INTRODUCTION As inflation continues to trend lower, most central banks appear to be done hiking interest rates. The European Central Bank...
A company which possesses the ‘duration effect’ is able to build value over time through compounding its free cashflows.
A portfolio of companies possessing this duration effect creates multiple sources of alpha generation, enabling a fund manager to look through short-term market noise to focus on a company’s long-term value creation potential.
It also enables a fund manager to capture upside as well as protect on the downside.
The duration effect is one of the market inefficiencies targeted by the Loomis Sayles Global Equity Fund.
Investment Specialist Peter McPhee discussed this recently with Co-Portfolio Manager Eileen Riley.
This video and the content contained within is provided and maintained by Investors Mutual Limited (AFSL 229988). Investors Mutual Limited is the issuer and responsible entity for the Loomis Sayles Global Equity Fund. Loomis Sayles & Company, LP. is the investment manager. The information in this video is provided for general information purposes.
Peter McPhee: In the following video, Eileen Riley, the co-portfolio manager of the Loomis Sayles Global Equity Fund, discusses an important concept, the duration effect. This is a company’s ability to add value over time through compounding its free cashflows. A key element of the investment approach behind the Loomis Sayles Global Equity Fund is to select companies which are able to generate growth in their own right, rather than relying on the state of the market or the state of the economic cycle. This duration effect, captured by the team, is explored by Eileen in more detail in the discussion which follows.
What is the ‘duration effect’, and why does it matter?
Eileen Riley: The duration effect is one of the market inefficiencies that we target in our investment approach. Specifically, it is a company’s ability to add value over time through the compounding of its free cashflow. We select high quality companies with competitive advantages we believe can be sustained over multiple years, which gives them the ability to compound their free cashflow over time, and these are the companies which offer the greatest duration effect.
This means that financial advisers and investors are therefore buying a portfolio of companies selected on the basis of what we believe should be able to perform well over the long term.
Why is it important to focus on individual company fundamentals, rather than relying on the state of the market or economic cycle for opportunities?
Eileen Riley: We believe it’s important for investors to focus on a consistent approach to investing. We believe our focus on individual company fundamentals is consistent with our philosophy and it’s also where our expertise and competitive edge lie. Furthermore, we believe the global macroeconomic and geopolitical outlook is always in flux. This presents a challenge for investors to generate attractive returns over the cycle.
If we look at our current situation, for example, the economic recovery in large part depends on the successful rollout of vaccines on a global scale. It also depends on the scope of continued fiscal and monetary support, and other relief packages, globally. These are quite challenging for anyone to forecast, and we feel the best way we can add value to our clients is to maintain our focus on investing in high-quality companies that we believe have the ability to successfully navigate the current environment and generate value over the longer term.
This is evidenced by our portfolio’s return on equity, which is meaningfully higher than that of the benchmark, the All Country World Index, as well as the financial leverage of our portfolio, which is significantly less than that of the benchmark. We believe this combination allows our holdings the flexibility to navigate challenging environments, and quite possibly emerge stronger.
A great example from our portfolio is semiconductor equipment company, ASML. It is a leader in photolithography, which is a long word, describing the process in which a light source is used to etch a pattern onto a silicon wafer. So think semiconductor manufacturing. The company is distinctly positioned within EUV, which is the next generation technology which is needed for chipmakers to continue to make smaller chips, while maintaining their power. We believe the required technical expertise for this industry, coupled with a shift to a more value-based service model, gives a high degree of confidence in this company’s ability to grow its cashflows over a multiple year period. Additionally, the company has a solid balance sheet, which we believe will help them withstand economic cycles.
Are there sectors, industries, and types of companies more able to compound their free cashflows over time?
Eileen Riley: We find companies that offer a duration effect in many sectors. There are some areas of the market however, we feel don’t offer as many opportunities, and where we have a harder time finding businesses that offer this duration effect. This includes areas of the market like commodities, oil and gas exploration and metals and mining. Typically what we see here are companies that have a high, and more importantly, somewhat unpredictable level of capital intensity. Many times these businesses are price takers, and all of that reduces our confidence in their ability to grow their free cashflow over time. We also don’t find as many companies in the utilities space.
