← Algy's Investment Podcast
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- [00:00]
A
If you don't take any risk at all, you can't generate decent returns. The best investments in the fund have been businesses where my guest today is Hugh Yarra.
- [00:11]
B
He decided very wisely to set up his own business. The Evenlode asset management business has been a huge success. A lot of people don't understand the power of compounding in the same way as you do to think, okay, 16 years, that fund is more than quadrupled and yet the fund is no more expensive now than it was when you first launched it.
- [00:29]
A
Yeah, it's probably in between quadrupling and quintupling.
- [00:33]
B
That's a great start. Are there any sectors that you just won't invest in?
- [00:37]
A
It's amazing how many undervalued, good quality companies there are hiding in the gaps between the oil and mining stocks of the UK market.
- [00:46]
B
Fascinating.
- [00:46]
A
These businesses can grow double digits, but what I would say is that people do get bored of these companies and move on. What we've said is we're going to define our pool that we're fishing in using the criteria that I've described. The market is a weighing machine. In the long term, it's a voting machine. In the short term, get rich slowly strategy, as we say.
- [01:06]
B
Would Warren Buffett love or hate your fund? Well, welcome to Algiers investment podcast and my guest today is Hugh Yarrow, someone who I've known for, you know, maybe two decades now. Hugh used to work at Rathburns many years ago, where he cut his teeth working on the Rathburn's Income fund with Carl Stick. And then we tried tempting to come to Jupiter to be the succession plan for Tony Knapp when he retired, but he wouldn't have it and he decided very wisely to set up his own business. And the Evenlode asset management business has been a huge success. And Hugh, thank you for coming today and talking about one specific fund, which is the fund that you have always run, which is the Evenlode Income fund. So, anyway, welcome.
- [01:59]
A
Thank you very much for having me on. Delighted to be here.
- [02:01]
B
Well, of course, the first question I've got to ask you, Hugh, is we always like to interview managers at a time when we think the markets are most interesting for that particular investment style, which might be either in or out of fashion. And yours has been out of fashion for a few years now, which is why it really piqued my interest. So I'm going to start off so that our investors and listeners get an insight as to what you do by asking what your investment philosophy is behind the strategy?
- [02:34]
A
Well, if you go right back to basics, the way we think of a share is a fractional piece of a business. And the basic algorithm as we see it is if you own a piece of a business, you get the long term free cash flow from that company and some of that comes back to you as a dividend. So we have this concept of the total fundamental return, or the fundamental algorithm, which is the dividend you're paid over the holding period plus the growth in. You can look at it in terms of per share earnings or per share free cash flow over time. So just to give you a really simple example, if your dividend yield is 3% and your per share free cash flow growth is 8% per annum, your total fundamental return over your holding period would be 11%. Now, in very short periods of time, valuation moves things around a lot. As I say, share prices wobble around a lot in the short term. But ultimately, as Ben Graham said, the market is a weighing machine in the long term, it's a voting machine in the short term. So if the companies deliver those dividends and that growth in free cash flow over time, then that will increasingly, the longer you hold a stock for, the more your total return will tend towards that fundamental algorithm. And you may have heard of the rule of 72, which is you take your annual compound rate, you divide it by 72 and that's roughly the length of time that it would take you to double an investment. So if you look at the UK equity market since say 1900, it's generally returned 7.5% to 8%. Now we're looking to deliver compound returns over the very long term at a double digit rate from relatively low risk equities. And we can talk about the sorts of businesses we're looking for. At 8%, you're doubling every nine years. At 10% to 12%, you're doubling more like every six to seven years. And you know, it's a get rich slowly strategy, as we say, but we are happy to be patient and invest in that way through cycle.
- [04:48]
B
Well, I think you answered my second question because I was about to ask you what your investment mantra was. But it is get rich slowly, isn't it?
- [04:55]
A
I mean, it's a good one. That is, it's not the most exciting, sexy approach, but we do call it a get rich slowly approach. I think another way that I'd put it is that ultimately business fundamentals matter long term. And the other point is that you will often find the stock market is a very emotional world. We are all humans and emotional and actually machines can follow momentum trends too. And we've found that you can take a very stable company where the intrinsic value is compounding at quite a steady rate. But it's incredible how volatile the share price can be over time. So buying good compounding businesses, but crucially, when they look good value is really our approach and our mantra, I suppose.
- [05:44]
B
And can you give me a thumbnail sketch then as to how you and the team run the money?
- [05:52]
A
Yes. So we're looking for a certain type of company which perhaps we can unpack later. But it's basically businesses that have, in our view, durable competitive advantages and crucially generate high returns on invested capital and very specifically are able to grow in a capital efficient way, which is another way of return on invested capital is effectively a shorthand for that. Now there's lots of other things we're interested in in terms of cash conversion, capital intensity, et cetera, but crudely, the way we approach research is we think of it from a quantitative and a qualitative perspective, and apologies for the jargon, quantitative analysis is almost all historic looking. So we have our own investment platform that we call Eddie, and we build a model of a company that will go back for 20, 25 years if we've got the data to do that. And that's basically looking at a business through the sort of even load lens, trying to answer the question, has this been a good cash compounding franchise in the past that doesn't take up most of our time. Most of our time is on the qualitative side. This is the forward looking bit and it can be informed by data. But you're trying to answer the question, there's no perfect business, but you're trying to answer the question, how confident are we that this franchise and the microeconomics it has will persist into the future? And for that we do a large range of qualitative work, partly talking to management teams. We like talking to sell side analysts. They're very good on the, you get to know the ones you like, but they're also very good on talking to other market participants. We always like to hear the bear case on a company. If we're thinking of investing it, do we fully understand that and are we comfortable with those narratives, those arguments, et cetera? And we also do a lot of expert calls. So talking to people that have worked at the company or sector peers, technology analysts, et cetera, which we find that whole body of research really helps you build up a sort of 360 degree perspective on a company. That gives us an investable universe of companies that have the criteria that we're looking for. We then select a portfolio of 30 to 40 companies from that universe of about 80. And then obviously there's the sort of portfolio construction and management that we do over time. And we are long term investors, but we do evolve the portfolio over time. We call it nudging the portfolio over time. So we don't just buy and hold forever, but typically our long term, our holding periods are pretty long term in terms of the number of years.
