When Things Change, Change

Readers will be familiar with our ‘zero-tolerance to balance sheet risk’ approach. Thanks to process, it does not crop up as frequently as an issue, but we also have a ‘zero-tolerance to governance risk’ approach. In the last few months, we have sold two of our smaller holdings due to governance issues we could not get comfortable with. One was a ‘front-foot’ sale, the other one was not.

We had owned Sword since 2020 after meeting the CEO on an investor visit in Paris. The company is an entrepreneurially organised IT services company with operations across Europe. Since holding the shares, Sword had delivered strong organic growth and also opportunistically bought and sold divisions very well. This led to substantial capital return to shareholders. We liked this pro-active capital allocation and felt aligned with CEO and the largest shareholder. However, a few recuring questions about some of this activity as well as discomfort around the terms of a new employee incentivisation program led us to sell our full position. My years as a bank analyst taught me (amongst many things!) that sometimes companies are there to reward certain stakeholders over all others, and whilst there is nothing necessarily wrong with that, our preference is a more balanced stakeholder approach. Since acquiring the shares, Sword contributed +2.2% towards the NAV.

We have owned Digital Value since 2021. Digital Value is an Italian reseller of IT hardware and software. Our initial case was based on the ongoing digitalisation of both the private and public sectors in Italy, which we believe have lagged behind European peers. The public sector comprises roughly 50% of the group’s operations. Based on our usual valuation and balance sheet analysis, DV initially presented an attractive opportunity. However, on 15/10, the company announced that there was to be an investigation into alleged bribery of government officials, leading to the arrest of the major shareholder and CEO/President. While the full implications for DV are not yet clear, the potential risks to the company are considerable and we took the decision to sell our position. Since acquiring the shares, Digital Value detracted -0.5% from the NAV.

When buying smaller companies, it is often the case that governance structures are not yet fully formed, documented and ready for the next stages of growth. Recognition of this is part of our process, including incorporation into valuation assessment. We also recognise this in position sizing, keeping companies with higher risk profiles with lower-than-average position sizes until we gain more conviction. We will continue to review and improve our investment processes and will continue to share more insights going forward.

Retreat of Tourist Capital Creates Less Competition

No this is not a comment on European small company investing (!) but a bullet point in a slide from Kinnevik’s recent Capital Markets Day (CMD).

Kinnevik is a relatively new holding and a different type of investment for us. An 88-year-old Swedish investment company which has in recent years pivoted to investing solely in unlisted growth companies. The company can be considered somewhere in-between the traditional European holding companies and a venture capital house. As a competitive advantage, the company cite their ability to provide permanent capital to their investments.

During the CMD I heard from the Founders of eight of the underlying investments and it was clear to me that Kinnevik’s ability to provide this type of capital is a comparative advantage. With IPO markets effectively closed at the moment, and many traditional VC’s needing exits as they are duration constrained by mandate, Kinnevik has been providing opportunistic secondary capital to its core holdings. A good illustration of competitive advantage in practice. The following slide helps visualise this:

A huge amount of portfolio repositioning has taken place in recent years and a lot of this has involved taking heavy write-downs to valuations. Earlier in the year the CFO described to us that valuations have gone from ‘exuberance to revulsion.’ Kinnevik gives us an exposure we cannot directly get ourselves to fast growing earlier stage companies. As a flavour, the core portfolio grew sales at 60% last 12 months, is forecast to grow 40% next 12 months and all these companies are profitable or funded to break-even. The following slideshows a portfolio overview:

A key attraction for us is the shares trading at a c.45% discount to NAV (1). Whilst we would not be so bold as to call the bottom in NAV developments, the type of valuations the core holdings are on suggest to us that we are far closer to the bottom than the top. The very significant cash pile should allow the company to maximise the current opportunities.

We love when we find long term assets mispriced due to market myopia. This strikes us as classic example.

(1) Chelverton Asset Management estimate

Independent Assessment

As part of our investment process, we use an external tool called Quest. Quest is a global cash flow return on investment database and underpinning it are many shared philosophies on returns, cash generation etc. Quest has many uses but we use it primarily as a sense check on our own tools and analysis - mostly at the stock level.

One of the services Quest provide is a portfolio review service where an independent analyst at Quest provides an objective overview of a portfolio. It can be thought provoking and is useful part of our own portfolio review as it can challenge us to justify positions we have taken.

Below we copy the summary from the (mostly human!) analyst without any adornment.

Our own high level response to this review is that we were comforted that the summary points echo how we think of the portfolio ourselves.

We would be happy to send on the full report and/or have a discussion if this is of interest.

Source: Quest, as at 11/9/24

The Abominable No-Man

We were asked recently for a deep-dive meeting to discuss idea generation. We demonstrated the tools we use to look at and either dismiss or take forward a new idea. For this quarter (Q3 2024) we kept a note of the number of ideas we had looked at and the source of the idea. The table below is the output.

^{Source: Chelverton Asset Mgmt. Stocks in Bold acquired for the fund in Q3. Please note with stock examples  - inclusion in table is not a recommendation to buy or sell a specific security.}

The main points we made during the meeting were:

• The objective is to turn over a lot of stones - From approximately 200 companies reviewed this quarter, c.10 merited more in-depth work, 5 made the buy list and 2 made the portfolio. Warren Buffet called Charlie Munger ‘The Abominable No-Man’ due to his swift rejection of most ideas. Point being, the hurdle to reach the portfolio is high.
• We are not fussy where ideas come from and have multiple sources, many with multi-decade roots.
• The ability to quickly decide whether a company merits further work is based on the quality of tools built. The tools we have, internal and external, highlight explicitly what we look for - cheap cash flows, healthy growth, sound balance sheets and solid returns on capital.

Having powerful tools such as the ones we’ve built allows us to spend the majority of our research time on in-depth analysis.

A Dividend Too Far

We have sold a long-standing position in D’Ieteren, the Belgian family controlled holding company. The most successful asset within the group has been Belron, the windscreen repair company trading as Autoglass in the UK. It has been a successful consolidator of this segment in many countries and is now by far the dominant player in a market where economies of scale have offered excellent economics to the holders. Belron grew to c.70% of D’Ieteren NAV.

A change in the ownership structure of Belron a few years ago brought in private equity investors into the shareholder structure. Operationally and financially, this has been highly rewarding for other co-investors and Belron has paid significant dividends. The ownership changes also brought a change in attitude to leverage at both the operating companies as well as the listed holding company we invest in. We have enjoyed this journey as the shares have increased 4-fold since purchase over 5 years ago.

The company announced (10/9) that as part of a re-organisation of family shareholdings, Belron is to leverage up to 5.5x net debt/ebitda so that large dividends can be paid to investors including D’Ieteren. D’Ieteren the holding company we invest in is also to leverage up to enable this dividend (yield of c.30%) to be paid. D'ieteren has hitherto operated with a very significant net cash balance sheet, counterbalancing the leverage in its operating companies - this protection will now disappear.

The net result of this is that our investment is now in a (newly) leveraged holding company owning stakes in a number of leveraged operating companies. Our assessment is that ‘look-through’ leverage will be between 3x and 4x geared.

Readers will be aware that we have a zero-tolerance approach to Balance Sheet risk, especially around these levels. We have sold our position and have re-invested the proceeds in existing holdings.

Back in the Loupe – Asymmetric Risk in France

Referring to political upheaval in France, we wrote in the recent Quarterly Report that ‘we do not think we would be credible or indeed it would be an effective use of time, if we produced a decision tree of probabilities attached to political outcomes, from which policy responses, from which company responses and made macro-based decisions this way’. Hence, we focus on stock specific opportunities.

One new holding thrown up by the recent political turmoil is Trigano, the European market leader in motorhomes. Trigano is an excellent case study of a successful family run business which has steadily grown and consolidated its leadership position in a sector which takes its investment case from an ageing population and the desire for both outdoor and more flexible holiday pursuits.

We have tracked the company for a while and the current political paralysis has thrown up what we consider a decent buying opportunity. Note that our inability to perfectly time means that tactically we average our way in over a period:

Shares discount a very gloomy future for the company as follows:

Source: FactSet (consensus), Chelverton Asset Management as at 26/8/24

Our own in-depth work shows what we think to be an attractive, i.e. asymmetric, risk/reward profile:

Source: Chelverton Asset Management as at 26/8/24. For broader discussion of our use of these metrics please see In the Loupe entry from 15/1/2019

The perception of Trigano is as a consumer cyclical with violent swings in profitability and cash flow. We think both the sector and the company are better than this.

We have had a break from our regular diary posts as we figured out how best to communicate regularly with professional investors. We tried to ‘beef up’ the Quarterly Report with more analysis rather than just factual reporting on the quarter (all historical reports can be found on the left hand side of this page). Nonetheless, we think ‘little and often’ is the better strategy and so with this entry, we re-boot the diary, noting the re-branding from our marketing intermediary, Spring Capital, to ‘In the Loupe.’

Feedback on content is always welcome.

Webinar Replay

We hope you enjoy this webinar replay with portfolio manager Gareth Rudd. To view the transcript please click here. Chapters include:

Investment Philosophy: 02:12

Investment Process: 07:28

Portfolio Metrics: 08:10

Intrinsic Value of Portfolio: 10:46

Portfolio Potential: 12:21

European Smaller Companies: 20:16

Q&A: 26:34

Core Holdings in Focus:

The UK is often criticised for lacking global technology leaders – but in 2021 a global leader in online auction platforms listed on the London Stock Exchange. With its roots tracing back to the 1970s print publication Antiques Trade Gazette (still considered to be the ‘bible of the antiques industry’), ATG operates six world-leading online marketplaces, as well as providing the technology for over 3,800 auction houses to run their own curated online auctions using a platform that would be technically and economically challenging for all but the largest auction houses to recreate.

We first invested into ATG at IPO, but exited the holding on valuation grounds after a very strong period in share price performance. A year later, and following a major acquisition, we restarted the position at an attractive valuation point, and in more recent months have added to the holding following disappointing short term Industrial & Commercial trading as inflation normalises.

Arguably the most exciting upside to the investment is the growth potential from ancillary services, such as delivery and payments, with CEO John-Paul Savant bringing highly relevant prior experience at eBay and PayPal. The payment and delivery functionality on auction websites is archaic to say the least – with successful bidders often responsible for arranging delivery and payment handled via bank transfer, or in many cases, cheque. At present, penetration of these services remains low, providing a long tailwind to growth if they are successfully adopted and implemented.

Investment Case

Key points in the Investment case are:

• Network Effects - ATG’s marketplaces are a market leader in each geography they operate in. As the number of listings increases, so too does the number of bidders – generating network effects and making the marketplace very difficult to dislodge.
• Capital Light - the business model is very capital light, requiring limited fixed assets and working capital to operate, and the company does not procure or supply any of the listings on its marketplaces. Incremental revenue should drop through to profits at a high rate with a relatively fixed cost base alongside high gross margins (c. 67%) driving a FCF margin of >35%.
• Services Opportunity -in the medium term, delivery and payments have the potential to double the take rate from c. 3% to >6% and become the company’s largest revenue source, replacing a complex and mainly offline payments process and/or clunky delivery services.

Currently (as at 15.5.24), the shares trade at 15x EV/NOPAT (our preferred valuation metric – see previous post ‘Our Approach to Valuation’). We view the company as a core technology holding that provides exposure to both US commercial and residential consumption (>80% of revenue) and a well-invested, market leading platform.

Core Holdings in Focus:

In this update, we will provide a brief overview of what attracted us to SigmaRoc, the Fund’s largest holding. Firstly, a quick history of the business:

SigmaRoc is a buy-and-build quarried materials group focused on Northern Europe. Key products include lime and industrial limestone, which are used in thousands of everyday applications, such as road construction, water filtration and toothpaste (in fact, we consume approximately 500 kg of limestone per capita in Europe each year). The strategy is similar to the one successfully deployed at Breedon (also a holding) and Summit Materials in the US; essentially, buying heavy material businesses with strong local market shares at attractive prices and improving efficiency over time.

There are two larger deals of note undertaken in recent years that have benefitted SigmaRoc's market positioning:

Nordkalk: the leading limestone producer in Northern Europe, bought in 2021. In August 2023, we visited one of the Nordkalk sites in Pargas, Finland (see photo below) to witness the quarry up close. Particularly impressive was the site’s limestone crusher, built over 50 years ago and located over 200 metres below ground to reduce noise and dust pollution for the local residents.

CRH Europe: in 2023 the group agreed to acquire CRH’s European lime and limestone operations. The deal effectively establishes SigmaRoc as a duopoly in most of its key markets in Europe whilst materially increasing market exposure to infrastructure  (reducing SigmaRoc’s exposure to more cyclical residential construction).

