Are the businesses enjoying stock price rises today

also the winners of tomorrow?

Insync Fund Managers

July 2022

Lately we are all experiencing one tectonic event after the next. Foundations of the political and economic framework that have dominated much of the world since the 1980s are now being challenged; the impacts on globalisation, the questioning of the USD central role, and previously deeply embedded structural relationships in the energy markets to name a few.

Our approach is far less dependent than our peers are on these issues, including inflation and interest rates. The jury is still out on whether inflation will be a temporary or a longer-term phenomenon.

Covid and the tragic invasion of Ukraine have created significant commodity, energy, and labour mobility pressures. Companies that:

• can raise prices are clearly better placed than those that do not
• enjoy high margins and operating leverage are better protected than low margin businesses with high marginal costs and no pricing power
• possess high incremental return on capital may be able to not just defend their profitability but actually see it expand!

These are the required factors for a business to continue delivering healthy returns in real terms and are thus the same attributes Insync seeks.

Most companies are not able to do this. Those companies possessing the most levers to pull going into an inflationary period are also the most likely to protect and even thrive for their investors. There will likely be tougher times ahead, quality growth investors should find themselves better positioned than most to weather the storm and come out substantially ahead.

Why earnings power is crucial

A shy, humble investor living on a suburban street in a small mid-western US city is often cited for his quips.

"In the short-term markets are a voting machine. In the long-term it's a weighing machine"

Over shorter periods sentiment in markets can shift wildly depending on the narrative of the day. This is driven by perceptions of investors trying to gauge where we are in the economic cycle, the path of inflation and interest rates, the impact of a geopolitical crisis, and what style of investing will be best equipped for the future. These are impossible to predict with any degree of certainty or to do so consistently.

The one thing that is more certain over time is that in the long-term, share prices follow the consistent growth in the earnings of a business.

We know that the most profitable companies remain profitable even ten years later fuelled by the enduring, large megatrends.

Megatrends are so predictable you can set your watch by them. This is whether it is the rising importance of the Gen Z'ers, the acceleration in the number of people aged 70+, GDP+ growth in spending on skin and beauty, or the insatiable desire to spend on experiences. A portfolio of the most profitable companies tied to megatrends provides consistency in earnings leading to strong stock price returns. They are also mostly impervious to interest rate settings, the state of the economy or current commodity prices.

3 portfolio examples of why Earnings Growth is good for investors

The evidence shows it all. Here are 3 companies in our portfolio. The coloured line in each graph is the path of earnings over the past 10 years. The white line is the share price performance.

Observe the strong correlation between the earnings growth and share price performance. From time to time the two lines deviate based on an 'event', as is the case now. Obviously, present prices present an outstanding opportunity to invest.

These highly profitable businesses benefitting from Insync's identified megatrends have become even more attractive due to recent price falls. This is because their ongoing and established earnings power remains intact. Such excellent buying opportunities do not often present themselves.

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

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Equitable Investors

August 2022

Funds operated by this manager:

Equitable Investors Dragonfly Fund

Disclaimer

Nothing in this blog constitutes investment advice - or advice in any other field. Neither the information, commentary or any opinion contained in this blog constitutes a solicitation or offer by Equitable Investors Pty Ltd (Equitable Investors) or its affiliates to buy or sell any securities or other financial instruments. Nor shall any such security be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.

The content of this blog should not be relied upon in making investment decisions. Any decisions based on information contained on this blog are the sole responsibility of the visitor. In exchange for using this blog, the visitor agree to indemnify Equitable Investors and hold Equitable Investors, its officers, directors, employees, affiliates, agents, licensors and suppliers harmless against any and all claims, losses, liability, costs and expenses (including but not limited to legal fees) arising from your use of this blog, from your violation of these Terms or from any decisions that the visitor makes based on such information.

This blog is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The information on this blog does not constitute a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Although this material is based upon information that Equitable Investors considers reliable and endeavours to keep current, Equitable Investors does not assure that this material is accurate, current or complete, and it should not be relied upon as such. Any opinions expressed on this blog may change as subsequent conditions vary.