- [08:38]
B
And when you nudge the portfolio, is that as a result of market volatility or because you're making strategic changes to underlying holdings?
- [08:49]
A
It can be both. The way I put it is we're nudging at the increment. We're nudging and recycling capital towards the areas of the portfolio where we've got the highest conviction in both the quality and growth prospects of the business, but crucially also the valuation. So sometimes we will just make decisions for valuation reasons. Often there's a bit of both because it's always what else is there? What's the opportunity cost of holding this versus other things?
- [09:19]
B
And does your investment style work?
- [09:22]
A
In all seasons, the fundamentals have proved to be very resilient through time. The algorithm that we've seen is typically a dividend yield of about 3% and then the per share earnings and free cash flow growth. We typically expect it, certainly in the fairly choppy economic world of the last few years, to grow at the top end of the 5 to 10% range. And that's what we've been seeing over the last few years. I mean, the earnings growth for the fund was 9% last year. It's currently forecast to be 10%. I mean, we actually think in better economic conditions, both in the UK and globally, you know, these businesses can grow double digits, but the top end of a 5 to 10% sort of earnings profile is, is, is what we're looking for. But what I would say is that these sorts of businesses fall in and out of fashion. And we've been running this strategy for a bit over 16 years now. And when we launched the strategy in October 2009, it does actually remind me quite a lot of today, a lot of the quality franchises that we invest in. Quality businesses were not what the market wanted at the time, as I'm sure you remember. There was what was called at the time a dash to trash in the 2009 rally. And a lot of the businesses in our investable universe were very good value and we look at, I'm sure we'll come on to this, a concept called free cash flow yield is one of the ways we approach valuation. And back then the portfolio was on a free cash flow yield of six and a half percent or so, which we think is very compelling for the types of businesses that we invest in. You then got a period during the 2010s, particularly the late 2010s, when those sorts of companies did become a lot more fashionable. And while we were managing valuation within our universe, as we were saying to clients at the time, when we soft closed the strategy in 2008, we don't expect the returns to be as high as they have been since 2009, the free cash flow yield probably got down into the low fours. What you've seen over the last five years as the sorts of quality businesses we invest in, and I'm generalizing here, but overall the opportunity set is very broad within our investable universe. And the portfolio's valuation is back to where it was in October 2009 almost exactly. It's actually lower than it was at the bottom of the COVID market, which is a pretty incredible place to have ended up in what's obviously been a very strong bull market over the last five years. And I think there are reasons for that. And I mean, just very briefly, two of them are there's been this very strong trade that's actually dominated the UK market in sort of asset intensive cyclicals in terms of financials and resources stocks. And then in the global context there's been this phenomenal trade that's actually been going on for more than 15 years in U.S. technology shares, which has morphed into a specific trade on AI infrastructure, CapEx. So those are the sort of two areas that investors have really been looking for exposure. And I think the companies that we look at have just not been what people want at this point in time. And that's led to this very significant derating in what's actually been overall a very strong market.
- [12:59]
B
So this is a derating of what you would call a quality growth investment style. Would that be fair as a book cover?
- [13:10]
A
With an important caveat that we have a valuation discipline. But I think clients have said we follow a sort of quality at a reasonable price approach. I mean, I might say more specifically we're investing in durable businesses with durable competitive advantages that can grow in a capital efficient way. And I can talk more about why that's a very appealing way to invest long term, if that's of interest.
- [13:43]
B
So just before we do that. Could you just concentrate what you've been saying and try and highlight to me maybe four characteristics which are typical of the DNA of the companies you invest in.
- [13:58]
A
Yes. Well, I mean the first one would be a very dry technical one which is the businesses all have high returns on invested capital and a low capital intensity. And the reason we like that going back to income and growth approach is that if you've got a low capital intensity, so there, I mean your capital investment levels to cash flow each year alone that you've got a lot of free cash flow. So these businesses convert the earnings yield and the free cash flow yield will be very similar.
- [14:30]
B
They don't suck up an awful lot of capital for fixed asset investment.
- [14:35]
A
Yeah. And they can have, they can be very, very much business models that operate in the physical world. So you know, we invest in niche engineering companies or businesses like Howden Joinery and you can walk around a factory and they've got own lots of big machines. But the point is that the profit that they make or the cash profit that they make relative to their asset base is high. And then this comes on to the second point in terms of your DNA question. It's like, well, why is that the case? And you tend to find that if it's sustainable then the business owns certain assets. They're often intangible assets that make it very hard for a competitor to replicate that company if they're starting up, for instance. So it's normally quite a complex network of what you might call intangible assets. So it's things like the brands that have built up over time, customer loyalty, switching costs, network effects, distribution networks, the R and D expertise. An organization builds up over time, I mean increasingly in a digital world. And this is very relevant for generative AI. Proprietary data we think is a very important part of the durable competitive advantage if you have a digital business model. So that's something that we spend a lot of time analyzing. I suppose a third point would be you want the company management to be a good capital allocator, but also you do want good avenues for growth. So these businesses don't need to be phenomenal growth companies, but you want to see some growth over time. A fourth one, which we find a lot of the holdings have is, is almost thinking about customer psychology. And again this comes to why are the economics of these businesses good? And typically we'll find, you know, whether it's a repeat purchase, low cost consumer brand or actually most of the businesses in the portfolio sort of 80% or so are business to business franchises, whether it's a sort of a niche engineer, etc. The customers are buying something that's very mission critical and important to them, but it doesn't cost much relative to the overall cost of the ecosystem. So rotork is a really good example which is the market leader in actuation. So very niche, but it moves actuators, move big valves or small valves in industrial facilities, desalination plants, power plants, refineries, etc. And if you're the procurement officer of that plant, you really want a rotor actuator because it always works. And if you've got a health and safety issue or everything needs to be precisely in the right place at the right time, you don't buy the Chinese competitor that prices below them because of the reputation that Rovetalk have got for quality, but also the after service that that business has in the distribution network. And that leads to pricing power, which helps with all of those economics.
- [17:37]
B
And so we move now onto portfolio construction. How do you put together a portfolio that gives investors enough upside return but not a ridiculous amount of individual stock or sector risk?