_{Nordalk’s Pargas Quarry in Väståboland, Finland. Source: Chelverton Asset Management}

So why do we like aggregates businesses? The three key points for us are:

1. Pricing power – due to the heavy nature of the product, transporting aggregates long distances is not cost effective. As such, quarries tend to operate local monopolies in their immediate area, with good levels of pricing power.
2. Barriers to entry– significant capital investment is required to set up a greenfield quarry. Supply is limited by the availability of sites, whilst securing permits has become more difficult in recent years.
3. Working capital efficiency – operators can respond quickly to changes in demand and do not have to carry high levels of inventory. As a result, the cash conversion of these operations has been very high. This has helped the company to pay down debt quickly and finance acquisitions.

SigmaRoc has built a strong collection of assets with favourable competitive positioning, attractive margins (16% FY24e EBIT margin) and a well-diversified demand profile. From a valuation perspective, the shares trade at a 40% discount to peer Breedon (as at 13.5.24), despite higher infrastructure exposure (and in theory, more predictable demand) and a more diversified geographical footprint. With the CRH deal being the company’s largest deal yet, execution risk will remain elevated in the short term - but with a consistent track record of delivering on integrations and a dynamic, entrepreneurial management team, SigmaRoc remains a core holding for the Fund.

Core Holdings in Focus:

Some of our most compelling investment opportunities have come from identifying an agile, tech-enabled player competing against slow-moving incumbents. In the case of Alpha Group, which has grown organic revenue sevenfold since listing in 2017, its core FX market remains dominated by the large banks. Banks’ FX solutions are often generic and lack the funtionality of a specialist like Alpha, which has consistently ranked as one of our highest conviction investments since IPO.

The core business is a high-touch, tech-enabled service called FX Risk Management, which helps finance directors minimise FX-related risks in their businesses. Playing a similar theme is Alpha’s more nascent Alternative Banking division, which helps alternative investment vehicles (e.g. Private equity and Venture Capital funds) efficiently open and manage local bank accounts. Banks provide a slow, encumbered service to these vehicles, often taking months to open bank accounts. Furthermore, there is limited non-bank competition.

Let’s walk through how the business met the screening requirements to join our investable universe.
(For more detail on these requirements, please refer to our prior post on 16th February ‘Screening for Investment Ideas’)

Alpha comfortably meets our screening requirements – so how does it fair in the Qualitative Assessment?

PREDICTABILITY OF SALES

• Consistent market share gains in risk management, largely at the expense of banks, which retain >90% market share
• Recurring annual Alternative Banking account fees
• Interest earned on Alternative Banking on stable client cash deposits (as a non-bank, Alpha is unable to pass interest on to customers)

SUSTAINABILITY OF MARGINS

• Consistently earned >20% EBIT margins since listing and averaged 39% in past 3 years
• Barriers to entry: well invested tech platform, strong brand and well-resourced compliance function
• Capital light, with limited fixed assets

MANAGEMENT

• Founder CEO Morgan Tillbrook owns 14% and is well aligned with shareholders
• Disciplined approach to capital allocation with supernormal interest income reinvested back into organic growth

Having passed both tests, representation in the fund becomes a valuation call. We have discussed our valuation methodology in prior posts; as the company is profitable and at scale, we use EV/NOPAT and a blend of FY24 and FY25 forecasts to give a FY12m forecast. After making our own adjustments to NOPAT to account for exceptionally high interest income and adjusting the EV for regulatory capital, we get to a FY1 EV/NOPAT of 18x (as at 10.5.2024) after a strong recent run in the share price, which we consider close to fair value.

Our approach to valuation

We use two core metrics for valuation: EV/NOPAT and EV/Sales. In this note we will explain what they are and why we use them to compare opportunities across our portfolio and investible universe.

Enterprise Value or ‘EV’ is calculated by adding net debt/deducting net cash from a company’s market cap. Simplistically, EV is the sum an acquirer would theoretically pay if they agreed to acquire the business. We make several of our own adjustments to get a better representation of EV, such as including the present value of future pension contributions, customer prepayments (e.g. software subscriptions paid in advance), deducting freehold property, and using a fully diluted share number (to account for future share issuance to management).

EV/NOPAT is a company’s EV divided by net adjusted operating profits after tax. We take our own view on the company’s adjustments to ensure they are fair and not recurring costs (or they will be added back). We then assess the company’s capitalisation policy – are profits flattered from hiding costs on the balance sheet? This can be particularly relevant for technology companies - in cases where the amortisation charge in the income statement is at odds with the amount spent on capitalised R&D, we make an adjustment to help level the playing field across our investment universe. We also include the cost of share-based payments – a real cost borne by the company but often ignored - in our calculation. The end product is very similar to Warren Buffett’s ‘Owner’s Earnings’ (EBITDA less maintenance capex).

EV/Sales is a complementary metric we use when assessing fast growing companies that are suppressing their operating margins to prioritise revenue growth, or for a company that is undergoing a temporary period of depressed profitability. In both situations, we will pay a higher EV/Sales multiple in relation to maintainable future operating margins (EBITA margin), as demonstrated in the chart below:

Why not use PE Ratio or EV/EBITDA? The PE ratio uses market capitalisation, which ignores leverage and can allow a company to gear the balance sheet with debt to acquire earnings inorganically, which can optically make the shares appear cheaper. Whilst EV/EBITDA takes into consideration leverage, it ignores all capex (in the cashflow statement and depreciation and amortisation in the income statement). As Warren Buffett aptly described it in his 2000 Letter to Shareholders; ‘References to EBITDA make us shudder – Does management think the tooth fairy pays for capital expenditures?’.

Furthermore, post the IFRS-16 accounting changes, an element of property lease costs is also charged through the depreciation line. This often produces a much more flattering version of company earnings than adjusted NOPAT – you can probably guess which metric management teams tend to prefer!

What is a Qualitative Assessment?

So, a company has successfully passed through our screening test, but what next? There are three quality indicators that play an important role in what we are willing to pay for an investment, let’s discuss why:

Sales predictability –helps management teams with capital allocation decisions (when to invest). As investors we will pay more for revenue visibility as it helps underpin financial forecasts (and therefore the accuracy of our valuation models) and limits downside risk. Examples of sales visibility might include a company that benefits from a design win that requires the customer to redesign and/or re-certify the end product if they are displaced (e.g. DiscoverIE, XP Power), or a business that sells multi-year data or software subscriptions (e.g. GlobalData, Craneware).

Sustainability of margins– can demonstrate an enduring competitive advantage, without which, profit margins would be eroded over time. Even more attractive is a business that can sustainably grow margins over time, provided it does not come at the expense of revenue growth. Furthermore, high margins can help improve cash conversion as the costs (typically borne before the cash is received from the customer) are lower relative to the revenue. You might hear us discuss the attractions of companies that can finance their own growth (without resorting to issuing debt or equity) which is a function of margins and cash conversion.

Management– must act as good stewards of capital and remain consistent with their strategy and messaging; aggrandising deals financed by debt or equity issuance can be hugely value destructive. With this being said, we are not averse to synergistic deals where they beat the company’s cost of capital in the near term. It is good corporate governance practices that alongside high-quality management teams, set the foundations for long-term performance

These factors – alongside others such as expected revenue growth, cash generation, customer concentration and leverage – contribute towards the valuation we are willing to ascribe to a business. In a later post, we will discuss what EV/NOPAT is and why it is our preferred valuation metric.

Screening for Investment Ideas

In a universe of over 2,000 UK listed companies, investors often ask how we find the time to analyse so many different companies. One of the most efficient mechanisms for narrowing down the opportunity set is a clearly defined screening process.

We screen for five factors – cash conversion, revenue growth, leverage, gross margins and working capital efficiency. This narrows the universe down to approximately 300 stocks – a much more manageable list. The first three are common screening criteria in the investment industry, but gross margin and working capital intensity are featured less prominently. In this post we will discuss why we think they are such important metrics.

Why Screen for Gross Margin?

Gross margin is a company’s revenue less its cost of goods sold (COGS) – typically these will be variable costs like raw materials, direct labour or energy costs that are directly tied to the manufacturing of a product or the provision of a service. A high gross margin is attractive for two reasons - it can indicate a competitive advantage or ‘moat’ that others struggle to replicate, and it can enable the company to scale more easily. Generally speaking, the higher a company’s gross margin, the less expensive it is to finance working capital (discussed below) and the faster revenue is converted to cash. This is important because as the business scales, it can divert less cash towards financing working capital (e.g. buying raw material or paying for the production of inventory) and more towards other areas such as Sales & Marketing, R&D or cash returns to shareholders.

Why Screen for Working Capital Intensity?

Working capital intensity provides a useful window into the relationship between revenue growth and the capital required to finance it. At its most basic, working capital is the capital a company requires to operate on a daily basis – example include:

• Wages at a manufacturing facility
• Cost of producing finished goods to be held in inventory
• Cloud hosting costs
• Cost of raw materials
• Credit supplied to customers

Working capital intensity is generally dictated by the bargaining power of customers and suppliers – for example, a large customer might be able to negotiate a long payment window that would mean receiving cash 90 days after the revenue was reported (thus reducing cash conversion). Alternatively, a supplier might demand payment in advance of supplying its services, or before a key component is shipped.

Conversely, companies can operate with negative working capital – this might be because they receive payment in advance of supplying a service (common with SaaS software companies) or because they pay their suppliers long after they receive the cash from the customer (e.g. supermarkets). In these situations, we can tolerate a lower gross margin since the customer is financing the growth of the company. The most desirable combination is high gross margins alongside negative working capital – which can make a business prodigiously cash generative, even whilst its growing.

If a company meets at least 4/5 criteria above (must include cash conversion target), it can proceed to the Qualitative Assessment, which we will discuss in our next post.

^{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

Market Darlings - What Price Novo?

Thanks to the success of its new obesity drugs, Danish pharma giant, Novo-Nordisk, is now the largest company in Europe by market cap.

We have been observing, ok bleating, about the valuation of the market darlings for a few years now. Below we have plotted the top 5 European market cap stocks on our usual FCFY/Growth chart:

We believe that the growth/value equations at Nestle and L’Oreal do not look too enticing especially compared to our portfolio average. Following recent underperformance and valuation now close to the market average, LVMH may require more work now. Due to much higher growth, Novo and ASML require a closer look and different type of consideration. We will use Novo as an example.

If a company can sustain 20% top line growth, what should we be willing to pay for this? To try and answer this we can use some simple assumptions:

• If a company grows sales at 20% it may well have operating leverage, therefore margins and cash flows can expand at a rate greater than 20%. Let us use a working assumption of 1.2x the 20%, i.e., 24% pa.
• If cash flows grow at 24% pa, then over 5 years the cash flows will have compounded 193% or 2.9x.
• The starting 2% FCFY of Novo will, all else equal (i.e., no change in share price), will be a 5.8% FCFY in 5 years’ time.

Sounds ok so far. However, we also need to think what the market might look like in 5 years’ time. If market sales continue to grow at the current c.5% pa and the same 1.2x multiplier is in operation, then the market cash flows will grow at 33% or 1.33x over 5 years. With a current FCFY of 4.5%, in 5 years’ time the market FCFY will be 6.0%.

So, in ballpark terms then Novo might seem ok. However, we are not comparing Novo to the market, we are comparing it to what we own in the portfolio. If we apply the same logic to our portfolio, we have the following:

• Our 3-year portfolio sales growth of 11.8% would translate into 1.2x this at the cash flow level i.e., 75% compounded over 5 years.
• From a starting FCFY of 7.2%, all else equal (i.e., static share price) our portfolio FCFY will be 12.6% in 5 years’ time.

We would say Novo looks a good deal less appealing now. This is a deliberately simplistic piece of maths and ignores probabilities around drug success, over-reliance on small number of products and any number of other things besides.

We used to own Novo and sold it as valuation became a stretch for us. Since then, they have successfully released two blockbuster obesity drugs. In our language a ‘best case scenario’ unfolded for Novo. We did not ever expect to be taking single drug risks in the portfolio so we should not beat ourselves up too much I do not think.

For us, one of the immutable laws in investing is margin of safety. The striking thing with Novo is the lack of a margin of safety. If the biggest company in Europe can compound cash flow growth for 5 years at 24% pa, then fair play to them and if they do, their drugs may well have done society a great turn. However, our observation is that there is very little margin for error if things go less well.

To answer the question posed in the title, and in the spirit of this simplistic analysis, what price Novo? Either we would have to convince ourselves that cash flow growth could compound well into the 30%+ range or the starting FCFY would need to be nearer 3% then 2%. We are not prepared to bet on the former as our central case. The latter is in the market’s hands.

^{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

Sex and Drugs and Rock & Roll

Actually, the title of this is Process, Intrinsic Value and Margin of Safety but that is a lot less likely to garner attention. Read on for tales of derring-do.

There is never a bad time to go back to first principles. This investment view reviews the way we think about valuations. At the heart of our thinking is the belief that we should be buying shares for considerably less than they are worth. Or in investment language, investing in shares with big discounts to their intrinsic value.

This gives us a margin of safety: Intrinsic Value – Price = Margin of Safety

Click here to read more.

^{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

Top Growth Contributors— A Deeper Analysis (part II of II)

The previous diary entry focussed on the top ten contributors to the portfolio’s free cashflow yield and gave some insight into how we are achieving the significant free cashflow yield premium to the market (portfolio free cashflow yield of 6.8%* versus broader market of 4.7%* as at end May 2023).