Equitable Investors does not warrant, either expressly or implied, the accuracy or completeness of the information, text, graphics, links or other items contained on this blog and does not warrant that the functions contained in this blog will be uninterrupted or error-free, that defects will be corrected, or that the blog will be free of viruses or other harmful components. Equitable Investors expressly disclaims all liability for errors and omissions in the materials on this blog and for the use or interpretation by others of information contained on the blog

Hedge Clippings | Friday, 19 August 2022

This week in review:

Scomo..... what was he thinking? Let's not go there... Neither in our view should further time and money be wasted on having an inquisition. It would seem nothing Scomo did was actually illegal, but the lack of transparency defies logic, and will define Scomo for ever. If nothing else, it at least shows the dangers of having a popularly elected President - if Donald hasn't already proven that.

Moving onwards and upwards - hopefully in more ways than one...

Markets bounced in July, with the ASX200 Accumulation Index rising 5.75%, after falling 8.77% in a horror June, while the S&P500 bounced 9.22% to make up for its June fall of 8.25%.  Funds generally enjoyed the ride, with 80% of the funds on  FundMonitors.com having reporting their July results, with those hit hardest in June enjoying the best of July. Having been on the nose in June (and if it comes to that for the past 6-8 months) growth stocks, and the funds investing in them, were the big winners, although in many cases they have a long way to catch up to their previous highs. There's no doubt there was some irrational selling, particularly in the small/mid cap space, as stretched valuations, gearing, year end tax selling etc., saw some companies trading close to or below cash backing.

While we (and others) tend to focus on "performance" and top performing funds, there's a risk doing so at the expense of looking at risk and drawdowns. When the ASX200 fell 8.77% in June, 72% of equity based funds outperformed (i.e. fell less than the index). In July's market rally of 5.75%, only 40% of equity based funds managed to outperform the ASX200. Over the past few weeks we have been publishing our "Spotlight" series of articles exploring quantitative assessment of funds' returns to create a top performing portfolio. For those of you who have been following these articles, chasing top performing funds over the short term (say 1 year) is not the solution.

The problem is that taking a longer term view (say 3-5 years) involves a variety of economic and market conditions, when funds with different styles, (for example growth or value) and strategies, perform very differently. In the past 3 years alone we've had 2 "bear" or negative equity markets. Extend that further, and the Global Equity Index benchmark (effectively the MSCI) was in negative territory on a cumulative basis from late 1999 through to the start of 2014 as shown by the chart below of Platinum's International Share Fund (blue) vs. the Global Equity Index (red), showing the effects of the dot com bubble of the late 1990s, the resultant "tech wreck" in 2000, and then the GFC in 2007-08. By comparison, the recent downturn (so far) puts things in perspective.

There's a lesson in this for markets - a bubble always bursts, and the bigger or longer the bubble, the greater the burst.  As for fund selection the lesson is equally clear: Protecting the downside through active risk management should, over time, result in good long-term performance.

This week Hedge Clippings attended the Portfolio Construction Forum, as always expertly managed and MC'd by Graham Rich, with the addition of a variety of excellent speakers and panels covering (as one would expect) Portfolio Construction. The underlying theme over the two days was "The future ain't what it used to be". Given the above chart showing the variable market conditions experienced over the past 25 years, it's no surprise that asset allocation decisions (equities, bonds, alternatives, etc) are vital, but that requires a crystal ball. Having set asset allocations according to forward looking projections, the actual stock (or in our case fund) selection for a diversified portfolio is made based on backward looking history, namely the fund's track record.

Nearly every advisor and fund manager we know (understandably) relies on past performance, but if "the future ain't what it used to be" is correct, it doesn't make fund selection, or portfolio construction, any easier!

Of the many speakers at the forum, one of the most insightful was Marko Papic, Partner and Chief Strategist of the Clocktower Group in Santa Monica, who challenged the view often held in Australia that conflict over Taiwan was inevitable. His view (as my takeaway) was that the cost to China, and not just in economic terms, would far outweigh the strategic or geographic benefit of a military outcome.

We hope he's correct, otherwise the future's not only not going to be what it was, but it's looking decidedly uncomfortable.

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Diageo strategy pays off

Magellan Asset Management

July 2022

In the mid-2010s, UK-based distiller Diageo invested in proprietary technology tools to uncover growth opportunities and improve returns on marketing spending. The analysis revealed the US was a ripe market for premium tequila, an alcoholic brew made from the blue agave plant that flourishes around the town of Tequila in the western Mexican state of Jalisco. Tequila volumes in the US doubled from 2003 to 2015, as Hispanic influence took hold and millennials-come-mixologists began making margaritas or sipping the liquid straight.

