and it seems quite possible that ‘long duration’ growth stocks have further left to go if the broader economic recovery loses momentum as feared. However, with valuations already high and inflation expectations and interest rates starting to rise, the medium term reward to risk for investing in the most highly rated growth stars does not seem very appealing to me at this point. I think there is a fairly high chance that there will be better opportunities to reinvest in the future. I’m happy with my decision to sell several of my more highly valued investments earlier this month eg Pinterest, Etsy and Atoss Software. This has left my portfolio composed of stocks where the valuation is more obviously justified and insulated it from the volatility that continues to afflict the high growth part of the market.

Running a large cash position for an extended period doesn’t sit well with me. There is no guarantee of whether and when a big sell-off might come. In the meantime there is an opportunity cost to bear in mind as well as the risk that my patience will be tested at the worse possible moment. So I have been thinking hard about how best to redeploy some of it. My aim has been to find businesses more likely to thrive if inflation expectations and interest rates continue to rise, but without compromising too much on quality. I find this a trickier balance to judge compared to my normal strategy but I have found a few promising opportunities. Some are from my watchlist, some from tweaking my screens to focus more on valuation and others from looking around at other investors for inspiration. I’ve made eight investments to bring my portfolio back to its normal 25, but kept them all small to start with, keeping half of my cash on the sidelines.

I’ve reinvested in IG Group, Burford Capital, Tracsis and London Stock Exchange. The first three are previous investments that currently seem cheap and have recently issued positive trading updates. For LSE I’ve taken advantage of a recent dip in the share price following an adverse reaction to its last results, where it announced higher than expected integration costs for the Refinitiv transaction. I’ve also made new investments in AO Smith, Focus Home Interactive, S&U and Volvere. I’m happier that my portfolio is now better positioned to outperform whatever the weather.

AO Smith

AO Smith is a US manufacturer of water heaters, boilers and water treatment products with a market cap of about £8bn. It has actually been on my watchlist for quite some time, though it has been below the radar due to challenges it has faced over the last couple of years.

Quality

  • Business economics: AO Smith has pretty decent business economics. It’s not actually all that capital intensive and has made consistently decent returns on capital in the high teens and twenties for a number of years. Cash generation is good and operating margins are consistently above 15% which seems pretty good given the nature of the business. Based solely on the numbers it looks like a high quality business but it’s not quite as profitable as some of the others on my watchlist.
  • Track record: AO Smith is very well established and has been making water heaters etc. for decades. Its track record over the last couple has been good with fairly consistent growth in revenues and profits over time, barring a couple of setbacks, unsurprisingly in the Financial Crisis and more recently in the last couple of years as its trading worsened in China. This appears to be largely due to the much reported slowdown in Chinese growth and a particularly strong dollar. These two trends have since reversed.
  • Competitive advantage: AO Smith is a clear market leader in its markets, in particular being the largest supplier of water heaters in its largest market, the US. AO Smith has been clearly established in this position for quite some time and appears to benefit from competitive advantages fairly typical for this sort of business. One is the quality of its products – energy-efficiency is becoming of increasing importance and AO Smith is a leader here. I believe the technical know-how that comes from years of experience and R&D is likely to be very valuable. AO Smith has further reinforced its competitive advantage through the distribution network it has built up over time, across both wholesale and retail. This is particularly strong in the US but it has also well established in important overseas markets such as China and India. These advantages appear to give AO Smith a degree of pricing power, particularly in the US. Overall, I’d say it’s competitive position looks pretty secure.
  • Growth prospects: growth prospects seem decent. While there is not a lot of scope for growth in volumes in the US given AO Smith’s already large market share, there is still scope for driving higher revenues from improving products sold as replacements. However, most of the growth opportunities comes from expanding overseas. AO Smith has already had quite a bit of success in China and India and looks well placed to continue.

Price

Long term this isn’t one of my favourite shares from my watchlist but I think it does seem well-positioned at the moment. After a difficult couple of years momentum has returned. AO Smith has been beating expectations recently as trading conditions have improved across its markets. The share price has been performing strongly and is back near all time highs. The valuation is not all that cheap but AO Smith is clearly a high quality business and would particularly benefit from improving economic conditions and the currency tailwind from a weakening dollar, so I think provides useful diversification for other shares in my portfolio.