Now we turn our attention to growth.  We have consistently achieved a meaningful growth premium versus the market as well, as the graph below demonstrates. This has largely been achieved as a result of our exposure to smaller companies, where the market, in our view, continues to undervalue the growth prospects of these businesses:

Source: Chelverton Asset Management, Factset, 31st May 2023

When we talk about growth, we are referring to the average sales growth expected over the next 3 years for a given company. We use this simple metric to show the expected organic growth prospects as it is relatively straightforward to adjust any short-term distortions from issues such as acquisitions and disposals.

Currently, the portfolio’s 3-year growth prospects are for 11.1%* per annum, versus the broader market on 6.0%*.  The table below shows the top ten contributors to growth for the portfolio, with a brief company description, the main drivers of this growth, and also the free cashflow yield - the price we are paying for the respective growth prospects.

Source: Chelverton Asset Management, Factset, 13th June 2023

Main points to highlight are as follows:

• The top ten contributors for growth account for some 5.1%* of the portfolio’s overall growth prospects of 11.1%*
• The contributors tend to have either digitalisation or commodities and energy transition themes as the main drivers of their growth – two very significant long term structural megatrends for investment. They are, however, very diverse businesses, operating in various sectors and markets.
• These companies have already delivered significant historic growth annually for the last 3 years of 28%* on average.
• The majority of these businesses are small companies, with only 1 midcap – BESI and one largecap – Rheinmetall. Excluding these two, the average market cap would be €537m*.
• Crucially, we are not losing our valuation discipline when investing in these growth opportunities. The average free cashflow yield of this group is 4.6%*, effectively the same free cashflow yield as that of the market, at 4.7%*.
• These companies are not leveraged. The average balance sheet has net cash, amounting to -0.5x EBITDA*. This compares to the broader market which has average net debt of 1.3x EBITDA*.

The analysis above adds substance to our general thesis that the market is not recognising the growth prospects of smaller companies.  The top ten contributors to growth have expected growth prospects of 24%*, 4 times that of the expected market growth of 6%*. But we are paying effectively the same price as the market (4.6%* free cashflow yield, versus market on 4.7%*) for these growth prospects. And with reduced financial risk, given balance sheet strength.  A very attractive trade-off between value and growth.

*Source: Chelverton Asset Management, Factset, 13th June 2023

^{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

Why Large Caps?

If you follow our narrative, you should have picked up that we are most excited by the inefficiencies, and hence opportunities, at the smaller end of the market cap spectrum.

Given this, we do get asked why we bother with large caps at all. Our stock response is that we want the freedom to invest wherever the greatest opportunities are. This may well be in small caps right now, but it might not always be the case. We don’t ever want to be boxed in.

There are opportunities in large caps which are very difficult to replicate in small caps. Banks are currently one such example.

As a former bank analyst, I (DWR) am acutely aware that banks have been an investment graveyard for most of the last 15 years. From peak in 2006 to early 2021, 75% underperformance of the index:

Source: FactSet Prices 14/02/2023

Interest rates fell continuously from 2006 and this made it very difficult for banks to earn decent returns. With interest rates sharply reversing of late, so goes the investment case for banks.

The opportunity is nicely summarised by one of our bank holdings Bawag, in their recent earnings release:

Despite our strong record of performance over the past decade with an average RoTCE c.15%, we have underearned over this period defined by negative interest rates. We have an opportunity to deliver more normalised returns in the years ahead – going forward we are targeting RoTCE >20%

Source: Bawag results 13/2/2023. Note RoTCE is Return on Tangible Common Equity.

The investment case on banks is relatively simple:

• the market has forgotten that these companies can make decent returns in a more normal interest rate environment.
• after more than a decade of balance sheet repair, banks face the economy in the rudest health in decades.
• as mature companies most banks have opted to have high payout ratios as well as topping up these dividends with either special dividends or share buybacks – this ‘total shareholder return’ (TSR) is the core part of our case

These are the banks we own and how we see their capital return potential:

Source: Chelverton Asset Management as at 16/2/23. Note 2022 DY is based on dividends as declared by all companies in recent results. 2023 TSR is based on our expectations, derived from company communications, of dividend growth and share buyback potential.

We currently have c.7% of the portfolio allocated to these banks, believing that the c.7-9% capital return on offer is attractive in its own right and a good diversifier for the portfolio.

Why not a higher allocation to banks? Our assessment of growth prospects are lower than portfolio average - 5% for these banks and 10% for the portfolio overall. This means that too much more in banks would compromise the robust growth we expect from the portfolio. Cyclicality and risk profile also part of the equation also.

There are times when we feel the market is missing something in large caps and this is a good example of why we retain the right to invest in large caps. Small caps look cheap for growth prospects, but this may not always be the case. It is great to have the investment flexibility.

^{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

But doesn’t everyone do cashflow analysis?

This is a question we have been asked by potential investors when discussing our process for picking stocks and managing the fund.  Any reader who has seen any of our presentations will know that we have placed cashflow analysis at the heart of our investment process and couch our language of valuation in terms of free cashflow yield – this is our valuation discipline.

But the question suggests that since everyone looks at cashflows, how is our approach different?

Our advantage, we believe is in the level of detail, attention, and consistency which we apply to our analysis.

Our first observation is that not everyone is doing cashflow analysis, at least on the sell side. The diagram below shows that as we look down the market cap spectrum, there are less analysts covering these companies, and more importantly, fewer of these analysts actually produce cashflow forecasts. This is a key inefficiency for us to exploit.

Source: Factset, Chelverton Asset Management 31 January 2023

That I spent 7 years at a deep dive cashflow analysis research house has helped negotiate the common failings of much cash flow analysis.

We think it is fair to say that markets like a short cut.  Single point price/earnings and enterprise value/EBITDA ratios still tend to dominate standard analysis. We feel that these ratios on a stand alone basis actually tell us very little about the true valuation of a business.

Cashflow ratios have entered this “quick fix” arena. When free cashflow yields are quoted, by either data providers or analysts they tend to be on a single year basis and tend to use a very basic, and in our opinion, flawed calculation. The standard definition of free cashflow is cashflow from operations less tangible capex.  This overly simplistic calculation ignores a number of important considerations:

• Intangible capex. Many businesses now legitimately capitalise intangible investments such as software development. This is a recurring cash cost and it needs to be included in the calculation of free cashflow. It is too frequently ignored by analysts
• Acquisitions. If the business is a serial acquiror, cashflow analysis needs to take this into account, as it is likely to be inextricably linked to the growth rate which the company is expected to deliver going forward
• Lease costs. The IFRS16 effect. Previously, operating leases were simply expensed through the P+L and the cash outflow was captured as a normal expense.  However, with lease costs now being capitalised, it is surprising how many analysts do not deduct the cash cost from the cashflows. Who pays the rent, then?
• Debt. Standard free cashflow yield is stated as free cashflow divided by market capitalisation, ignoring debt. This creates a very uneven playing field for comparisons, where heavily indebted companies appear to have higher free cashflow yields (look cheaper) than their better capitalised peers. Value Trap risk high with this approach.
• Short-termism. Looking at single year cashflow ratios risks annualising big swings in cashflows. For example, say in a given year a business has a big working capital fluctuation – it could be that a big payment arrives late – this is quite common for smaller companies. This could have a material effect on the free cashflow of the company in any given year.  Annualise this, and the analysis will be useless – an element of smoothing is required.

To do cashflow analysis properly, we need to adjust for all of these factors, and consider them over both historic and forecast time periods – which is why we use two years of historic free cashflows and two years projected forward when calculating the free cashflow yield of a given company.

Even after doing this analysis, it is not enough to verify the cash-based valuation of the company. It is also necessary to perform DCF analysis of the cash flows in a much longer time horizon, in different macro and micro scenarios and using different discount rates. Only after doing all this work can we satisfy ourselves we have a company which can be considered cheap on a cashflow basis.

In conclusion, we do not purport to have a patent-protectable process when it comes to cashflow analysis.  But to do it properly is complicated and time consuming.  We believe it is well worth the effort, and we also believe, for the reasons discussed above, that it is still done poorly by the market generally.

_{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

New Holding: Ox2 – Lean, green cash machine

The European Commission’s 2019 roadmap for becoming carbon-neutral by 2050 has at its heart decarbonisation of the power sector.  The EU is mobilising €1tn of capital available for sustainable investments over the next decade.  Within this, wind power generation is widely expected to be the EU’s primary source of power by 2050 - a clear multi-year megatrend for investment.  However, gaining exposure to this attractive area has not been straightforward for us.

We have analysed the European wind turbine manufacturers – one angle with which to play “picks and shovels” to the megatrend.  We have struggled to get our heads around the high valuations, taken alongside issues such as technological developments and a very competitive environment.

We have also examined several potential investments in renewables developers - the project management companies, which is another potentially attractive way to play the service provider angle.

It seems to us that many of these companies have fairly crude business models and can be characterised bluntly as follows - a business, with a field, which plans to install turbines and make money in several years’ time.

Ox2 combines strong growth with being a service provider to the energy transition megatrend. It is fully funded from internally generated cashflows, with a strong balance sheet and it is therefore an attractive addition to the fund.Business models have appeared to focus more on financial discount rates, cost of capital, maximising debt finance and maybe the promise of large profits long term.  This is not our style of investing.  Also, many of the companies which are engaged in development projects had a small concentration of projects, thus increasing the risk of any of these projects going wrong (delays etc).

Ox2 is refreshingly different. Ox2 is a leading European wind project developer.  It also has solar and energy projects within its portfolio, but it is onshore and offshore wind where it has built an enviable track record.

Source: Ox2 Q3 presentation 2022

Ox2 is involved in all aspects of wind farm development. It has projects in Sweden, Finland, Åland and Poland. It acquires rights (though not land as it operates an asset-light business model), then develops these rights achieving all the required permissions, before selling projects on to large corporate buyers (utility companies and businesses such as Ikea) once they are ready for construction.  Ox2’s involvement in the project doesn’t end there.  They then project manage construction, and in certain cases continue to operate and maintain the facilities once they start producing energy.

One major advantage which Ox2 has over many other businesses is experience.  Founded in 2004, it has significant expertise in all aspects of project development.  It has been involved in over 70 sites, and all have been profitable.

The company itself has been profitable and cash generative for several years, another rarity.  This is down to the depth of the portfolio.  It is also extremely well capitalised, with over 10% of its current market capitalisation held in cash.

Given its strong order backlog, Ox2 is expecting to grow its sales by 30-40% per annum over the next three years.  It is strongly cash generative and is on a free cashflow yield of over 5% - giving cash available to fund future growth opportunities.

Ox2 combines strong growth with being a service provider to the energy transition megatrend. It is fully funded from internally generated cashflows, with a strong balance sheet and it is therefore an attractive addition to the fund.

_{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

Early Rollover - We believe our portfolio can grow at twice the market rate over the coming years

As the calendar is about to change and another year becomes history, we customarily ‘rollover’ the numbers – 2022 become Financial Year 0 (FY0) and 2023 becomes FY1. We do not normally do this until 2022 results are reported but we have done this slightly early this year, hence this is a ‘sneak preview’. The main reason we are doing it early this time is that 2022 has contained some distortions which have quite literally inflated 2022 sales growth and we are keen to look through this anomalous year and report a more ‘normal’ trend growth.

Prior to rollover, the portfolio and market 3-year sales growth looked like this:

Source: Chelverton Asset Management, 16/12/22

Unless we are on the brink of a hyper-inflationary period, the 2022 levels of sales growth are not normal. This has much to do with inflation, covid bounce back and sector specific factors in energy in particular. So even though we do not know final 2022 numbers we think it is reasonable to roll-forward the numbers where 2023 becomes FY1. Doing so creates the following picture:

Source: Chelverton Asset Management, 16/12/22

Our portfolio growth is much more durable than the market. With all the usual caveats in place around forecast error, we believe our portfolio will be growing at twice the pace of the market over the coming 3 years. Sales growth does not automatically become cash flow growth but based on the structural drivers of the portfolio we expect to see operational gearing from this level of growth. In other words, we expect cash flow growth to exceed the sales growth level.

Here is the longer run chart of sales growth. A consistent story but with the premium over the market right now at very healthy levels – we think a good situation given economic fears.

Source: Chelverton Asset Management, 16/12/22

This is of course only one metric and should never be considered in isolation. What are we paying for this growth? Rolling forward our Free Cash Flow Yield (FCFY) assumptions in the same way as above shows that we are still paying modestly for this growth – in fact specifically our cash flows are still 30% cheaper than the market:

Source: Chelverton Asset Management, 16/12/22

It can be seen that our FCFY premium has fallen to 30% - but in absolute terms is a healthy 7%. The balance for us is always in trading off growth for value and this is what we see here. Over the last 3-4 months we have deliberately invested in companies with double digit compounding growth prospects and the valuation we have been paying - of around market FCFY levels brings down our overall FCFY premium. We think this is an excellent equation and as long as we maintain our valuation commitment to a material portfolio FCFY premium to the market, we think this will serve investors well over the coming years.