- [17:55]
A
Well, it is a get rich slowly strategy. So as I said, the returns we're aiming for are double digit and better than long term market averages. But as an equity strategy, the sorts of businesses we're investing in are inherently low risk in nature relative to the average equity. They're good businesses. As I've been discussing, there's also a lot of repeat purchase cash flow in the portfolio. Many of these businesses have aspects of the economic sensitivity is not huge for a lot of these companies. We will invest in more cyclical businesses, but it's never been big part of the portfolio. The leverage levels tend to be low. So if you can generate a high return on invested capital, you don't need to use a lot of leverage.
- [18:45]
B
So they haven't got a lot of
- [18:46]
A
borrowings, debt and also total leverage in terms of the assets to liabilities ratio. So they are quite low risk. And so to your point, you know you would expect them to have a low return because if they're priced appropriately then they're low risk. So they should have a lower return than a high risk business. I suppose that's where the valuation discipline comes in. I think this is a bit technical, but I think it's something that's very important in equity investing. Going back to this return on invested capital. If you do a discounted cash flow of two companies and they have exactly the same growth rate, let's say 7% per annum, but the incremental reinvestment rate on the 1st is, let's say 20% in terms of the incremental return on invested capital it gets, and the other one's 10% to get them on the same fair value. To capture the appropriate fair value for both of those streams of free cash flow longer term, the high return on capital business should trade on a price to earnings multiple of nearly twice the low return on invested capital business. And I think this is one of the reasons quality as a factor has been quite persistent in markets over time. Because they rarely get perhaps in the Nifty 50 in the 70s, but they rarely get on high enough multiples to justify the long term free cash flow that you should get out of them. So people do get bored of these companies and move on. And that's definitely what you've seen over the last two years.
- [20:26]
B
And yet, I mean, just to give a little bit of a teaser to listeners, what has your fund generated as a return since it launched?
- [20:41]
A
So it's been about 10% per annum after fees.
- [20:44]
B
I've never mentioned that. But what about the absolute performance long term? But if you compound that out 400%.
- [20:57]
A
Yes, it would be, yeah, it would have more than quadrupled.
- [21:02]
B
More than quadruple over time. I think that's really important because a lot of people don't understand the power of compounding in the same way as you do. And actually to think, okay, 16 years that funds is more than quadrupled. Okay. And I really understand it. And yet the fund is no more expensive now than it was when you first launched it.
- [21:21]
A
Yeah, yeah, it's probably in between quadrupling and quintupling.
- [21:26]
B
Okay.
- [21:27]
A
From these slightly boring businesses. And to your point, the valuations are a rock bottom at the moment. They're back to where they were coming out of the great financial crisis.
- [21:37]
B
You see, this is why I find it so interesting. And in terms of the risk reward at portfolio level, do you really need 35 stocks, how much diversification do you really need and how much of your portfolio is padding?
- [21:56]
A
Well, we like to have a decent diversification by end market. And so having a list, I think arguably 25 to 30 companies in a portfolio is enough to meaningfully reduce idiosyncratic risk. And I think we have been down perhaps at 29. Holdings is the most focused we've been, but we've also been up at 40 and sometimes it just feels like it makes sense to broaden out the portfolio. I think about there's our investable universe. But there's also the pipeline of potential ideas to add and I think of it as tools hanging up in a shed. Each of those potential holdings or holdings is a tool that you might need at a certain point in the market cycle. And sometimes I think it does make sense to broaden out portfolio a bit more. I mean another point I'd make is that there are some companies, it might be because they're smaller in terms of market capitalization, it might be they're more focused, it might be that they're more cyclical where we'll have, we set maximum position sizes based on the various risks of each business. And so if you've got more of those, where there's a smaller maximum position size, you probably want a bit more room to have a few more names.
- [23:12]
B
What's the smallest company you've got in your portfolio in terms of its market capitalization?
- [23:16]
A
Well, the way that I describe the whole strategy is that it is a multi cap strategy. So these are an excellent list of I'll fly my Union Jack British based British headquartered market leaders. Some of them are domestic market leaders but actually most of them are global market leaders. The strategy is reasonably big, so we manage liquidity carefully. But it is very much a multi cap strategy. And the minimum size we'll look at is about 500 million. In terms of market capitalization that would mean a 1% position would be 20 million which would represent about 4% of the outstanding shares of the company if it was half billion market cap. But the vast majority are 1 to 5 billion plus.
- [24:05]
B
And are there any sectors that you just won't invest in?
- [24:10]
A
Yes, some of the sectors have performed best over the last particularly two years, but more generally the last five years and that's because of our process. So if you think about the asset intensive businesses and actually they're a very big part, they were a big part of the UK market in 2020 and they've become an even bigger part. But there are subsectors of financials that have too low a return on assets to meet our criteria. So that would include banks, insurers and also real estate investment trusts. And then the other key one would be resources companies. So both oil and mining producers in terms of the businesses that are actually getting the stuff out of the ground. I mean we'll invest in the picks and shovels names, weird groups. An example that sells slurry pumps, very, very strong market leader. But that has absolutely all the economic characteristics that we, that we, that we like. Now with those asset intensive businesses we've Never said that they aren't necessarily good businesses or good investments. What we've said is we, we're going to define our pool that we're fishing in using the criteria that I've described. And we'll do that through cycle to capture that long term compound effect. And if you'd like to join us on that journey, we'd love you to be on it. And the water's quite warm, but, but, but, but, yeah, there are certain types of businesses we won't have in the portfolio and if you want exposure to those businesses, there are lots of other approaches that will give you exposure to that.
- [25:42]
B
Okay, that makes a lot of sense. And then how scalable is your strategy? You've got to save a couple of billion pounds in your fund. Some people would say that's an enormous amount of money, but in my experience, £2 billion for a strategy is not enormous at all. Do you find you still have the flexibility that you had 16 years ago today?
- [26:07]
A
Yes, I think, I mean it's been between sort of roughly 2 and 3 billion for the last decade or so. And it's a very liquid portfolio, effectively. I mean, we do have some holdings, as I said, that are down the market cap scale towards a billion or even slightly under, but it's effectively a very liquid strategy. That means that we can change the portfolio as we want, as you want.
- [26:33]
B
And then to what extent do you look at the downside? You're looking to buy a stock, you've done the research, it's on the bench as a potential investment. What should the downside versus upside ratio be for you, for the team to say, do you know what we really need to inject this stock into our portfolio?