Diageo's key step in its campaign to penetrate the high-end US tequila market came in 2017 when the company spent US$1 billion (including a US$300-million 'earn-out' based on sales) to acquire Casamigos tequila, a company founded four years earlier by US actor George Clooney and two others. Casamigos, which translates to 'house of friends in Spanish, was the fastest-growing (40%+) 'super premium' tequila in the US. With the purchase, Diageo added Casamigos, which Clooney still promotes, to its tequila portfolio that includes complementary brands such as Don Julio.

By 2021, the campaign's success was obvious. Diageo's 'organic net sales' of tequila in fiscal 2021 had soared 79% from the previous year, numbers that meant tequila sales comprised 8% of the company's organic net sales. (This sales measurement excludes the effects of currency translation and takeovers and divestments.) The company subsequently announced it would spend US$500 million to expand production in Jalisco where it has two tequila plants.

Thanks to strategic portfolio adjustments such as this, Diageo has outperformed peers in the US, which accounts for nearly 60% of group operating profit. Globally, the owner of Baileys Irish Cream liqueur, Captain Morgan rum, Johnnie Walker whisky, Tanqueray gin and Smirnoff vodka posted sales of 12.7 billion pounds in fiscal 2021, an increase of 12% from the year earlier.

Diageo, whose spirits hold the No. 1 spot in six of the nine biggest spirit categories, extends beyond spirits. The company brews beer including Guinness, makes wine and offers ready-to-drink (pre-mixed) options. All up, the company boasts more than 200 global, local, and luxury brands that are sold in more than 180 countries. Through a 34% stake in LVMH's Moët Hennessy, Diageo stretches into the high-end cognac and champagne categories.

Spirits represent about 80% of Diageo's revenue - scotch generates 25% of Diageo sales, while vodka accounts for 10%. Beer brings in about 15% of sales while other categories such as ready-to-drink products and wine generate the remainder. In terms of locations, the company sources about 40% of sales in North America, 20% in Europe (including Turkey) and another 20% in Asia Pacific.

The modern history of Diageo, which can trace its start to 1759 when Arthur Guinness leased a brewery in Ireland, began in 1997 when Guinness and GrandMet merged. This union and subsequent bolt-on acquisitions have created a company with three key competitive advantages.

The first is that Diageo owns the best brands for which consumers are prepared to pay a premium. Spirits variants are distinguishable in terms of flavour, production process, provenance, and vintage. Such points of differentiation allow distillers to charge higher prices for luxury categories. Johnnie Walker's 18-years-to-produce Black Label scotch, for instance, sells at 3.7 times the price of Johnnie Walker Red Label whisky.

Diageo's second competitive advantage is that it has secured superior access to distribution channels. Bars, bottle shops, pubs, restaurants and supermarkets have finite space to display drinks. They favour brands that sell quickly and deliver higher margins. They want brands that can be supplied and restocked by a reputable and reliable company such as Diageo.

The third advantage is Diageo has the turnover to achieve economies of scale in advertising, data analytics, distribution, manufacturing, research and development and procurement of ingredients. Lower average costs mean competitive pricing and higher margins.

Diageo's three key advantages mean that the company is likely to generate superior returns for the foreseeable future, the attribute that stocks must possess to enter the Magellan global portfolio.

To be sure, Diageo faces challenges. Hot categories such as tequila inevitably attract competition. Celebrities Dwayne Johnson (the Rock) and Kendall Jenner have launched tequila brands in recent years that they promote via their widely followed Instagram accounts. There is a risk that this could dent category returns, as new brands take market share and prompt existing players to increase their marketing spending. The counterargument to this point is that new celebrity-backed brands generate buzz for the category, and they typically compete based on product differentiation rather than unhealthy price competition. Diageo must be quick to adapt to fresh competitive threats and new industry trends, as the company did when it stormed the top end of the tequila category in the US in 2017.

Sources: Dunn & Bradstreet, company filings and Bloomberg.

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

Important Information: This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 ('Magellan') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should read and consider any relevant offer documentation applicable to any investment product or service and consider obtaining professional investment advice tailored to your specific circumstances before making any investment decision. A copy of the relevant PDS relating to a Magellan financial product or service may be obtained by calling +61 2 9235 4888 or by visiting www.magellangroup.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any strategy, the amount or timing of any return from it, that asset allocations will be met, that it will be able to be implemented and its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of a Magellan financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

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