The last part of our jigsaw is the financial risk profile of the portfolio via the leverage ratio, net debt to ebitda ratio. We have taken a zero-tolerance attitude to balance sheet risk recently, selling a couple of stocks at losses where balance sheet risk has arisen (more to follow on this topic). This has left the portfolio with an extremely healthy balance sheet position:

Source: Chelverton Asset Management, 16/12/22

We continue to find significant inefficiencies at the smaller ends of the European market. This is why we can construct a portfolio with meaningfully better growth prospects than the market as well as cheaper cash flow than the market, with a very moderate financial risk profile.

_{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

Caverion bid - Man with a Van has a Fan

It’s been a challenging year for equities generally, and smaller companies have largely suffered to a greater extent, as sentiment towards them has waned in the face of macroeconomic challenges.  We have often argued that seeing smaller companies as somehow inferior, less well capitalised, and less able to cope with economic headwinds is a misplaced concern.

Periodically, we get reminders to stick to process, focus on cheap cashflows from well capitalised, healthy growing businesses. One such reminder was the recent bid for Caverion.

We first began investing in Caverion back in November 2020. We were attracted by the simplicity of its business model – most of its business is long term service contracts maintaining and upgrading buildings – hence “man (or woman) with a van”.  There is also an environmental angle to the Caverion story, with energy efficiency standards, and renewables usage driving much of the demand for renovation, upgrading and refurbishment of buildings. These are long term structural tailwinds for demand for Caverion’s services.

We have added to our position in Caverion on multiple occasions since purchase.  During the last year, the decline in the share price had been quite severe. Despite a reassuring capital markets day back in May, and solid results in August, the markets generally shunned Caverion this year – we believe that part of the issue was its main place of business, Finland, and concerns over its proximity to Russia in light of the Ukrainian conflict.

Source: Chelverton Asset Management, Factset, 25 November 2022

At the end of October, the valuation of Caverion (as plotted on our favoured free cashflow yield/growth axis above) was 10% free cashflow yield for 4% growth. This felt like a very low valuation for this business. On 3^rd of November, it was announced that Caverion had received a bid at 7 Euros (over 50% premium to the prior day’s closing price) from a consortium led by private equity firm, Bain Capital. We also received 6.4% in dividend yield over our holding period.

As can be seen, the bid price represents a much more sensible free cashflow yield valuation of just over 6%. We think that Bain has paid a sensible price for what had become a significantly undervalued business.

It is a pleasing reminder to remain patient investors, especially when our smaller company investments go out of favour. We have had and continue to expect to see corporate solutions for a number of our investments, especially when the public markets refuse to value the cashflows sensibly.

Over the last year, we have had corporate activity across several of our holdings, as shown below. These are either full out bids, or significant corporate activity (disposals and cash returns).

*31 October 2022

This justifies having a process which aligns strong balance sheets with cheap cashflows, and healthy prospects being a good discipline to have.

_{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

Energy 2.0

When we launched the fund in 2018 one of our higher conviction ideas was oil services. This was a painful experience at the time as we were too early and had to retract. Looking back at our work of this time, our investment case in one of our then holdings, Fugro, was representative of how we felt:

2017 Annual Report unwittingly provides the investment case for Fugro: ‘2017 was the 4th consecutive year of exceptionally deep downturn in offshore O&G services.’ Fugro is a provider of geo-intelligence & asset integrity solutions. This is typically early cyclical as it forms part of the exploration stage of a final investment decision (FID). As well as operational leverage, Fugro has more financial leverage so should be seen accordingly as a higher risk play on the oil.

Source: Chelverton research document from 2018

A mea culpa / lament was later found in a quarterly report of the time:

Tactically, we were too bullish in the energy sector, and it has cost us at least 200 basis points. When we launched the fund, we felt that there had been such a capex hiatus in the industry that the best way to play the sector was via capex beneficiaries. These stocks are more leveraged to the oil price where our working assumption was broadly a $60-$80 central case. No sooner than we built up a full sector weight in anticipation of a 2019/2020 cycle than the oil price fell 30%+ in Q4. We ended up a bit lopsided in our names and are re-appraising the mix of holdings here.

Source: Chelverton European Quarterly Report Q4 2018

Three reflections from this distance stand out:

1. In a cyclical sector, timing is important
2. In a cyclical sector, balance sheet strength is important, especially if you get point 1 wrong
3. Do not be overconfident on an oil price forecast

So here we are again having another go at the energy sector. What has changed? We think a few, very important factors:

• The underinvestment in supply which we saw in 2019 has been extended by a further 3 years. We are not at a point in the energy transition where we can wean ourselves off oil and gas, and it is unrealistic to expect production to continue without investment in supply. The medium-term supply/demand balance looks skewed to prices at least supportive of current levels
• Geopolitical events have led to a reappraisal of and acknowledgement that whilst the energy transition is vital, fossil fuels have an important role to play in this transition and that energy security is part of this equation

Nearly every oil service company starts their presentation with a version of the following slide. We had thought that a positive cycle was going to embark 2019/2020. It is now likely that capex will grow over the 2023-2025 (at least) period and that this will be a constructive backdrop for the energy industry, especially the service companies. Capex is still 50% below the peak levels of the last cycle, 2013-2014.

Source: Noram Drilling

It is difficult not to form judgements of the oil price. However, history tells us we should be cautious about the confidence we attach to a central view. Therefore, when we have a strongly macro driven sector such as energy it is crucial to perform sensitivity analysis under a wide range of different scenarios. The oil prices we have used in our cash flow analysis is in a range of $40-$120. The overwhelming conclusion is that there is considerable risk adjusted upside for a range of shares across the sector. As long as balance sheet strength protects the downside scenarios (i.e., don’t buy financially leverage companies), the best-case upside significantly outweighs the downside and that on a central scenario (current oil price range), the sector looks very attractive on a 3-year view.

We have hence been building up our exposure during this year as we have done more work and continue to get confirmation of the thesis from industry participants.

A summary of our current exposure is as follows:

Valuation and Risk Profile

We have tried to diversify our exposure across parts of the exploration, services, and production spectrum and across geographies. We have looked closely at the ‘EPC’ companies such as Saipem or Technip Energies which (e.g.) do the construction of liquification facilities and whilst they have good order books and growth it is difficult to get comfortable with their execution capabilities and therefore risk profile. We also looked at the many E&P companies which produce oil in parts of Africa or Middle East and similarly concluded that risk profile was too high for the valuation on offer.

With regards to downside risk, we have discussed balance sheet a lot. In general, oil sector company balance sheets are in good shape. This is because either they have been generating a lot of cash due to high prices of late (mostly E&P companies) or the downturn forced a refinancing and a resetting of balance sheet risk. There were more financially leveraged options we could have chosen to invest in which one might argue would give us ‘more bang for our buck.’ However, we have opted for safe balance sheets as operational leverage itself should ensure sufficient returns from this part of the portfolio.

A valuation summary of our holdings is as follows:

Source: Chelverton Asset Management

There are few points worth making on the valuations. Our analysis of expectations is that for the next few years there is a natural fade in oil price expectations and therefore cash flows – an element of understandable caution in numbers. As readers will be aware, our FCFY calculation is calculated on a 4-year average of FCF, meaning that currently the number contains typically 1 bad year (2020), a better year (2021), a very good year (2022) and a faded year (2023). As we roll forward and if oil prices stay around current levels there is upside to both FCFY and DY numbers noted above.

The other obvious observation is that free cash flow is translating into dividends – a healthy equation – for shareholders at least.

Note that we haven’t included growth figures here as they don’t to us look representative of what to expect. They contain sales growth this year of 40-50% for 3 of our holdings which is not what we expect to recur. Our service companies we are expecting consistent double digit top line growth plus operational leverage for the years to come.

Conclusion

As we look out over our investable time horizon, the next 3-5 years, we find the oil services sector as one where there is a greater likelihood of growth in sales and cash flows than in many other areas. The basic equation we see is double digit compounding growth allied to high single digit FCFY’s for the service companies and double-digit dividend returns from the producers. Both are attractive equations.

_{Any opinions expressed are our judgement at the time of writing and are subject to change without notice. This diary entry does not constitute Investment Advice or a Recommendation in respect of the Companies referred to below. Please refer to the disclaimer on the right hand side of this page for further information.}

The Good, the Unproven, and the Very Out of Favor

Readers will be aware we have a significant portion of the portfolio in invested in micro-caps, sub €500m market cap companies. This is the part of the market where we see the most inefficiency and the greatest long-term opportunity. Here I’d like to expand upon 3 stocks in this category – one which has started to reward us, one which hasn’t done anything yet and one which has been very poor to date but in which we retain confidence – the good, the unproven and the very out of favour.

The Good – Limes Schlossklinikum

We met the Founder, Dr Frank at an online conference in February 2021 and quickly realised this was a hidden gem. We started accumulating shares almost immediately.

Limes is an operator of mental health clinics in Germany & Switzerland. They specialise in the treatment of stress related illness and mental emotional disorders – depression, anxiety, burnout, ADD, OCD etc. They have 3 operating clinics with a 4^th to open at the start of 2023. Most clients self-fund although insurance can cover costs too. The 2 clinics that have been operating the longest have day rates of €450-600 and average stays are in the region of 45 days. On a different level is their clinic in Zurich, Paracelsus Recovery. It is one of the most exclusive rehab centres globally and typically treats ‘A-listers’ and royalty. A staff/patient ratio of 15/1 gives an idea of the service. Costs can be €800k for 2 months of intensive treatment.

Source: Paracelsus-recovery.com

The company are on track to report €8-9m of ebitda in 2022 from 3 sites. The fourth site near Cologne will open in 2023 and as it will be the biggest one yet, it could add another €8m of annualised ebitda over 2-3 years. The plan is to grow the portfolio towards ten clinics over time. Plans to launch young adult (14–21-year-old) clinics are well underway. These clinics will treat, amongst others, the children of existing clients – this is the fastest growing segment of this market.

One of the most impressive aspects of the business plan is it has been bootstrapped and self-financed by Dr Frank himself. Properties are held by investment funds and leased to Limes. The properties are effectively brand new and require minimal capex – very positive for free cash flow prospects.

Based on the four existing properties we can see ebitda potential approaching €15-€20m over the next few years. This could translate into FCF of €8-€14m. Importantly, the company has in the last 2 years already been delivering good FCF, so our case is not all about the accuracy of this forecast. Market cap is €84m and we expect there to be no net debt at year end (the company has smartly agreed a financing facility at cheap rates to finance future expansion). This means we can see a double-digit free cash flow yield for a company growing well over 20%. An excellent equation and despite the share price rise, one we continue to back.

The Unproven – Cyberoo

Cyberoo was another company we met at an online conference at the end of 2021. Like Limes, we started buying the shares not long after the first meeting. The shares are around the same level we first bought them.

Cyberoo are a cybersecurity provider, offering Managed Detection & Response (MDR) services. The company was initially a reseller of antivirus, antispam, firewall etc systems. Then in 2015 they pivoted and developed their own MDR. MDR is considered the next level of proactive protection against cybercrime. Gartner, the technology researcher, states that ‘By 2025, 50% of organisations will use MDR services that offer threat mitigation capabilities. Cyberoo operate in Italy where penetration of MDR services in SME sector is minimal. They are the only Italian operator at present and Gartner name Cyberoo as the only Italian company in their 2021 Gartner global market guide for MDR services.

In the most recent reporting period (H1 2022) they reported 50% organic revenue growth and an ebitda margin of 28%. Their business is seasonal and expect to grow even faster in the second half. This is still a very small company, forecast to only do €18m of sales this year.

These results are very impressive considering that at the start of the year they had 50 of 150 employees in Ukraine (Kyiv and Ternopil). Ternopil University has a centre of excellence for software engineers, hence why the company have an important base here (HQ is Milan). During covid and pre-war most staff were WFH which made it much easier to respond to the war. The business of MDR operates through Intelligence Security Operations Centres (ISOC’s – Cyberoo operate four in total) – this is where they monitor client systems and provide their ‘intelligent or automatic remediation’ response to cyber threats. Pre-war two of these were in Ukraine. One was swiftly brought back to Italy and the second located in Ternopil, near the Polish border. An impressive operational response to an unprecedented situation.

Speaking to the company about this, Ukrainian staff are highly determined and motivated to work. The company tell us that ninety percent of cybercrime against businesses is from Russians (mostly for ransom) so they feel they are playing their part in the war against Russia. Most Ukrainian staff can speak Russian and read Cyrillic script, hence are a huge asset in the fight against dark web cybercrime.

Source: Cyberoo presentation

The company is forecast to grow by another 40-50% each of the next 2 years. All growth is organic. Their client sweet spot is a 1000-2000 employee company for which the client pays €80kpa. Their sales pitch is that this is a small cost to keep their business going. As Cyberoo ‘own’ the services, profitability is very high.