- [27:00]
A
Yes, I mean, downside risk and the management of that is very much a key part of our process. And I think of it from the perspective of margin of safety. So you've got the fundamental margin of safety and we've been talking a lot about that. Does this business have a very good business model and good economics and does it generate bucket loads of cash? That's always helpful. Then there's valuation, of course, and you can get downside if you have a stock on a high rating that goes back to a lower rating. Clearly if the compounding continues and you continue to hold that business, then that's not necessarily an issue over the longer term. I think where we've had the biggest issues, where basically you get a deterioration in free cash flow probably combined with the derating and particularly if there's some debt involved, that's not helpful either. But I mean you're going to get, you're going to get investments wrong. This is a game of probabilities or a discipline of probabilities. I think our hit rate has been sort of 65% on average and that's in terms of investment episodes and whether they've outperformed the market or not. I mean the worst performance we've had in a holding was actually WPP which was down 40% during our holding period in terms of percentage terms. So generally because of some of the qualities of the businesses and the fact we're managing valuation when there is downside, there's a degree to which it's limited. But to your earlier point, if you don't take any risk at all, then you can't generate decent returns. So it's always trying to optimize between going back to the quality and the growth prospects of a business. But crucially with that valuation discipline as well. And really the best investments in the fund have been businesses where you've had the double dip. So you've bought them, they're very good businesses, but you've bought them when the market really doesn't like them and therefore they're trading at depressed valuations. And if you hold them for a long period of time and they come back into fashion, then that can be very powerful from a compounding perspective.
- [29:21]
B
And just so I understand that number you gave me, is it that 65% of your purchases have been money making
- [29:34]
A
stocks that have outperformed the market. Outperformed the market over the holding period? Yeah.
- [29:40]
B
And that's a great stat.
- [29:43]
A
Well, we would like it to go up over time. You are always trying to learn and I mean our approach hasn't changed in terms of the guardrails of our approach over the last 16 years. But clearly there's always room to improve your tennis stroke or your golf swing. And the execution is something that we think about a lot.
- [30:07]
B
And how do you avoid group thinking and being over processed?
- [30:15]
A
Very good questions. Well, let's take over processed first. And this is something we talk about a lot and I've noticed that in an asset management business I've only worked in two, but the temptation is to add process. But actually sometimes you need to strip things away and I think you need to know enough in our business you're never going to know every single thing about a company as the Pareto principle. In a way you can spend 20% of the time knowing 80% of the things. And there is a danger if you spend too long on researching a business that you have the sunk cost fallacy, where you feel like you know it so well and you've done so much research on it that you couldn't possibly exit it from portfolio. So I think just having a culture where you discuss these things is important. I think there's also a culture where you not just what can we add to make things better, but what should we take away? Because going back to the guardrails, you need some basic guardrails. But then within that, we're humans using a lot of technology to try and make good decisions over time and sometimes it makes sense to move quickly. And there's been periods in the markets after Brexit or during COVID or actually in 2022, there was a big sell off in a lot of very high quality UK listed businesses where it makes sense to, to really make some changes. I think another thing that we do, and I'm not saying this is the right way to do it, but I think we find it's helpful is there's not an individual ownership of a stock in a portfolio because we think that that can lead to a sense of loss, personal loss, if your stock algae is taken out of the portfolio and we do blank sheet exercises where you're building the portfolio from scratch. And I think the N charging helps as well because as I was saying, it's sometimes about valuation, but it's also about, it's about how much conviction you've got in terms of the fundamentals. And there's this phrase, the French exit. I think the US call it the Irish goodbye, where you leave a party without saying goodbye out the back door. And I think going back to that sunk cost fallacy, I think that can help if you exit a position incrementally as your conviction in it lessens over time. So it's something we think about, you're never going to get it perfectly. That was the second question.
- [32:55]
B
I think the second question was about group thinking.
- [33:02]
A
Yes, I think it's very helpful to. I mean, I think the atmosphere we try and encourage is an atmosphere of trust, but also openness and willingness to ask the difficult questions and challenge. So you're trying to get that right. But I think also the expert calls, you do the conversations with the sell side about the bear cases on the stock. I think those are all very helpful ways of surfacing the issues that you absolutely need to take seriously in an investment case.
- [33:41]
B
And just moving on to portfolio valuation, I've been wanting to ask this question all day. What PE is the Portfolio on what price earnings ratio is the portfolio currently
- [33:55]
A
on 15 times next 12 months?
- [34:00]
B
15 times the next 12 months?
- [34:02]
A
Yeah. A bit over 16, kind of current. Slightly over 16, yeah.
- [34:08]
B
And how does that relate to history?
- [34:11]
A
It's low.
- [34:12]
B
Good.
- [34:13]
A
Yeah. And I mean, I think of it from a free cash flow yield perspective, but actually, if you invert the price earnings ratio, you get the earnings yield and the earnings yield would be very similar to the free cash flow yield. So the free cash flow yield on the portfolio, I think it's 6.4% this year. It's forecast to be 7 next year.
- [34:33]
B
7 next year. And of course, free cash flow is really a better number than profit, isn't it? Because it genuinely is the cash that the business throws off that it can either spend or buy back shares or pay as dividends.
- [34:50]
A
Well, how long do you want to spend on this? But no, I think we look at free cash flow as the sort of. It's an incredibly important metric because it's a measure of quality. And if you look at the free cash flow yield, the valuation appeal, we do look at earnings as well. And you can look at adjusted earnings and you can look at GAAP earnings, and all of those measures are important in terms of building the picture of a business's fundamentals. But yes, I mean, free cash flow is what's genuinely left over for shareholders is cash. What's left in the till at the end of the year. If you were running a shop, say, what's genuinely excess that you can take out and it wouldn't harm the franchise long term. And some of the key differences between free cash flow and earnings are it sort of takes out the effect of any accounting shenanigans. So if you have aggressive revenue, accrual, etc. But there's also the capital investments you make in the business each year, both working capital investment, so where you're buying inventory, but also capital investment on machinery, factories, buildings, et cetera, which in the earnings account are depreciated over time. And obviously there's a big debate on this in the AI world with the chips and what time they should be depreciated over. The great thing about free cash flow is it factors all of that in, it's the cash profit. So you take your operating cash flow, you take the expenses, cash expenses off, interest costs off, working capital investment tax, and then you also take capital investment now. And if you're Buffett, you. Then you don't just think about the capital investment, you look at the maintenance capital investment, which might be different to what the actual accounting depreciation is, which is the genuine amount you need to spend to keep this franchise healthy and growing. And then you look at the growth capital investment, which is what sort of extra expansion might you be doing. And for Buffett, he called the free cash flow after maintenance capital expenditure, the owner earnings yield, which you may hear
- [37:10]
B
talking, I do remember him talking about that.
