Expert: Alistair Corden-Lloyd, Morgan Stanley Investment Management Facilitator: Sam Shaw
Headlines:
- Quality is not universally defined; being ‘economically agnostic’ is crucial
- Different quality managers all own very different stocks, which must mean each has a different definition of what a quality company is
- As central banks reduce demand (by raising interest rates), those companies with more resilient earnings will likely fare better than those with more fragile earnings profiles.
Discussion points:
When it comes to quality, a strategy for all seasons makes particular sense right now. Why now? Inflation lifts prices, which lifts revenues and earnings. If central banks succeed in bringing down inflation, it could subdue revenue growth.
“So you face the risk of a slowing of revenues, if you win the battle against inflation”.
The market (looking at analyst estimates) is not pricing in a recession – only a “very modest reflection of a slower rate of growth” but no anticipation of no growth or negative growth on the horizon. Because historically, there's never been a recession without an earnings decline.
BUT if there were a significant downturn, recurring revenues and pricing power would help to protect revenues and margins. No one is invulnerable to a significant downturn but having strong and recurring revenues and stable margins improves your ability to recover. “The further you go down, the harder it is to get back up.”
The audience said the current environment made a more compelling case for this kind of strategy. One delegate stated he had shifted heavily into quality in 2021, following the last tech rally.
MSIM looks for leading global brands, strong networks, powerful intangible assets and/or asset-light businesses, all with high levels of free cashflow and resilient margins (which demonstrate pricing power). E.g., Companies selling things we need, irrespective of the economic conditions, will have more resilient recurring revenue streams, e.g.: we brush our teeth and wash our hair, regardless.
Even if unemployment goes to 5%, 95% of the workforce is still going to work and logging on and using Microsoft. If we’re in hospital, it’s an injection, a test, a diagnosis, a drip … these are all economically agnostic.
Favouring asset-light or intangible assets, as opposed to asset-intensive companies:
Building a new oil rig is very expensive. And it’s not something that gets paid for out of operating costs via the P&L. Typically, highly capital-intensive companies use leverage to fund the assets required to grow.
An asset-light company doesn’t have to do that. E.g., L’Oréal. The cosmetics giant has high gross margins of 70%, good operating margins of 20%, giving an operating cost of 50%. If 50% of sales are operating costs, that is high but also a huge barrier to entry.
It means L’Oréal can spend 30% of sales on marketing alone. The average company has a gross margin of 30%, so if it tried to compete at the same marketing intensity as L’Oréal it would go out of business on day one. In Warren Buffett terms, this is its moat.
Intangible assets include strong brands, such as LVMH, Procter & Gamble, Reckitt Benckiser, Davide Campari and Heineken.
Networks are another intangible asset. Here examples cited include Microsoft, SAP and Visa. These are essential networks embedded into the everyday life of what we all do. “Microsoft is in almost every single office in every country on the planet – what a powerful position to be in…”
Sectors to avoid are those where visibility and control over pricing is limited:
The team avoids food companies, where pricing power has become much more challenging. Between the discounters, the craft industry and own-label penetration growing all the time, it is seen as a sector facing too many threats on pricing.
Similarly, healthcare is tricky. Although clearly pharma is defensive short term, the industry is typically not a compounder in the team’s view.
“As investors, it would be arrogant to try to predict whether a new drug in trial, or at stage one, two or three is going to be a blockbuster. You cannot possibly know, therefore predicting its future is very difficult for a long-term investor to be confident in the company’s ability to compound over the long term.”
They steer clear of commodities. They are low return, cyclical businesses lacking pricing power. Your fortunes as a commodity producer are completely driven by market supply and demand; if there isn't much supply but good demand, prices naturally rise. When prices rise, this attracts capital, which increases supply, which then affects prices… you get caught in this endless cyclical vortex.
It's important to avoid commoditised businesses, where they make “roughly the same stuff as someone else”. The team wants those with the ability to innovate, to benefit from R&D.
How do you compare with peers in the same space? Fund (Morgan Stanley Global Brands) often gets pitted against Fundsmith Equity and Lindsell Train Global Equity. The delegates agreed that name alone was insufficient; it invited further due diligence when a manager was particularly high profile. Their investment committees and/or fund selectors would consider things like the underlying holdings and process, whether the strategy suited clients’ needs (e.g. possibly less well-suited to income investors), how long is the track record, have they stood up by luck or skill, etc.
The MSIM team was praised for sticking to its quality guns, rather than drifting elsewhere to chase down performance.