Usually with a high growth stock like this you get growth but not cash flow. Here we get both. This year and next the company are forecast to deliver €6m then €15m of ebitda. The company gets paid upfront for what is a recurring service and as these services are scalable (use of distribution partners) we would expect at least 50% of ebitda to translate into FCF. If they keep growing sales at well into double digits (German market entry in 2023) we could see some very strong FCF numbers. We have a free option on this growth at the current valuation.

The company has no debt and a market cap of €75m. This means we are paying a c.5-10% FCFY for a rapid growth company. Cybersecurity is a hot area for obvious reasons. At some point we expect Cyberoo’s valuation will catch up with its fundamentals.

The Very Out of Favour – Huddly

Huddly IPO’d in February 2021 at NOK15.5. Our initial purchase was just below this level in April 2021. The shares are currently just below NOK4. A somewhat chastening experience so far. Here is the story.

In 2010 the fund I was managing held shares in Tandberg, a Norwegian pioneer in video conferencing equipment (VTC). It was one of the best technology companies in Europe at the time and it was acquired by US giant Cisco. As often happens with acquisitions, acquired personnel seek new ventures and so it was that in Oslo, a ‘video valley’ grew up from ex-Tandberg employees who left to form their own companies.

Huddly is one such company. They produce ‘smart cameras’ for meeting rooms. Physically their products look ‘just’ like cameras, but they think of their product (& USP) as software defined hardware allowing remote updates to comply with the latest Teams/Zoom/Google Meet features.

Source: Huddly presentation

The investment case is that (depending on source) 80-90% of meetings rooms do not have proper AV equipment that allows for the hybrid and tele-working which is a key feature of the future workplace. Huddly are a small player but appear to us to have a technological edge. We do not think their partners such as Microsoft or Google would collaborate with them if they did not have something special. This was our initial case, a small company which was a technology leader in an enormous and rapidly growing addressable market. In 2020 they had delivered Nok70m of FCF which meant a 3% historic FCFY for what was forecast to be 40-50% growth. This was an equation we were perfectly happy with especially as they had a large net cash balance sheet which at the time amounted to c.10% of market cap. This was our operational margin of safety.

Fast forward 18 months and c.70% lower share price, what has happened? Primarily two things - supply and demand.

Supply chain has been a major issue. Huddly outsource manufacture of their cameras, but sourcing parts has been a major challenge. However, the wider issue is that a Huddly camera tends to get bundled with other bits of more mundane kit and it is the broader supply chain challenges that have hurt the company. On the demand side, the company expected a boom in ‘back to work’ post Covid sales. What is happening in practice is that large corporations are taking their time and reconfiguring meeting room spaces prior to deciding on the exact solutions they require.

The company see this as demand delayed rather than cancelled and we are inclined to agree. Supply chain challenges are also easing. However, forecasting >40% sales growth and delivering -7% is not a good look.

There have been many ‘flaky’ IPOs in recent years, several of them on Scandinavian exchanges. Often weak business models, rationales, and finances. We do not think this is one of these. Although there have been some disappointments, we see the certifications from industry giants and awards the company have received in the intervening period as evidence that the technology is very robust.

We expect a return to the rapid growth that was expected a couple of years ago. The market has given up on this possibility. The market cap is c. NOK800m. They have c.250m NOK or 30% of the market cap in cash. They have demonstrated they can deliver 70m of FCF, but this is before the significant growth we expect to come. We have our timing wrong here but think it is a company to continue backing – we continue to average down on our purchases.

Common Features

As is obvious, there are risks attached to investing in below the radar in small companies such as these. We systematically mitigate the risk by:

• our co-investment policy. All our smaller companies we are co-investing alongside material Founder/manager stakes thereby aligning capital allocation and incentives. All three of these companies are still run by their Founders
• by only investing where there already exists positive free cash flows, not cash flow X years down the line
• where balance sheets are strong enough to fund growth
• where we can credibly see exit potential in the years to come

We can see that all three of these companies have multi-bagger potential. Limes has started to deliver on this (up c.3x since investment), Cyberoo needs to keep delivering before investors will realise there is something very powerful going on and Huddly needs to start showing proper growth again. We think the risks are worth taking. Between them these three holdings represent c.4.5% of the fund.

New Holdings: Assystem, EQS & Frequentis

My brother has worked in the police since he left university, nearly 30 years ago and although our jobs are very different, when we speak about what we like about our respective jobs it is the variety or unpredictability of what we face each day which appeals to us both.

For me as a fund manager it could be analysing an announced acquisition, a set of results or thinking through a major new macroeconomic or geopolitical development. For my brother, the nitty gritty of the real world and sometimes of course matters of literal life or death. However, we are agreed that what gets us out of bed is the anticipation of not knowing exactly what we will be facing and pitting ourselves against an appropriate response.

As an unconstrained manager with over 3000 different companies we could invest in, the variety of company we meet and invest in is one of aspects of the job I love the most.

In the last couple of months, we have started positions in some new holdings. Here we will focus on three - companies in different but very interesting fields: a nuclear consultancy, a provider of whistleblowing software and a leading supplier of safety-critical control towers.

One German company, one French and one Austrian. Market caps between €200m and €600m and all having significant management/founder ownership and hence strong alignment of long-term interest with us as co-investors. The valuation/risk equations:

• The average sales growth of the 3 companies we would anticipate around a 10-15 CAGR%
• The average FCFY (to enterprise value) of the 3 companies is around 5%
• One has some debt but will degear very rapidly and the other companies have significant net cash balance sheets (in one case adjusting for very material non-core stakes).

Here is a bit more detail about each of the three new holdings.

Assystem is a rare direct play on the renaissance of nuclear. The EU recently declared that nuclear energy is to form part of the EU’s so-called taxonomy - a list of activities deemed to support the climate neutrality goals. This will be a long-term boon to Assystem. The company is French and have been working for 50 years with EDF the monopoly provider of nuclear energy in France (as well as operating in the UK), a country which is the second largest nuclear market after the US. They are the dominant provider of engineering services to the industry.

Source: Company

Note that ET&I is Energy Transition & Infrastructure. Framatome & Expleo are the two non-core holdings which the market might expect to be disposed of over the coming years.

Their business is made up of maintenance services as well as new build engineering advice. As new reactors get built their business mix shifts to higher value-added construction advice and we expect long term revenue growth to accelerate from the current 6%. There are currently 56 reactors in France and 6 in the UK generating 60GW in France and 8GW in the UK. 14 new reactors (6 France/8 UK) have been announced and the construction phase (of at least 5 years) ensures a considerable long-term tailwind. After decades of the opposite, pricing power is returning to the industry suppliers.

As well as the delivery of solid growth and rising margins, other investment catalysts could include:

• disposal of 2 non-core stakes which could account for over half the enterprise value
• possibility of an ownership change as the Founder/CEO/majority shareholder is over 70 and has no family members in the company

Risks include nuclear accidents as well as the single customer risk, so we can’t right now see this as a top 10 holding but it should provide a long-term defensive and relatively uncorrelated portfolio position.

EQS is a ‘regtech’ company. It was founded in 2000 and built its software initially around the needs of the Investor Relations department. They have more than 90% market share of the DACH regulated market (DGAP) – similar to RNS for the LSE. The growth now is based around the regulatory driven needs of the Corporate Compliance Function. All their products are pooled in cloud-based software called EQS Cockpit.

The imminent driver is the EU Whistleblowing Directive which has been passed and is getting implemented by different parliaments this year and next – Germany being the key market for EQS. The Directive aims to provide protection to whistle-blowers who see breaches of EU law within their employer. EQS’ product provides a simple software solution to corporates to allow them to comply with the new law. All EU companies above 500 employees (50k of them) have to comply when local parliaments sign off and then companies between 50-500 employees will implement later.

As can be seen from the following, the implementation of this directive and EQS’ ambition of taking c.20% of the available market share will transform the group. They assume that 50% of companies will comply. Experience from early adopter countries Denmark and Portugal appear to verify this. Note that Business Keeper was a 2021 acquisition of a key competitor in the whistleblowing solutions area.

Source: Company

The above targets are only based on current product plus the whistleblowing opportunity. The company is also developing a product for an upcoming EU Supply Chain Directive as well as ESG and climate reporting. We regard these are relatively free options. Customers would just add another module to their existing ‘cockpit’ and increase their quarterly direct debit to EQS.

We have watched this company since early 2021 when the shares were in the low €40’s. We were put off slightly by the high price they paid for Business Keeper but with the shares now in the high €20’s, an equity raising done and the whistleblowing directive more imminent, the risk/reward and timing appear better now. For us EQS is a slightly different investment as most of the cash flow is forecast rather than balanced between historic and forecast but we are confident in the regulatory drivers, the company’s market position as well as the recurring nature of the cash flows.

Frequentis is a 75-year-old Austrian business which provides hardware and software solutions for safety-critical control centres. The business is split between air-traffic management and public safety & transport. Government bodies are 90% of the customer base.

Source: Frequentis

Like Assystem, this is another long-term business with lifecycle management of 20 years typical. There is a recurring/maintenance element to the business but also strong new business growth drivers:

• Remote digital towers (RDT) – management of air traffic from remote locations – this is the replacement of outdated & costly concrete control towers – the Frequentis offering provides a compelling business case as recent tender success testifies. A recent example is the French Air Navigation Service Provider, DSNA, who selected a Fequentis RDT to remotely traffic for an airport based in Toulouse
• Drone management – ensuring the safe coexistence of unmanned aerial vehicles and manned aircraft in shared airspace
• Upgrade of police/fire/emergency services to 5G/LTE broadband services

The business can be a bit lumpy and seasonal, but the order book and the growth drivers provide the sort of long-term visibility we like to see. Another company we have tracked for over a year and it took our third meeting with the company to get fully comfortable with the case.

In all three cases we have taken position sizes between 0.6% and 1% and will build position sizes over time depending on (as usual) share price performance as well as competition with competing ideas. Variety is indeed the spice of life.

Long-Term is the Light Approach. Buy when the Lights Flicker.

We often say that the biggest arbitrage opportunity in markets is time horizon. Data show that the average holding period of equities can now be measured in months.  Longer term investors can take advantage of volatility created by such short-term behaviour in markets.

In order to do so, it is essential to have the correct toolset for undertaking analysis of a given business.  The toolset is firstly behavioural and secondly fundamental. Readers will know that cashflow analysis is the fundamental backbone of our process.  Also, by trying to incorporate historic as well as prospective free cashflow of a company into our analysis, we are attempting to get away from single point forecasting, which can often lead to very short-term behaviour on behalf of investors.

Furthermore, we use scenario modelling in our assessment of a business’ value. At all times, our aim is to be approximately right, as opposed to precisely wrong.  Finally, it is important to place any changes to short term forecasts in the context of the bigger valuation picture, and to do this, one needs to consider the effects of, for example a short-term downgrade, on a company’s wider valuation.

I will attempt to bring our process to life using an example from the recent results season.

Signify is a stock we have held in the portfolio since early 2020. There is a diary entry around purchase time. It is the former Philips lighting business, is a global leader in lighting, and has an interesting environmental angle, being one of the largest suppliers of low energy-consuming lighting solutions.

We think that Signify is a cheap company.  In our parlance, it is on a free cashflow yield of over 11%, for over c.3%-5% long term revenue growth.  As can be seen from the graph below it is firmly in the value area of our investible curve – healthy, growing a little slower than the market, but compensated by a very high free cashflow yield, good dividend (current yield in excess of 4%), and a share buyback programme.

Source: Chelverton Asset Management, Factset, 15 Aug 2022

At time of writing, the shares are down -25% year to date, -14% of which occurred in the last 3 weeks. Part of the issue was the recent interim results announcement from the company which was taken poorly by the market. Although organic growth is strong, and ahead of expectations one of the main culprits for the price fall was a temporary lowering of free cashflow forecasts from “over 7% of sales” to “between 5% and 7%”. The company went on to explain that cash generation was low in the first half as they stocked up on inventory due to supply chain shortages. They are confident that this is already reversing, and that next year, this will go back to normal.

The point of this narrative is to show the effects to the overall valuation of the company from just such an adjustment.

The graph below is taken from our central case scenario for Signify. The solid line denotes the historic cash flows achieved by the company and the dotted line is the level of free cash flow which we assume the company will generate going forward. As can be seen, we are factoring in quite conservative absolute levels of cash generation versus Signify’s historic levels achieved in recent years. Also, we would remind readers that Signify made a significant acquisition in 2020, further strengthening our thesis that these expected cash flows shown below are modest assumptions.

Our central case valuation suggests at least 86% upside to the share price.

Source: Chelverton Asset Management, Factset, 15 Aug 2022

Now, we factor in a much-reduced level of free cashflow for this year. Here, we are taking a very conservative view of short term cashflows. The company has guided to “between 5% and 7% of turnover, which would give a low end free cashflow of 380m. We assume that the actual number is 150m for the year – be conservative, and be pleasantly surprised is our theory.

As can be seen from the graph below, the actual effect on our implied valuation is negligible – the upside is 83%, rather than 86% - in other words, the market appears to have over-reacted to newsflow.