Focus Home Interactive

Focus Home Interactive is a fairly small (£290m market cap) French video game publisher. It is publisher of the rather niche cult hit Farming Simulator (a surprisingly popular game which attempts to realistically recreate the tedium of farming) and a wide variety of other second-tier games it publishes in partnership with a variety of independent games developers. I came across it initially when looking into the publishers that were making use of Games Workshop’s IP. My interest was piqued when it also popped up on some of my more value-oriented screens.

I have added it to my watchlist of high quality businesses mostly because I think the video games sector has excellent prospects in general. Focus Home Interactive looks like a good business, though not the highest quality in the sector to be honest. I find Focus particularly attractive at the moment as the valuation doesn’t require much extrapolation into the future to justify.

Quality

  • Business economics: The business model doesn’t require much capital expenditure or R&D. However, Focus does need to pay large cash advances to studios to finance the development of its games. Consequently the cash flow generation can be a bit erratic. This isn’t a problem in itself but it highlights that the business does effectively make risky investments in advance that may or may not pay off depending on the commercial success of the game. There are significant execution risks with this business model. However, so far things have worked out well – Focus has been consistently profitable with returns of capital consistently around 30%.
  • Track record: Focus has been around for about 25 years and listed in 2015. Its has a decent track record of consistent growth in revenues and profits since then. It has launched several successful games and has developed a healthy back catalogue from which it generates the majority of its profits.
  • Competitive advantage: there is a lot of demand for original differentiated video game content. This content is not straightforward to produce. Ownership or part-ownership of this IP through its back catalogue therefore does confer Focus some competitive advantage. However, the value of this IP diminishes fairly rapidly over time and from a more long term perspective Focus faces some competitive risks from its reliance on external development studios. This makes it vulnerable to its best partners being acquired by, or entering into exclusive relationships with, other competing publishers. I’m not sure exactly how much of a risk this is in practice but it is a concern. I would feel more comfortable owning a business that had complete control over the ability to produce the IP itself, all else equal. Focus’s strategy to mitigate this is to vertically integrate with development studios – it recently completed the acquisition of its first studio, Deck13. This seems a very sensible direction to be going in (and is probably inevitable) but in the meantime I’d say that Focus’s long term competitive advantage is a little questionable.
  • Growth prospects: the growth prospects are the main draw. Demand for video games content is growing rapidly and looks set to continue for a long time. Focus has the attraction of having a valuable back catalogue, which gives some certainty in being able to generate continued revenues in the near-term, while also being small enough that striking gold with a newly developed game could really make a big difference.

Price

Momentum is excellent. The pandemic restrictions seem likely to have benefited Focus if anything and it doesn’t seem to have suffered the same extent of disruption as some of its peers. The share price started making progress last year after being fairly stagnant for several years beforehand and is currently consolidating near its highs. The valuation still seems pretty cheap to me given the growth potential though there is clearly some risk.

S&U

S&U is a UK-based provider of motor finance with a market cap of about £250m. A blog post by Lewis Robinson brought it to my attention. This well-written post sets out the investment case better and in more detail than I’m going to (Lewis has even apparently read all the Financial Ombudsman case decisions on the company since 2017). I found it compelling and while I’m not wholly convinced about S&U’s quality, I think it provides some useful diversification for my portfolio. Below is my bird’s eye view according to my normal framework.