There are some examples of industries and types of companies where we typically have been finding opportunities. These include within technology – distinctly positioned tech companies ranging from electronic payments to semiconductor manufacturing and equipment. We also find opportunities in consumer companies that are capturing demand for e-commerce and at-home connected fitness. Another area is within healthcare. We’ve been finding opportunities within healthcare companies offering services and products. They’re geared towards higher growth areas of the market, and also, or often times at the same time, offer greater revenue visibility and manageable reimbursement risk. And lastly, if we look across industries, we consistently tend to find opportunities in businesses and industries that offer strong network effects.
What are the potential barriers to a company’s ability to compound its free cashflows?
Eileen Riley: We’re investing in a concentrated group of names – typically somewhere around 40 stocks – so barriers to cashflow generation tend to be company-specific. Potential barriers to a company’s ability to compound its free cashflow relate directly back to the assessment we are making of the quality characteristics of a company. For example, these include companies where businesses are price takers, or businesses where their own business model presents challenges – and it could be something as straightforward as lacking recurring revenue.
To address this, we continually reassess quality attributes of a company. And as part of our process we create a downside scenario for each stock we value to model the potential headwinds to free cashflow growth. For example, MasterCard – most people are aware that it’s in an effective duopoly in the global payments processing space, outside of China. Potential impediments to its free cashflow generation could include risk of displacement by new technology, or growth stalling within its ancillary businesses such as its business-to-business payments and data analytics segments. We modelled both of these dynamics into our downside scenario.
How does taking account of the ‘duration effect’ add value to the investing process?
Eileen Riley: We think of it as seeking to create multiple sources of alpha generation. Through our three alpha drivers of quality, intrinsic value growth, and valuation, we’re seeking to capture the two market inefficiencies of mispricing, through the valuation alpha driver, and the ‘duration effect’ through the quality and intrinsic value growth alpha drivers.
We look for companies that are building value over time. So if we’ve done our research and forecasting well, we will also see that value in our scenarios climb over long periods of time. And we think this approach helps us with upside capture as well as downside protection.
This focus on duration effect also aligns well with our long-term investment thesis and resulting low turnover. We can’t take advantage of the duration effect if we don’t have a long time horizon. Ultimately, by focusing on this ‘duration effect’, we’re able to look past short-term market noise to focus on the long-term value creation potential for investors. We feel our lengthy track record is a testament to this.
Can you share examples currently in the portfolio and discuss their duration effect?
Eileen Riley: Sherwin-Williams is an example of a company currently in the portfolio. It is the largest coatings company globally, when their brands include Sherwin-Williams, Valspar, and Thompson’s Water Seal. And when we’re talking about coatings, you can think about industrial coatings, but you could also think about architectural coatings, or, paint. The company rates highly across our quality criteria with a strong management team and leading brands. We believe the market structure in the US, which is its largest market, is particularly attractive, where we’re seeing the larger global companies consolidating the space. This is a business that has strong pricing power, as its core architectural business is geared more towards the higher growth professional painter, than it is to the do-it-yourself painter. And professionals are typically less sensitive to price increases on materials, because if you think about the builder creating, materials are a small percentage of what they charge their end customers, and additionally, using a premium product can also save their end customers money on labour costs. The acquisition of Valspar in 2017 has created a platform for this business to grow its architectural and industrial business internationally.
Alphabet is another stock in this portfolio. Many of you are familiar with their Google property, where they continue to lead the global search market, having somewhere between 65%-95% market share across the geographies they operate in. The company amasses consumer data from their Google search and its other properties – brands you know like YouTube, GooglePlay, Chrome, and Maps – and that increases its value proposition to their end advertisers. Alphabet is well-positioned to potentially benefit from growth in digital advertising with few other companies offering the ability to reach desired audiences at that scale. Alphabet also continues to grow its market share in the cloud business. The company is highly cash generative and we expect intrinsic value growth to be driven by revenue growth and return of capital to shareholders including buybacks.
This video is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein, reflect the subjective judgements and assumptions of the authors only, and do not necessarily reflect the views of Loomis, Sayles & Company LP. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecast and actual results will be different. Data and analysis does not represent the actual, or expected future performance of any investment product. Data and analysis does not represent the actual or future performance of any investment product. Information, including that obtained from outside sources, is believed to be correct, but Loomis cannot guarantee its accuracy. This information is subject to change without any notice.
While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.
Examples above are provided to illustrate the investment process for the strategy used by Loomis Sayles and should not be considered recommendations for action by investors. They may not be representative of the strategy’s current or future investments and they have not been selected based on performance. Loomis Sayles makes no representation that they have had a positive or negative return during the holding period.
Past performance is no guarantee of future results.
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