Source: Chelverton Asset Management, Factset, 15 Aug 2022

The point here is that we do not believe that Signify has suffered a structural change to its business. Cashflows may temporarily suffer but we can easily see through this, and quantify it with the toolsets available to us.  Signify has moderate financial leverage, and can easily absorb a short-term reduction in cashflow such as this.  In fact, we would expect our holdings to use their balance sheet strength to build up inventory in the current environment as this should help with customer satisfaction and lead to long term market share gains. Negative share price tantrums such as this provide opportunities, and we have been adding to our position.

What we have been buying/considering in turbulent times

When we launched the fund over four years ago, our overarching aim was to have no style bias. We wanted to develop a process, based on sound principles of low leverage, cashflow analysis and a valuation discipline.

So, we are free to look at every area of the market for ideas. This brings in periodic reviews of areas such as Telecoms, a pertinent debate, since, year to date, they are one of only two sectors of the European market which has posted positive returns – the other being Energy (arguably for more obvious reasons).

So why are Telcos performing? To start with, some perspective is needed.  The outperformance has been over a short time period and also from a very low relative base – they have been poor absolute and relative investments for years.  But is there more to it than “every dog has his day” this time?

One consideration is that the economic environment is changing. It is very clear that a decade of low interest rates and low inflation is now over.  We cannot forecast actual levels for either but think we can be fairly confident that interest rates will move higher, and that a degree of inflation will be a feature going forward.

Given this, it is sensible for us to be considering potential inflation hedges.  Telecoms are one sector which is perceived to offer this – telcos tend to have inflation pass-on contracts.   We have hitherto avoided telcos.  However, as unconstrained investors we frequently re-appraise all of our thinking and challenge our prior conclusions, especially when there appears to be a significant shift in fundamentals – for example, the return of inflation as a feature for markets to deal with.

As well as being perceived inflation hedges, other reasons for owning telcos include infrastructure ownership, potential consolidation, and being the backbone of the digital revolution.

The other side of these arguments remains that they are heavily regulated, over leveraged, consume capital, with poor returns and are perceived as a commodity service.

If we look at return on capital employed and return on assets for the largest 3 European Telcos – Deutsche Tel, Telefonica and Orange, owning a network doesn’t appear to be a particularly attractive thing, certainly not in terms of returns.

The average return on invested capital for this group, over the last decade is 3.5%.  The average return on assets is worse, at 2%.  As a comparison, the average return on invested capital and return on assets for the portfolio for the same time period is 14.5% and 7.4%¹. If telcos have attractive assets and opportunities to make good returns from the capital they invest, then they are yet to show it.

From a valuation discipline perspective, are they cheap?  Readers will know that we view all of our investments through the lens of a free cashflow yield and growth trade off.  So where, on our graph do these companies sit, versus the market and our portfolio?

Telecoms remain one of the most leveraged sectors in the market, with average net debt to EBITDA currently running at approximately 3x.  The free cashflow yield of telcos therefore needs to be taken at the enterprise value level, since using the free cashflow yield to market capitalisation will flatter these companies.  The results are below:

These telcos are firmly in what we often term the “bond proxy” quadrant where investors get a free cashflow yield which is submarket, combined with growth which is also submarket.  We are not convinced that telcos are actually cheap.

For now, we conclude that the negatives are outweighing the positives for Telcos, and will look elsewhere for companies which can benefit from an inflationary environment – more on this in a subsequent diary entry.  We will continue to monitor areas such as Telcos though – it may well be that we can find an investable business which doesn’t possess as many negatives as those we highlighted above.  For now though, we feel from a valuation perspective that there are better opportunities elsewhere.

Is it time to buy the darlings?

The other side of the equation, given the rotation of the market towards areas such as Telcos is the underperformance of quality.  We have discussed over time the valuations of the so called “darlings” in Europe – quality cash compounding businesses, with good to excellent growth prospects.  There is a reasonable spread of businesses which fit this description, and many of them are at the bottom of performance tables year to date in Europe.

Our stance with respect to many of these companies has generally been to admire the business models but avoid them as investments due to lofty valuations.  Periodically we have taken advantage of pull backs in these types of businesses and bought positions, most notably around the Covid-induced turmoil of early 2020.  Around this time, we found a few “darlings” which we could actually own as they passed our valuation discipline. These included companies such as Kering, Moncler, Adidas and Reply.  But opportunities in recent years have tended to be fleeting, and we subsequently sold these holdings as they re-rated.

Luxury is an interesting sub-set of this group.  The graph below shows how the growth/value trade-off has been affected by the sell-off year to date in the following companies – LVMH, L’oreal, Kering, Moncler, Hermes and Richemont.  By the end of May, these stocks had fallen on average 30% since the start of the year.

The graph below shows how the valuations of these companies (through our lens of free cashflow yield and growth) have changed since the end of the year:

As can be seen, the share price falls have improved the free cashflow yields of all the companies, though growth forecasts have slowed as concerns over Chinese consumption and economic prosperity generally cause reductions in forecasts.  Valuations of this group are definitely becoming more interesting with the current growth/free cashflow yield trade off starting to look quite a lot more favourable following the share price falls.

Kering in particular was looking attractive again, and a few weeks ago we began to accumulate shares. There can be a perception that Kering is lower quality, being substantially a one-brand company.  However, the quality metrics of this group are very high (return on invested capital, for instance averages 16% - compare this with the Telco number above of just 3.5%), and Kering ‘s returns are broadly in line with the group average across a range of quality metrics. This suggests that Kering should not be rated less favourably for any qualitative reasons.

We will take our time – recognising that sentiment, and forecasts could work against the shares for a while. We may be too early with our initial purchase, but we have left plenty of scope to add in the event that shares fall further again. We think valuation support is emerging even with slowing growth and some pressure on operating margins factored in.

Another subsector which has suffered a retreat year to date has been the so-called quality industrials.  We use Schneider, Legrand and Siemens as examples.

The graph below (as with luxury above) shows how the free cashflow yield versus growth metrics have changed as the share prices of these companies have fallen by approximately 25% year to date:

To us, Schneider and Legrande are probably at fair value, with approximately market free cashflow yield for slightly better growth.  Siemens on the other hand started to look really interesting from a valuation perspective and, similar to Kering, we started buying shares.

Whilst we concede that Siemens has a number of cyclically exposed elements to its business, which may suffer somewhat in a downturn, it has various areas of business which are not.  It still owns significant stakes in health technology (Healthineers), and alternative energy (Siemens Gamesa Renewables, where it is currently buying back the minority).  Further, it is exposed to attractive investment themes such as mobility, power provision and factory automation.  These provide an attractive combination, and we took advantage of the recent sell off to accumulate.

¹ Source: Factset, 24th May 2022

Portfolio & Macro Risks

Events of the last 6 months are a useful reminder of the folly of macro forecasting. You can now place your bets anywhere between a stagflationary environment and a re-enactment of the roaring 20’s! Our approach to incorporating different macro scenarios is both bottom up and top down. At the stock level we incorporate a (typically very) wide range of macro outcomes in our cash flow scenario analysis work. From a top-down perspective our portfolio construction deliberations consider sensitivity to different macro scenarios. Without committing to a specific macro outcome, this diary entry focuses on our portfolio structure as a consideration for how we might fare in a worsening economic environment.

Firstly, a digression. When we were talking about establishing this fund five years ago, one of the basic premises was that we did not want to be beholden to a particular style being in vogue or having a portfolio whose success was largely dependent on a particular macroeconomic outcome. Been there, done that. Hence from a stylistic perspective we adopted a blend of value and growth, and by emphasising the under-researched parts of the market we have been able to focus on smaller companies where we feel the structural growth opportunities outweigh cyclical considerations.

It is this latter point, structural versus cyclical we seek to emphasise in this note. Without of course being immune to cyclical pressures, we feel the fund is positioned to benefit from structural more so than cyclical factors and that this distinction should help us through what could be a more challenging economic environment.

The standard factsheet depiction of a portfolio can give helpful information, but, in our view is best supplemented by thinking more about the underlying exposures and why they exist in a portfolio.  The following table is another way of thinking about our portfolio and the narrative which follows expands on the exposures:

The following sections take each of these groupings in turn prior to looking at how this might compare to ‘the market’.

IT Services

The key debate here is whether an economic slowdown might derail the strong tailwinds these companies are experiencing from the technology investment by their clients. The consistent message we get from our holdings is that the work they are doing, and the tailwinds are so strong that (at this stage obviously) they are confident their growth will continue.

Companies are telling us that the constraint on growth is not ability to get clients, it is shortage of IT engineers and we are seeing this in prices being passed on to clients. We believe there is a significant shortage of human capital in the areas of Artificial Intelligence and Machine Learning over the coming decade and that the companies we have invested in can benefit from this supply/demand mismatch.

Many of our holdings are due to receive a boost from ‘NextGenerationEU’, the stimulus package which will boost digital investment where it is needed most. Of course, there is risk that fiscal priorities change but we believe this stimulus is a long-term committed one.

For this segment of the portfolio then, we feel confident that whilst there may be some project deferrals, we will continue to get good growth. We have written extensively on this sector, please our diary entry below (24/3/22) for analysis of how diversified the exposure is. 

Other Technology

This is a more heterogenous grouping and more difficult to make generalisations.

• Following a sharp correction, we are in the process of building back up our semi-capex exposure (BESI and ASM International) as we feel the structural case is very strong.
• We think the cases of Huddly (remote working), JDC (digitalisation of German insurance contracts), MGI & Enad (online gaming), Cyberoo (cybersecurity software), Serviceware (measurement software) and Prosus (Tencent exposure) are case specific enough to not be strongly correlated to a downturn.
• Alkemy replaced Artefact as our key digital marketing exposure and the structural case allied to valuation after a fall makes this one of our better ideas right now – even though there might be a nearer-term reduction in client spend.
• Neosperience and Digital360 are held for their exposure to the aforementioned EU stimulus plan.

There will be some elements of cyclicality in this group, but we are happy that the strength of the structural growth means this group can grow sales and cash flows through a tougher economic environment.

Green Cluster

Thematically it may seem obvious to seek exposure to the energy transition. Executing this in practice is another thing again. Obvious areas such as wind turbine manufacturers have major headwinds from their capital intensity and supply chain issues. Solar players, amongst which many recent IPOs, look unattractive due to extreme leverage and inappropriate embedded return assumptions – in our opinion.

Nevertheless, like IT Services, we can use a pick and shovel approach to achieve solid exposure here. Consultants such as Arcadis, Rejlers and Caverion are involved in a wide range of projects around water usage, energy efficiency and the achievement of a number of other UN Sustainable Development Goals. Signify is a market leader in energy efficient lighting solutions. Like Signify, Recticel has specific regulatory drivers in its field of insulation panels. Greenvolt is a management story currently in biomass sector, pre-build wind projects, and is expanding into installing solar panels onto Spanish roofs. INIT provides solutions which supports the electrification of public transport.

There can always be slowdowns in growth but the regulatory support for these companies is strong on a multi-year level.

Defensive Cluster

Without compromising our value/growth objectives, we specifically built up this cluster as a protection against possible market falls.

• Our pharma holdings are in here, as are Unilever, Essity (tissue & related) and Vidrala (glass bottles) in staple like areas.
• Industrial companies whose profits are based on their service/repeat offerings are in here – Kone and Knorr-Bremse.
• Swedish Match was in here to be defensive but has just received a takeover bid.

As a group we would expect outperformance from this cluster in a market downturn. If this proves to be the case we are likely to use holdings from here as a source of cash for ideas, which will be thrown up in a sell-off.

Banks & Energy

Positions here are as close as we get to holding deep value names - both these sectors offer inflation protection as well as stock specific cases.

For many years now speaking to bank executives they have been crying out for higher rates so they can rebuild crushed margins. So, whilst we acknowledge the risk in a downturn of downgrades, the combination of valuation plus margin upside favours some exposure here.

In Energy, we own an integrated company (Shell) and TGS which is a play on the restart of exploration activity. We purchased these positions in Q1 as we felt that risk reward favoured a higher oil price over our investable time horizon.

Cyclicals

Again a varied list of companies in here – mostly with more obvious cyclical growth characteristics.

• Amadeus Fire in German IT/Finance recruitment, Kinepolis as a cinema operator and D’Ieteren  we worry less about from a cyclical perspective as they are all high-quality operators who take share in adversity.
• We had cause to recently sell BPost and reduce Knaus Tabbert (motor homes) when we reflected on risk/rewards. We retained PostNL from the postal sector – long term value remains compelling.
• Kaufman & Broad is a French housebuilder whose activities are financed by their customers and whose management stake and high dividend yield give us comfort.
• Kering and Siemens are two recently initiated positions as deratings in their respective sectors offer good entry points – we’ll build position sizes up over time.

Completing the stocks in here is lastminute.com our travel recovery play.

There’s an element of subjectivity in the placement of stocks in these 6 segments but we don’t think overanalysing or trying to come up with a false level of precision is appropriate - at any time, and especially this environment. So, when we consider the above we see obvious cyclicality in somewhere between a quarter and a third of our portfolio.