Quality

  • Business economics: lending business typically don’t have great economics, given their undifferentiated and commoditised nature means they compete directly on price. One way to generate good returns is with leverage and enough scale to access cheap capital but that obviously comes with other risks. Another is to specialise in lending to riskier customers in a specific niche. There are obviously higher impairment risks but if they are well-managed the lending can generate higher returns. This is what S&U does, resulting in consistently decent returns on capital in the mid-teens.
  • Track record: S&U has a really quite decent track record of consistently growing its revenues and profits, especially over the last ten years. It’s not much to write home about compared to many of the businesses on my watchlist but it does stand out in a sector where its rivals all seem to be constantly getting into trouble for one reason or another and destroying most of their shareholder value over time. The track record is the main thing that keeps me from deploying the barge pole and allows me to consider the merits of its valuation etc.
  • Competitive advantage: the competitive dynamic for financial businesses, like lending and insurance, is a little different to most other businesses. While winning business is just a matter of offering cheaper finance the challenge is to do so without taking on too much impairment risk or resorting to sharp practices, either of which can hurt returns or cause the business to blow up at some later point. Long term competitive advantage consequently comes from better use of data to judge impairment risk and judicious financial management. These are pretty hard aspects to judge but it seems reasonable to infer that the best indicators of competitive advantage would be a consistent long term track record and scale within the relevant competitive niche. S&U seems to score pretty highly on both of these counts.
  • Growth prospects: S&U seems to have decent growth prospects. It has been steadily growing over the medium term up until the pandemic and appears to have plenty of addressable market left to grow into by further growing its market share.

Price

S&U has been affected by the pandemic. Demand for lending has fallen and S&U has made big provisions to account for the risk of an upcoming increase in impairment costs. However, it feels like we can see light at the end of this tunnel now and it looks like S&U is likely emerge in a better position than many of its rivals into a less competitive pricing environment. After falling last March with everything else, the share price has recovered to roughly where it was at the beginning of last year pre-pandemic (though prior to that it had been going through a multi-year consolidation since 2014 despite some healthy growth). The valuation seems cheap provided it doesn’t take too long for S&U to recover to pre-pandemic levels of profitability.

Volvere

Volvere is an interesting business, quite unlike any of my other investments. It is essentially an investment vehicle that invests in small undervalued and distressed businesses and then tries to turn them around before selling them again. I’ve been aware of Volvere for a long time, have been to several investor presentations over the years and many of the other private investors I know have invested. I’ve always seen the attraction but have eschewed it up till now, preferring to stick to my favoured hunting ground in more growth-oriented quality businesses.

Volvere is very small (only £36m market cap). It owns two operating businesses at the moment, Shire Foods (Volvere owns 80%) and Indulgence Patisserie, both in food production. However, most of Volvere’s assets (about £24m) are currently held as cash. With so much of its assets in cash my normal framework for assessing the quality of prospective investments is less relevant. I see an investment in Volvere as essentially a bet on two things: a) that you are getting good value on Volvere’s existing investments and b) more importantly, that Volvere is going to invest the cash pile it is sitting on wisely.

There is not a huge amount of information to go on (at least without some serious digging), but it seems pretty clear regardless that Shire and Indulgence are collectively worth quite a bit more than the £(11-12)m of market capitalisation they account for. Shire was a beneficiary of the pandemic, growing revenues by 18% to £27.2m in 2020 and making £1.6m in profit before tax. Volvere seems to have had quite a bit of success in turning around Shire since it acquired it and its revenues have been consistently growing for several years. Profits have not been growing quite as much but it seems that this is partly due to the costs of imported ingredients being inflated by a weaker pound. This seems promising as the pound has strengthened a lot more recently. Indulgence, which is more geared towards foodservice, has suffered from the pandemic. It is much smaller than Shire with £3.6m in revenues and a loss before tax of £1m in 2020. Of course, Volvere’s business is to ‘turn around’ Indulgence and return it to profitability. I have no idea how successful Volvere will be in doing so and consequently how much Indulgence is worth but it seems that Shire on its own is sufficient to make Volvere’s overall valuation relative to its current assets seem cheap.

Assessing whether Volvere is going to do something useful with its large pile of cash is largely a question of faith in the management. This is not something I typically feel well-equipped to judge, but I am reassured by Volvere’s track record. At least I am very reassured that they are not going to do something stupid, as they have historically been very cautious in making investments. The investments they have made have have tended to be very successful. The risk is more that they are perhaps too cautious and prone to letting their cash pile accumulate dust. This is a risk I am comfortable with. Overall I think this investment gives me some safe diversification from my other investments and the outside chance of some serious upside if they find a great opportunity. The one drawback is possibly that the shares are extremely illiquid so probably suited for a long holding period (but equally this may present an opportunity for small private investors who are prepared to be patient).

1 thought on “Weather-proofing

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s