- [37:13]
A
And that's what that is. So then you've got your free cash flow and then there's basically four things that you can do do with that. This is the shareholder, it's the shareholders cash flow to do algae. What would you like to do with this cash flow for your share in this piece of the company? So you can pay a dividend. You can then pay down debt so the debt level comes down. You can also make acquisitions so you could make a bolt on acquisition in a particular division or particular area of your company to expand what you're doing and then you can buy back shares. So those are effectively the four uses of free cash flow. And it's a very good structure to think about a business and a portfolio.
- [37:57]
B
And how much has the dividend on the fund grown since you launched it? What dividend yield would I now be getting as a day one investor in your strategy today?
- [38:16]
A
Close to 8%. So the average dividend growth has actually been lower than the free cash flow and the earnings growth. So I talked about that growth being more in the high single digit range. It's averaged about 4 1/2 percent. I think CPI inflation's been about 3%. Now I think we can talk about this a bit more in the context of the UK market. But I think there's been a very strong culture of dividends in Britain over the decades and arguably centuries. And I think it is a healthy discipline to pay a dividend. But I think it's fair to say that the dividends, particularly coming into the 2010s and the pre Covid period, the payout ratio on the UK market did get too high. I think the 2000 and tens, it was a low inflation period. Companies, perhaps their growth rates weren't as strong as they were pre the great financial crisis, but perhaps the dividend growth sort of carried on for a while and that brought the payout ratios up. So what we've seen is that the dividend growth, particularly post Covid, has been, it's there, but it's not been as high as the earnings and free cash flow growth. And I think businesses have used the extra cash flow that they've had to partly pay down debt. But also crucially, we've seen a very big inflection and increase in share buybacks. And I think that's partly about the change in the shareholder register in the uk, but I also think that a very large part of it is you've got this dynamic in the UK market, which is a deeply unfashionable backwater of global markets. If you peel away the top few sort of banks, resources, et cetera, over the last two or three years. And I think the valuations are very compelling, but the free cash flow is very strong. So we're seeing 80% of the holdings in the portfolio buying back shares.
- [40:20]
B
80%?
- [40:21]
A
80%, yeah.
- [40:22]
B
That's very healthy.
- [40:23]
A
And if you look at the buyback yield, so you can take the dividend yield, which is how much dividend if you invest 100 pounds, if the dividend yields 3%, you get 3 pounds back as a dividend. This year, the buyback yield is how much of the shares in issue is each company or the portfolio buying back currently on an annual basis. So if we look on a 12 month trailing basis, the buyback yield is at 2%. But there's been a lot of announcements this year with pickups in buybacks, reflecting this dynamic of very good valuations and lots of excess cash flow. So that's. Now I think that will probably head up to 3%.
- [41:08]
B
And have the companies in your portfolio got the discipline to ensure they don't buy back their shares at ridiculously high prices? Because it does sound to me as though they've been quite canny about doing it now.
- [41:19]
A
Yes, I think that we don't always support buybacks. I mean, from a technical perspective, if a business is buying back shares above its intrinsic value, then they shouldn't really be doing that. They should return the cash to us in a different form so that we can invest it somewhere else to generate a better return on capital. But I think you've got this dynamic in the UK markets at the moment, where there is such broad based valuation appeal that we are supportive of that trend. And particularly because I think the flow trends in the UK market have been very, very challenging. You've effectively had most of the domestic investor base leave the UK market over the last 25 years. That process is largely done certainly from an institutional perspective, in terms of the pension insurance funds. I think the wealth management sector. When I started at Rathbones in 2002, most wealth managers would have had 45 to 50% in UK equities. That's now down to more like 15 to 25% on average. But that has been a big Trend in the UK market over the last 20 years, but particularly in the last decade where it's accelerated. So I think one of the biggest buyers, because for every share that's sold you need a buyer. One of the biggest buyers has been the companies themselves in recent years.
- [42:47]
B
So asking a question a different way, would Warren Buffett love or hate your fund even though it's got no Apple and no Coca Cola?
- [43:02]
A
Well, I certainly hope Buffett would approve. We are buying businesses with durable competitive advantages and high returns on invested capital with a valuation discipline and applying that approach in the context of the UK market.
- [43:22]
B
Very good answer. And if your strategy remained out of favor for the next three years, that's an incredibly depressing assumption. But if that did happen, all investors got was a 3% dividend yield. Looking at the underlying fundamentals of your, of your portfolio, just for our listeners, what would the, the price earnings ratio of your portfolio come down to in three years time?
- [43:55]
A
Well, it would be getting down to 11 times based on the growth that we've been seeing recently.
- [44:01]
B
Yeah, I just found it's really interesting because the 3% actually is paying people to be patient. But the upside from that portfolio of stocks when the market does and may be beginning to realize the value which is to be unlocked is very exciting. Let's move on to performance and return expectations just for a second. How does the portfolio get on in a rising interest rate environment? Because for many of the years that you've run the strategy, we've been living in a sort of zero interest rate world. Now that's changed. How should the strategy perform in a rising or slightly elevated interest rate world to the one we've been used to?
- [44:53]
A
Well, I think that change in interest rates, both interest rates going to almost nothing in the late 2000 and tens and then the very sharp rise back to much more normal levels. By the way, I mean, if you look at UK interest rates since the bank of England was founded in 1694, they've averaged 4 to 5%. But it's the extreme move, I think, that has had a significant impact on the valuation of these sorts of quality franchises. I think that's been a very key factor and you can, you can think of it in a very simple way. I mean they get called bond proxies, right, some of these businesses. But if you can only get half a percent in bank interest for your savings, or if you buy a UK gilt and it only pays you half a percent or 1%, which was the case in the late 2010s the attractions of a stock paying a dividend yield of 3 that is also a real asset and can grow in real terms over time, was very attractive. There was this phrase, Tina, there is no alternative. And that applied, you could argue, to the whole equity market to some degree. So clearly the other point with these quality businesses, as I've said, is that they should technically trade on a higher price earnings multiple and a lower free cash flow because of the way that the return on invested capital works in terms of the compounding of the free cash flow. But that does mean that your overall calculation of intrinsic value, there's more free cash flow in the out years, if you like, in years 5 to 15 or 10 to 20. So when interest rates go up, the sort of discount rate that people use in their valuations goes up and that reduces the value of those cash flows sort of 15 or 20 years out. So you'd call those assets long duration assets. But what's incredible about how far this narrative has now come is, is that going back to the portfolio's free cash flow yield at 6.5%, that's more than the UK market. So it's a cheaper portfolio than the UK market. It's also more than twice the free cash flow yield of the global, the MSCI global market. So these businesses are now shorter duration assets, despite their qualities. They're actually you're getting more cash today from these businesses than you are from businesses that don't have the quality characteristics and the return on invested capital that they have. So I think that does show you how far in the pendulum has swung in terms of the sentiment towards these types of companies.