Structure of European Index

The common perception is that Europe is a more cyclical market than most. The outperformance of the high-quality growth stocks in recent years has eroded this, but the following table shows that in the broadest sense Europe still has a high level of cyclicality:

Again, without trying to be too precise, we wouldprobably call c.50% of the index as cyclically exposed. Our simple conclusion from this is that, although clearly not immune, our portfolio should be significantly less exposed to the downgrade cycle than the market overall. This is logical when you consider our limited exposure to large sectors such as banks, industrials and consumer discretionary.

Small and Mid Cap Exposure

The other angle we need to think about is our small and mid cap exposure. At 70% of the fund, we could conclude that we are more exposed to an economic downturn. From a fundamental point of view, we would push back strongly on this. The analysis above we hope helps but when allied to our standard value, growth and risk charts we think our portfolio metrics tell a strong story.

Whilst of course we will have exposure to lower growth and falling estimates, we feel that in the areas we have exposure, the structural opportunities for our portfolio will outweigh the cyclical, certainly over any time period that matters to the long-term investor.

One thing which is difficult to quantify in a down market is forced selling of small caps as an asset class. We would make 3 observations:

• The small cap stocks which appear in our top 10/20 holdings are naturally our highest conviction ideas and we have grown with most of them over the last 4-5 years. As we have written about elsewhere these companies have by some distance the safest balance sheets in our portfolio
• Last year we took the decision to diversify our number of holdings and went from 40 to currently 62 holdings partially as an acknowledgement of this risk
• We have taken a tactical decision to carry an extra 2-3% cash in the current environment to allow us to take advantage of any forced selling in our core holdings (i.e. now 5-6% in total)

Conclusion

If it is to be a recession, we would argue that the worst combination of portfolio characteristics you can have would be cyclicality, leverage and high valuations. Our metrics show that we have the converse of this - a cheap portfolio on well considered cash flow metrics and a safe portfolio balance sheet. In addition, and as we have analysed above, we have a disproportionately high exposure to companies with strong structural drivers and less reliance to companies needing strong cyclical conditions to perform.

We of course cannot and would not wish to, eliminate cyclical exposure but we feel we can look forward to whatever the cycle brings. If our assessment of the structural is correct, then we will be well set when opportunities present themselves from both within and outwith the portfolio.

Through the Looking Glass

As a portfolio manager you always have to be aware of unintended exposures and risks at the portfolio level. We have been very conscious of this as we have built up our IT Services exposure over the last three years. This exposure now constitutes around 29% of the portfolio.

We have extensively written on the reasons for this exposure. The investment case is about digitalisation, it is about the structural need for companies and governments to keep investing to improve efficiency but to also maintain and extend competitive positioning. It has been a long time since technology investment has been ‘nice to have’.

There are many reasons we have chosen to invest in this theme through IT services companies. The companies offer broad software and hardware agnostic solutions to their client needs. The majority of our holdings do not depend upon one specific solution (e.g., Microsoft, SAP) they provide tailored solutions for their client – this means we have a lot less company specific technology risk than we might otherwise have. The companies we invest in also have owner/manager/founder incentivisation which aligns us from a capital allocation perspective. And leaving the most obvious reason to last, the combination of good growth and cheap cash flows are also present.

These companies are the pick and shovel manufacturers for the digital era.

We also selected the holdings with a view to the underlying sectors they give us exposure to. Infotel is one of our largest holdings and since the founding of the company over 40 years ago, they have worked with large French corporate clients helping them with various technology solutions.

Source: Infotel

As can be seen in the slide above, Infotel works with BNP and other French financial institutions and in aggregate over half of Infotel revenues come from the Finance vertical. So, when we think about our 2.8% portfolio holding in Infotel, we consider 1.4% or so of the portfolio being exposed to technology spending by French financial institutions.

When we aggregate this across all our IT Services holdings we get the following net exposures:

Source: Chelverton Asset Management

So, 7% of our portfolio is exposed to technology investment by European banks and insurance companies. Our top-down view of the world is that this 7% is a more reliable growth engine than the earnings of the underlying bank sector where we would have to figure out loan growth, interest rates, margins, cost growth, bad debts, and regulatory attitude to capital returns amongst other factors. This doesn’t mean that we can’t and won’t invest in the banks sector: we do, albeit with only 4% of the portfolio. It’s just that with the threat of fintechs and the mess of the legacy IT systems, continuous investment in IT seems a surer structural investment and growth driver for our portfolio.

The second largest sector exposure is the public sector. We have been keeping an eye on this recently and have trimmed a couple of positions. Atea for example has 60% exposure to public sector – mostly in Scandinavia. During the COVID period, governments kept technology spending high for obvious reasons, but as we enter a new phase, and with perhaps other public spending priorities emerging, we need to be alert for funds getting diverted away from digitalisation programmes. Having said this, many of the technology programs our holdings are involved in at local government or EU levels are multi-year, and are unlikely to be scaled back too much. 

Currently, our largest holding is Sword. Sword works with EU institutions such as the European Patent Office. The backlog referred to in the slide below represent nearly 4 years work for this particular unit of Sword – we don’t think this tap will be getting turned off overnight. Public sector is 35% of Sword’s activities.

Source: Sword

There are other aggregate issues we need to think about in our IT services exposure. The most obvious right now is inflation. For most of our consultancies, wages are the largest costs and as is well documented, wage inflation is on the rise. From speaking to all our companies, clients are well aware of the shortage of good IT professionals, and we believe our companies have good pricing power in this regard – even if there may be time lags between wages rising and clients being charged the new rates.

We selected our holdings in this sector in part based on their lower than industry average staff turnover. For us this is a key KPI. Loyalty of staff is a good indicator, and in an overall tight labour market we don’t want our holdings suffering higher than average churn with all the implications this carries for client satisfaction. Having reviewed all our holdings under this specific prism, we recently sold TietoEvry, the largest consultant we owned – as we fear they might suffer in this environment.

We view digitalisation as a structural trend. You can think of us as having 29% exposure to this trend or another way of thinking is that we have 4% direct exposure to banking + 7% ‘look through’ and therefore 11% exposure in aggregate to banking. Either way we think all these companies are well placed.

Valuation Update & Corporate Activity: Fundamentals Matter

In times of volatility, it is a comfort to know that you are adhering to a robust and proven process.  We have had three recent reminders of why we focus so much on strong cash generation and healthy balance sheets. We often say that by emphasising strong cash-generation and healthy balance sheets, that when coupled with attractive valuations, we are well aligned with potential corporate purchasers and private equity buyers.

Readers will be aware that this is the demonstration of our valuation discipline (materially higher free cashflow yield than the market) and risk discipline (much lower financial leverage than the market). In recent weeks these numbers have become a bit of a moving feast with data starting to roll forward into a new year.  Whilst the absolute precision of these numbers may move around a bit, the direction of travel remains clear – we believe we have a cheap portfolio, low debt and good growth prospects.

Corporate Activity

In recent weeks, two of our companies have received bids, and a third has announced a potential disposal of part of its business which will leave it with an estimated cash balance of over 50% of its current market capitalisation.

We firmly believe that the common thread running through this corporate activity relates to the strong cash generative features of these businesses (undervalued by the market), combined with strong balance sheets.  Two of these businesses are IT services – an area where readers will be aware we very positive on, with around 30% of the portfolio exposed to these types of businesses.  The third company is very different – it is an industrial business offering dredging services.

1. Be Shaping the Future is an Italian IT consultant, focussing purely on the finance sector. Traditional banks are facing existential challenges from competitors in the shape of fintech companies, and also due to the fact that they are still, in the main operating on very old IT infrastructures. Be Shaping is ideally placed to help them. When we invested in the company last year, in our language, it was on a free cashflow yield of over 7%, growing at over 10% per annum – a very attractive equation, given that the market free cashflow/growth equation at the time of purchase was 3.7%/7.7%. So, better growth and cheaper cashflows.  Bain Capital clearly agreed with our view, as they launched a bid for the company on 14^th February. Management of the company owns 23% of the shares and have recommended the bid.

2. Sword is French IT services company. It is best described as a holding company, operating a cluster of autonomous businesses, but controlled by a very entrepreneurial CEO. Jacques Mottard also happens to be the largest shareholder at 18%.  Not afraid of change, last year Sword disposed of one of its French IT services businesses, where growth prospects had become more pedestrian.  This resulted in the company having over 30% net cash on its balance sheet, so it paid a 15% dividend. The  group is  growing at around 15-20% organically and generates strong free cashflow. In a recent meeting, Mr Mottard suggested that he could achieve a very high price for the software division. This business is a market leader in Governance, Compliance (GRC) software but is ‘only’ 20% of group profits.  While most CEOs are fond of pointing to undervalued businesses within their portfolios, doubting the word or intentions of this particular CEO can be dangerous. A few weeks ago he announced that they are in talks with Riskonnect to dispose of the GRC business within 6 weeks. Although the price is not yet disclosed, on the valuations he has suggested he would consider a sale, the company would be sitting on a cashpile in excess of 50% of its market cap. Accordingly today’s announcement that he would pay a €10 per share dividend (22% dividend yield) – was not a surprise to us. This leaves the company still with significant net cash which we believe Mr Mottard will be an excellent steward of.  Despite a strong share-price reaction the pro-forma valuation of the rest of the group is still attractive – we estimate somewhere between a 5-7% FCFY for double digit top and bottom-line growth.

3. Boskalis is a Dutch dredging company. Between it and a further 3 Belgian and Dutch companies, they account for 70-80% of the global dredging services market.  This was a slightly unusual investment for us as more capital-intensive businesses tend to struggle to generate consistent free cash flow. However, the combination of a healthy net cash balance sheet, an oligopolistic market, a long history of managing the business through cycles and a very strong outlook, we were confident that the company was rated on a thru-cycle free cashflow yield approaching 10%, and that, though obviously cyclical, should be able to grow over time. The company has just announced that it has received a bid approach from its 44% shareholder, Hal Investment BV. The valuation looks on the cheap side to us but there appears a low chance of a counter-bid.

These events serve to remind us that having a solid underpinning through our cash-flows, balance sheet and valuation focus is really important in times of extreme market volatility.  These three events give us confidence that we are focussing on the right factors, and that our process will allow us to take advantage of market volatility.

Electric Shock

We are not long off a call with the CEO and Founder of one of our newest holdings, Digital360. An electric shock is how Andrea Rangone described the impulse which the epidemic has given to large parts of the Italian economy, specifically with respect to their technological preparedness. As is well known, the Italian public and private sectors are well behind most other large European economies in their digital transformation. D360 is a consultant and introducer of software and hardware products to Italian corporates large and small. They report a sharp increase in phone calls from companies, large and small, calling up asking about a cybersecurity product, how to get into the cloud, how to manage all the data they are gathering and many other services beside.

This electric shock is happening prior to a potentially game changing development. The National Recovery and Resilience Plan (NRRP) is a package of reforms at the heart of the EU’s coronavirus response.  The following extract is a summary:

Source: European Parliamentary Research Service, January 2022

Stimulus plans have been touted before for Italy and failed to hit the mark, in no small part due to what appears to be a permanent state of political upheaval. We think this plan has a higher probability of succeeding.  Sergio Mattarella agreeing (on 29/1/22) to serve a second term as President and Mario Draghi’s presence in the governance of the country should serve to reassure at a time being described as ‘once in a generation’ opportunity for Italy.

As the extract above highlights, Digital transformation is due to receive €48bn of stimulus over the next 5 years. We also spoke to (another holding) Alkemy recently. Alkemy is an Italy based digital marketing specialist, it has been growing sales organically at c.15% organically for a number of years. They were equally as positive as D360. This is what CEO Duccio Vitali had to say on the matter in their recent results release:

"Precisely in these months we are going through an exceptional historical moment comparable in scope perhaps only to the second post-war period. Thanks to the PNRR (National Recovery & Resilience Plan), in Italy alone, E24bn will flow into this market over the next 4 years to support digital transition of private companies, to which another E16bn for the Public Administration will be added. Alkemy has the positioning, the corporate structure and the most focused and coherent offering to capture the enormous expansion that will follow"
Source: Alkemy results release 11/2/22

As per the slide below Mr Vitali quantifies the current market for Digitalisation at €6bn and before stimulus, the market is growing at c.10% pa.

Much of the stimulus will filter into Alkemy’s markets as it will D360’s. These companies are already growing their top lines at 15-20% organically prior to stimulus. The challenge will be meeting and executing on the signficant demand.

As readers will be aware we have been building up our portfolio exposure to digitalisation long before the NRRP was a feature of the landscape. In recent quarters, we have however specifically boosted our Italian and Spanish exposures. The companies we hold and which are most exposed to digitalisation in Southern Europe and the PNRR are as follows:

Unlike many technology-based investment cases round the world these companies are generating cash flow and they are also cheap, primarily due to being below the radar for the majority of investors. These companies also share the common characteristic of having significant management involvement in the shareholder register. We are happy to be co-invested alongside some ambitious entrepreneurs here.