- [47:52]
B
And how many of your companies have got the potential to double over the next three years. That's a cool question, isn't it?
- [48:00]
A
I think going back to the get rich slowly approach, it's tricky to know that over three years because you would rely on valuations mean reverting. And that's entirely possible because you look at a lot of these global UK listed multinationals versus their global and I'd say particularly US peers, and there's at least 30 to 50% upside. I mean that shouldn't be the case because the markets are supposed to be efficient, but there's a sort of structural difference in a lot of these, not all, but a lot of these companies. And looking back at their valuation multiples versus their long term history, there's similarly 30, 50% plus plus upside. But I think if I can go slightly longer term. Over the next five years, I think most of the constituents of the portfolio could double. That's just by thinking about the basic building blocks of return. So if you take the fundamental total return algorithm that I've discussed, the dividend Yield is about 3. Let's call the share buyback yield 2, which is sustainable in terms of whether free cash flow is. That gets you to five. So actually you don't need to get to a 12% return from fundamentals, you need 7% per share earnings or free cash flow growth, which is doubling over six years. So if you get a bit of icing on the cake in terms of valuations mean reverting from their currently very depressed levels, then that gets you to a doubling over five years.
- [49:49]
B
And that actually is a very, very intriguing opportunity. I'm going to move on to now. What's going on in the market? Is there much MA takeover activity in the UK equity market? And if there is, is it UK investors or international investors?
- [50:18]
A
There is. It's been a theme for at least 10 years. I think it picked up in the late 2010s, there was a bit of a pause during COVID and then it's picked up again in the last four or five years and it's fairly steady flow of activity. And I think the common it might be private equity, it might be trade buyers, but the common theme that you've seen across the UK market with takeover activity has it's generally been foreign buyers. And I think there are attractions to buying UK companies, as we've discussed. They're very interesting from a valuation perspective versus a lot of their global peers. I think also buying companies in the uk. The UK speaks the international business language of English. I think generally US and European and global acquirers are comfortable with the legal code, the stock market codes, et cetera. So it's an attractive hunting ground for private equity and trade buyers to buy sort of swallowable acquisitions.
- [51:33]
B
And our value investors now finding quality growth stocks are sort of knocking on the door of their portfolios now. What are the jungle drums telling you in the industry?
- [51:48]
A
Yes, I think they are and I think that we've seen that with UK managers. But I think the other thing that we've seen is very sensible long term valuation based US and European managers buying companies that we've held long term. And I think that's really been the big change in the shareholder base. I mentioned that companies have bought back a lot of shares and they've been one of the big marginal buyers of UK Equity. But I think the other big marginal buyer has been overseas investors who are taking institutional shareholders who are taking stakes
- [52:31]
B
and then moving on to sort of stocks and sector selections. I can't let our conversation go by without talking about artificial intelligence. So I'm going to ask you the question wrapped up in how is AI affecting the, the valuation of your digital information holdings?
- [52:54]
A
Yes. So information services companies are about 16% of the fund, I think, you know, if you count sort of digital orientated businesses more generally, it's slightly over 20% of the fund to get to give some context. But the key holdings that we have in the information services sector are Relex, Experian and Elseg. And those businesses have seen they had good re ratings over the period between about 2001 to 2000, well to last summer to summer 2025. Generally seen as beneficiaries of digitalization trends more generally, but also actually generative AI. They've then seen sharp, very sharp DE ratings over the last few months and they've been our biggest detractors to performance if you look over the last year. So we think that these business, they get called AI losers at the moment we call them AI underdogs because we actually think that they are at the increment net beneficiaries of the general trends in digitalization and machine learning. But actually in terms of this new wave of technology, generative AI, we think that they are net beneficiaries, as do the company management teams. I think crucially it comes down to going back to competitive advantage. What are the, as Buffett would say, what is the economic moat of these businesses? And we don't think it's software, which has become a lot easier to create. We think it's the incredible proprietary data sets that they have built up over time, but also crucially are being continuously updated. And many of those data sets are contributory. So there are lots of participants in a network that are anonymously contributing their data because it's very valuable for them to have a third party that will then help them package that up to add a lot of value to the, the customers. You've then got continuously improving algorithms that are led on top of that data. And then you've also got these businesses, take Experian in credit analytics or Relics in law and cyber fraud, et cetera. These are very mission critical industries where the cost of failure, the cost of error is extremely high and the customers are very embedded. So as long as those businesses are genuinely on the front foot in terms of investing in those technologies, and harnessing them to add value to customers. And also they can improve the efficiency of these businesses as well. In terms of Experian has grown at double digit rate over the last three years with no increase in headcount, for instance. So there are also benefits in terms of the operating efficiency for these businesses. It's not going to be sort of dramatic changes in growth rates, but we think at the margin and there are some areas of the business where if they don't execute well there might be some risk, but we think overall they're in a good place to continue to drive good compounding growth.
- [56:19]
B
Just in the very short term. As we speak today, there's a lot of IP activity coming out in the us. Do you think that the, those, those AI stocks, whether it's anthropic or, or actually then they've got Elon Musk, Space, SpaceX. Do you think this is going to suck a huge amount of liquidity out of markets, creating short term volatility that investors are going to have to suck up?
- [56:53]
A
Well, I think that it's been a general trend over the last decade that the US market has sucked in a lot of capital. I mean, it's been in a way the only game in town in terms of the trade there. And it's been quite specific to technology shares up until the last two or three years where it's become in a way a more focused trade in that there are some technology stocks, like the software stocks that have started underperforming in the us, but on the other hand there's sort of energy stocks, et cetera, the picks and shovels of the AI infrastructure build and the microchip companies that have sort of really joined and kind of led that trade. So I think that has been a big trend. I think you've also got a lot of passive money in global markets. Now there's not brilliant data on the UK, but estimates have suggested that more than 60% of the US market is more passive. So momentum as a factor has been incredibly powerful, incredibly powerful when you've had flows into sectors and the opposite on the other side. So yeah, I think that that's been, it feels like the markets have, the structure of the markets has changed quite materially over the last 25, 30 years. I mean, in a way that shift from active management to passive management has been the big trend in the asset management industry. And if you look at the net flows into the US market now, more than 100% of them are from effectively passive strategies. The active asset manager is in Net
- [58:39]
B
outflow is making our timing even more interesting. Okay, let's move away from AI and let's talk about people again. Who are the three most outstanding chief executives that you've got in your portfolio?
- [58:58]
A
That's a tricky one.
- [59:00]
B
You've got a lot to choose from.
- [59:01]
A
Yeah, I think chief executives are important. I think I'd make a couple of points, though. I think the business model is more important.
- [59:10]
B
Okay.
- [59:13]
A
There was a good Buffett quote on that. In terms of when a great management team meets a business with poor economics, the reputation of the business survives intact, but not necessarily the management's reputation. And so I think great leadership is super important. But I think I particularly like businesses where you've got a good CEO, but actually there's a broader cultural. It's almost hard to put your finger on, but there's a cultural underpinning to a business that's broader than just the CEO or the executive management team. So I might cheat and try and give you three categories, but I'll name names. I mean, the first one would be Halma, which is what I would call a hidden champion of the UK market. It's actually performed extremely well. It's a beneficiary of the AI trade in its photonics division. And that's one that we still hold, but we have reduced the position for valuation reasons. But it's an incredible story of a British company compounding over half a century. It started out as an oil and rubber conglomerate in the 19th century, but the modern Halma was floated on the UK Stock Exchange in 1972, I think by the founder David Barbour and his co founder. And I'd recommend there's a brilliant essay by David Barber from 1997 called delivering shareholder Value, which is a great exposition of how you can create value as a company. And he wrote that speech in 1997 when Halmer had compounded at, I think, over 20% per annum. So you might have thought that was a sort of victory lap and the best days for Halmer were over. But I think the interesting thing that Halmer did was they. It's sort of like a Berkshire Hathaway of hazard detection and life protection. And they put in a very clear structure with a lot of capital discipline, like with Berkshire Hathaway. The headquarters doesn't have many people in it. It's sort of. It's a farmhouse in Amersham or an old farmhouse, and it's maybe 150, 200 people, but then they have 50 global companies and there's a lot of Autonomy with very clear financial guardrails within those companies. And they've got this very. Some very key metrics that they use to manage the business on and incentivize the divisional management as well. One of them is return on total invested capital, which adds back any written off goodwill. So it's not just about the business, the return you've made on organic investment. It includes acquisitions and if there's ever impairments of the goodwill that you've paid for acquisitions, that gets added back and management get paid based on that figure. Which actually very similar company called Diploma, which is earlier in its journey on that sort of Halmaresque route. So that's a good example of a sort of. It's a FTSE 100 company, it's £18 billion, but stop a passerby in the street and I'm not sure they would have heard me. Another category is very focused niche businesses which really understand their clients and or their customers and are sort of laser focused on delivering for them over time. And I think Halden Joinery in the UK is a very good example. It's an interesting business because it wouldn't sort of necessarily fit into a sector that people would think these sort of high quality businesses come from. And I slightly had that feeling when I first the idea crossed my desk for the first time in the early 2010s. But the more you peel the layers of the onion back on Howden, the more you understand the power of that model. And it's the market leader in the UK kitchen and joinery sector. But specifically it's providing kitchens to the trade, so to the British white van man. And it's got this little bit like Halma, it's much more focused business. But the depots are run autonomously with clear financial guardrails. So 10% of the gross profit goes to the team in the depot, half of it to the depot manager, the rest is shared between the rest of the team and crucially, it's a profit metric, not a sales metric. And then they've also got this vertically integrated manufacturing model with an in stock model. So if you're a builder and you order your kitchen for your client from Howden, they either have the stock in store or it will turn up the next day. If you order from, I won't mention any names but other competitors, it will be a retail model, it will be delivered to the home, not to a depot for a builder to pick up. And often it will take six weeks made to order. And what you found with Howden is they faced a very difficult market over the last four or five years. So kitchen volumes are now lower than they were in 2009. But Howden have grown over that period because they've been taking share from their competitors that just don't have the competitive advantages that Howden have. So, I mean, the current CEO is very good. He used to work at, he used to lead Screwfix and he's moved to Howden Andrew Livingstone, and he's just a very good operator and he understands the strengths of the business and how they can broaden those strengths over time. And then I guess the last point, we've already talked about the information services businesses, but I think Relex is a very good example of a business that has plowed back continuously investment over the last 15, 20 years in developing, being absolutely on the front foot with listening to clients, broadening out into the adjacent markets that make sense for them to do and adding, just think, how can we add value to clients over the long term? They were very early in artificial intelligence back in the early 2010s. They spent a lot of time in Silicon Valley understanding it. They've got a huge team of technologists in house. They're very much on the front foot with generative AI, just to take an example. In their legal business, they are. There's hundreds of thousands of lawyers that are now using their LexisNexis+AI database and their agentic service protege. So that's, I mean, I call that the organic plowback. They have made the odd, you know, they have made acquisitions over time. But the primary growth driver of that business has been the management team saying what are our competitive advantages? But how can we grow and strengthen those competitive advantages over time by investing back in the business.
- [66:22]
B
Those are three great examples. Thank you. That's absolutely wonderful. So what percentage of your fund is dependent upon a global cyclical recovery? You've mentioned one or two stocks there that have some cyclicality in them. But, but what is your cyclical exposure?
- [66:41]
A
Well, there's different ways to look at that. So we have a sort of scoring mechanism that helps you give us get a sense at the portfolio level. We have a, is a company above average cyclicality, average cyclicality or below average, which would be a very repeat purchase business. And it's roughly two thirds of the portfolio that's in, you know, basically repeat purchase businesses that aren't very economically sensitive. And then another 20% would be in not very cyclical businesses. And that leaves about 13 or 14% of the portfolio that's in more cyclical markets where there's less repeat, you know, there's not much in the way of repeat purchase cash flow necessarily. But we want to make sure that that is that cash, that, that, that that bit of the portfolio is well diversified by end demand. Another way to look at it is, I think looking at this year for instance, the portfolio has definitely been impacted by the geopolitical situation in Iran. Now actually, as we talk today, I talked about the growth, the growth prospects this year for the portfolio. They're very similar to where they were in January. So we've just had the quarterly results and they've been very reassuring in terms of companies guidance. So there's been some small upgrades, some small downgrades, but we are seeing the growth coming through. But I think that situation has definitely had a meaningful impact on valuations this year. And so I think if there was an improvement in that situation, it could be very positive in terms of a, a catalyst for RE rating. I mean, a good example is our niche engineering exposure where some of those businesses do have 5 or 10% of sales in the Middle East. And short term there may be some disruptive impacts, but actually longer term a lot of what's happened is probably very positive for investment in energy security, energy efficiency, the electrification of everything, et cetera, which these businesses are well placed for in terms of capturing that end demand long term. So in short, I think that the events, the geopolitical events of this year have not been helpful for portfolio valuation. But actually it hasn't had a huge impact on the operating results themselves. Can I make a follow on point, which is a sort of a general reflection actually and I was reflecting on this. Unilever had their first quarter results and they posted good numbers. So 4.4% organic revenue growth and they did maintain guidance. The stock is very unfashionable at the moment. It's another of these names that's trading right at the bottom of their long term sort of valuation history. But their guidance now beds in $115 oil for the rest of the year, which is quite a lot higher than where it is today. And these businesses are now quite used to coping with an awful lot of volatility. If you think about, we've had Covid, we had the supply chain shock coming out of COVID we had the input cost inflation spike that was partly related to Covid, partly related to the Ukrainian war. You've subsequently had all of the tariff volatility and disruption and uncertainty and then you've had this, well, this year you've had. It's not just Iran, is it there? Venezuela, Greenland, take your pick. And I think these businesses are getting, they're very lean and they're getting better at dealing with that uncertainty both in terms of dealing with input cost, inflation and also dealing with supply chain shocks. So it's not to say they're immune, but I think that's just a point worth bearing in mind. That's a nice thing about investing in equities is that it's a company full of people who can adapt the business model over time in response to the way the world changes.
- [70:57]
B
Unity has survived world wars, isn't it?
- [71:00]
A
Yeah,
- [71:05]
B
Cheeky question this one, but what's the watch list looking like? You know, who's on the watch list, who's winking at you? That's not in the portfolio yet that our listeners might be intrigued to hear that you're doing a lot of close detailed analysis on.
- [71:24]
A
Well, I might slightly dodge that question in terms of mentioning names, but it is a broad opportunity set. I mean I'd also note that clearly given the valuation of the current portfolio, there's a lot in the portfolio that we think looks very interesting. So the bar's quite high but I think there are opportunities to broaden out the portfolio. But if I look at the watch. So we do have watch lists, so we have our investable universe. There's a watch list of about 10 names that are probably the most interesting for potential inclusion at this point in time. It's actually quite heterogeneous in terms of. So there's domestic market leaders, there's global market leaders, there's large companies, there's smaller companies, there's consumer facing businesses, but there's also niche business to business franchises, niche industrial franchises, et cetera. So it's quite a broad, I mean it goes back to this point. It's, it's amazing how many undervalued good quality companies there are hiding in the gaps between the oil and mining and banking stocks of the UK market that have been more than left behind, put it that way.
- [72:40]
B
Absolutely fascinating. I got a few last questions to ask you now. What would you deem to be success story in 10 years time?
- [72:54]
A
Well, I think delivering the fundamental algorithm would be a definition of success. So double digit returns by following the process that we have and hopefully getting some valuation re rating over time as well. Given our starting point, I think that's obviously key. I think also just doing it in a team of people who enjoy what we do and are fascinated by the way that businesses work and create value and the way that markets work too. And being a part of that team, it's a very collegiate team that we have, even though we work across the whole team across our three strategies and then we have sub teams to manage each strategy. I am the lead manager on Even Load Income, but it's delivered as a team approach. So I think those would be my key hopes.
- [73:54]
B
And who do you think you've learned most from in your investment career thus far?
- [74:02]
A
I mean, I've had a really good experience in this industry. I loved my time at Rathbones and worked with some excellent people, worked with some excellent people at Evenlode and more generally in the UK capital markets and corporate sector. There's some very, very good analysts and very good corporate management teams. So I think if I'm going to name a specific name, it would actually be my father who is now retired but was a financial advisor and an investor and he actually got me into investing when I was 10 and started giving me investment books to read. And this is showing my age. Algae. But I remember at the age of 10 sitting at the kitchen table with him. And you may remember these logarithmic graph paper.
- [74:57]
B
I do remember these.
- [74:58]
A
That you could draw the earnings and share price of individual companies on. So we'd get the Financial Times on a Saturday morning, look at the price and add the weekly dot to the chart. So the industry's changed. The industry's changed a bit since then
- [75:15]
B
and that's what he had you doing. That's brilliant. I wasn't expecting that answer. And if investors had to remember just three things from our conversation today about the Even Load Income Fund, what would you want them to remember?
- [75:37]
A
It's a portfolio of excellent British based, British headquartered market leading companies, both global market leaders and domestic market leaders. It's trading on the most attractive valuation that we've seen it on since launch in 2009 and it's run based on the fundamental algorithm of investing in pieces of companies to deliver dividends and per share growth in owner earnings over time. And that's what we will continue to do over coming years.
- [76:16]
B
Hugh, that's the most wonderful way of wrapping up a fascinating conversation. Thank you very much indeed for joining me on the podcast and good luck for the rest of the year.
- [76:26]
A
Thank you, Algy.
- [76:28]
B
All content on the Algies Investment Podcast is for your general information and use only and is not intended to address your particular requirements. In particular, the content does not constitute any form of advice, recommendation, representation, endorsement or arrangement and is not intended to be relied upon by users in making or refraining from making any specific investment or other decisions. Guests and presenters may have positions in any of the investments discussed.