Supply Chain Issues

One of the consequences of the strange economic environment we live in is the bottlenecks in global supply chains. This started off earlier in the year in the semiconductor sector and has spread across many sectors. In a diversified portfolio we feel it is hard to avoid having some exposure to these issues. This diary entry focuses on one example, Knaus Tabbert, as an illustration of how we approach challenges such as these which can crop up in an investment case.

Firstly, a bit of background. KT is a German manufacturer of recreational vehicles (RV’s) – camper vans and caravans. The long-term case for the segment is relatively well established and has been bolstered by Covid.

KT is a leader in the German market and a rapidly growing challenger across other European markets. They are also a leader in lightweight construction which is a pre-requisite for the move to e-vehicles as weight of the unit is a crucial factor in allowing a consumer to drive a motorhome on a regular driving license (3.5 tonne limit).

The company IPO’d at €58 last year, raising capital to allow them to build more assembly capacity in Germany and Hungary. Their goal is to double capacity and grow sales from €900m to €2bn by 2025, a sales CAGR of c.20%pa. We think their plans are credible and bought our initial position as below. Current market cap is €540m.

When we purchased the shares we were aware that the company was having difficulty in sourcing chassis for their vehicles. They had hitherto primarily sourced from Ducato, a Fiat subsidiary and due to the chip shortage, Ducato were struggling to supply KT with all their requirements. They were in the process of agreeing new supply arrangements with Mercedes and Ford. However, by the time Q3 results came it was obvious to the company that the supply chain issues were worsening, and they wouldn’t be able to meet the booming order book they have.

We have 3 primary questions in this situation- questions which apply to other companies with similar issues:

• Are the supply chain issues short term – ie: fixable over the coming quarters?
• Will the company lose business as a result of these issues?
• Is the Balance Sheet flexible enough to absorb the working capital expansion which will arise?

We spoke to management on the back of the Q3 warning and have satisfied ourselves that this is a short-term issue. Next year they will source half their chassis from new suppliers and have 4 effective sources – with no pricing effect. There have been no cancellations of orders – in fact the order book today is double the level of a year ago. They are not losing market share as the same issues are being experienced by competitors such as Trigano and Hymer. Finally, the Balance Sheet can withstand a good degree of inventory build and lower profitability.

When we re-look at our detailed modelling, our long-term valuation of the company is little changed. The short-term earnings risk is there, but we consider the long-term value is clear. The following excerpts from our models illustrate this:

As can be seen above there is not the long-term history we normally prefer to see with an investment. However, our other checks on KT versus peers, suggest the level of sales they are converting into FCF are within sensible bounds and perhaps we are being conservative (this is the graph below).  In practice, when we look at the graph above, the outcome we think is most likely is an upside in between the central case and the best case – it is relatively easy for us to see how the shares can double from here. Note we always use these outputs as a guide not a prescriptive formula.

Implicit in the upside/downside chart above is a 9% discount rate. As readers will be aware we use discount rates between 6% and 10% depending on a number of factors not least of which risk profile and ESG considerations.

Sally Clifton is our Head of Responsible Investment¹ and provides an ESG review independent of the investment decision makers. Extracts from her report suggest the following:

• Knaus are interesting to look at, with much to commend and a thoughtful ESG management structure that offers flexibility and development opportunities, as transition pressure increasingly impacts.
• While this mapping takes into consideration best-in-class sustainability frameworks, most notable GRI standards, the company do not map to GRI or any voluntary global frameworks and therefore do not set sustainability targets to report against. Instead, they comply with German regulatory and governance code standards. The identification of risks is nevertheless comprehensive, and it generates a highly transparent reporting structure, including trend data (just can’t be compared to targets, except for certain metrics).
• Supply chain management needs special mention as it is not obvious from the above matrix but is a central tenet of their ESG management activity (and also operational capacity). Knaus seem keenly focussed on supply chain management and building resiliency. They require all suppliers to comply with a supplier code that includes ISO 9001 or similar QMS (i.e., not just a social focus (human rights etc), but also environmental standards. Knaus comply with the ISO 9001 QMS).
• This is not to suggest improvements on the ESG management front are not available to improve credibility in some areas. However, in general I think they walk-the-walk as well as talk-the-talk, and the structure and process in place offers transparency, suggests alert management building resilience and agility with plenty of opportunity focus into their approach.
• I would rate E 3, S 2, G 3, and a discount rate from the ESG perspective around 8 – 9% dependent upon your final assessment of the financial position and other factors.

¹The Fund is not a labelled sustainable fund, but ESG is part of the risk management framework.

The latter ESG scoring of 3/2/3 (scale of 1-5 – 1 being best) suggests slightly above average. Sally’s conclusion is that an 8% or a 9% discount rate could be used to value the cash flows. Our decision as the investment analysts is that the overriding factor here is that the company is new to the stock market and deserves a higher hurdle rate, 9%, until we live with the company through a number of reporting seasons. Having said this we are never about precision in valuation and when we look at the sensitivity of the blended upside to various discount rates it can be seen that it doesn’t really matter – we think that the shares are cheap irrespective of discount rate used:

On conventional metrics the shares look to be on a 2022 PE of 11.6x, ev/ebitda of 6.7x and on our preferred metric of FCFY we can see how the company can be on a 5-10% FCFY for a 20%+ sales CAGR – comfortably in our sweet spot.

So, we have topped up the shares (to 1.6%) and left a bit of room for a further top up in case short term guidance needs to come down again. As we look ahead to 2022 and 2023 we think that Knaus Tabbert as well as other supply chain affected holdings such as Huddly, Boskalis, Signify, ams, Knorr and Kone could be amongst our better performers.

Serviceware: Another MIFID II casualty is our opportunity

Readers will know that we see one of our biggest opportunities to deliver performance coming from mispricing seen in smaller companies.  MIFID II has exacerbated this opportunity by removing sell side coverage.  Compounding this is the fact that many of the best performing European Funds of recent years are now simply too large to be able to invest in smaller companies.

Recently we met Serviceware, a German software company.  Our initial meeting was at a conference.  We were suitably interested in the company to arrange a follow up meeting with management.  Following this meeting, we initiated a holding.

Serviceware’s software products enable companies to monitor the efficiency and payback of their IT projects – a vital piece of analysis, given the expanding nature of IT budgets generally.  Founded in 1998 by the CEO and the FD (both of whom retain 31% of the equity each), the company has grown strongly, and boasts 5 out of the top 7 German companies, and 15 out of the top 30 DAX members as clients.  It is capitalised at €187m, with almost €30m cash on its balance sheet.

It floated in 2018, brought to market by 2 investment banks.

As can be seen, the share price today remains well below the initial price achieved in the wake of the IPO.  This, despite the company growing sales by almost 50% in the last 3 years and returning to profitability following a heavy investment phase (all articulated at the IPO) to develop a pan-European network (partly helped by the partnership of big consultancies such as E and Y who rate the product highly enough to re-sell it themselves).

So why the poor share price performance?  Well, the wider market conditions during Covid didn’t help.  However, the main factor was the role of the investment banks which brought Serviceware to the market.  Having floated the business and taken their corporate fees, they quickly withdrew coverage of the investment case.  It simply wasn’t profitable for these banks to pay their analysts to cover the company.  Management hunkered down and concentrated on steering the company through its build-out phase.

In terms of competition, the two largest players are both American.  ServiceNow is listed in the US, and trades on 19x 2022 sales.  The other competitor, Apptio, is owned by private equity and was bought for over 10x sales.  Serviceware is currently valued at 1.8x sales.  Whilst we understand there has been interest from private equity keen to de-list the business, management remain committed to developing Serviceware in the public markets.  How long their resolve will hold in the absence of the market recognising the potential for the company remains to be seen.

We rarely consider sales multiples as valuation tools – we are much more interested in cash generation.  However, they are the yardstick by which much of the market values software companies, and so we note the stark difference in sales multiple purely for reference.

So, what of cashflow valuation at Serviceware.  The company has largely completed its investment phase, so the EBIT margin will rise over the next few years towards 15%. Modest assumptions on cash conversion rates mean that, we believe, Serviceware will within the next few years be on at least a free cashflow yield approaching double digits.  And this, for double digit organic growth, and a net cash balance sheet.  For reference, the broader European market is on a free cashflow yield of 3.7%, for revenue growth of around 8%.

The market is beginning to wake up to the Serviceware story, but we believe that the share price has a long way to go before the company’s opportunities and growth are fully recognised by the market.  We have taken an initial 1.1% position in the portfolio and expect to grow with the company over time. Obviously, as a smaller company, there are execution risk issues, such as managing staffing levels for growth, successfully expanding the international business and collecting payments from clients in a timely manner.  Whilst we believe that we have discounted these risks in our scenario modelling, we would like to see results which confirm that the company is executing to its potential.

Serviceware is another example of the opportunities available in smaller companies and why we are excited about the portfolio.

What of growth?

Readers will know that we actively consider the growth opportunities of an investment as part of the valuation.  Our belief, like that of Warren Buffet is that you cannot disentangle growth from value – they are inextricably linked.

This leads to us considering our investible universe on a free cashflow yield/growth basis:

Source: Chelverton AM

The crucial thing for us is to not be overpaying for growth.  This is our valuation discipline.  We can pragmatically accept either a slightly lower growth rate, as long as the valuation (free cashflow yield) is more attractive (higher), but can also accept the opposite – better growth for a slightly higher valuation (lower free cashflow yield).  However, we have a hard investment rule that the portfolio will always have a materially higher free cashflow yield than the market.  This keeps us honest, preventing us from drifting into highly valued companies. The chart below shows the extent of this premium over time.

However, we do not have a corresponding rule that the portfolio must have higher growth prospects in aggregate than the market.  Our rationale is that if all good growth companies were significantly re-rated and became expensive, then we would hunt more in the upper left quadrant of the above graph, accepting lower growth but seeking much higher free cashflow yield.

Yet to date, we have always had better growth prospects, at the portfolio level, than the market. The graph below shows the consistent growth premium over time:

We remain confident that this premium will continue in the future.  The main reason for our confidence remains the opportunities in smaller companies.

As can be seen from the table above, the valuation characteristics of smaller companies are quite striking.  At the €500m to €2bn market cap level, our holdings are expected to grow at over 11% for the next three years, but are on a free cashflow yield of 6.5%.  This compares to current market growth and free cashflow yield of 8.1% and 3.7% respectively.  At the smaller end of the market – sub €500m market cap level, the opportunity is even more attractive – 13.9% sales growth and 6.7% free cashflow yield.

Our conclusion from this is that the mispricing in smaller companies remains significant.

There is a further reason for our confidence that we can retain a growth premium.  At the moment, the average market growth rate of 8.1% is buoyed by 2021’s recovery bounce in more cyclical areas:

The table above highlights the issue.  As can be seen, market growth rates are elevated in 2021, but are predicted to fall back to more normalised levels going forward.

Further, we can estimate the growth of our portfolio for 2024 (which will shortly be year 3), and also assume that the market stabilises around a normal 4% growth rate:

We believe that the abnormally high 2021 growth rate from the market has already been discounted.  Once the market numbers normalise (table above) then our growth premium to the market will increase significantly:

The only thing which could affect this is performance – if our higher growth small companies suddenly re-rate then we would have to hunt elsewhere for good ideas.  This would however, go into the “nice problem to have” category!

So to conclude, we remain confident that the portfolio is likely to remain in our “sweet spot” upper right quadrant on the below graph, populated in aggregate by cheaper companies, growing faster than the market. Growth with a valuation discipline.

What of Quality? Part 1

Most investment philosophies and processes major on a small number of factors and these factors become the primary focus and the main selling point. However, there are many successful ways to invest. Whilst we have our primary focus, there is value to be found in analysing a wide range of styles and incorporate the best bits into the way we invest. 

The factors we refer most to are value and growth. We are looking for companies that grow faster than the market AND have cheaper cash flows than the market. That is what the following chart depicts, and we tend to lead with this when we discuss our approach.

GROWTH & VALUE INEXTRICABLY LINKED

One of the most successful approaches over the last decade has been investing in high-quality companies. These companies tend to have characteristics including solid growth from repeat purchases, defensible market positions (economic moats), consistency of returns irrespective of environment, ability to reinvest and compound at high rates of return and sound balance sheets. Leaving price to the side, who doesn’t want these qualities in an investment?

The financial metric which best captures a high-quality company is a consistently strong return on capital employed. The logic is irrefutable. If I as an investor give company A £1 of my capital I want that company to invest to make a return higher than that which I can earn passively elsewhere – the higher and more consistent this return the better.

There are many ways of measuring return on capital – CFROI (cash flow return on investment), ROIC (return on invested capital), ROE (return on equity) and ROA (return on assets) are amongst the more widely used. Each has its advantages and disadvantages, but our preference is for CFROI as it focuses on cash, a more reliable number than profit.

When we look at a company for the first time, amongst many factors, we figure out what the growth/value trade off looks like but in the same exercise we also consider the quality of the company.

Here is an example of the return on capital metrics we consider using Europe’s largest company, LVMH, as an example.

Source: Factset

Consistent returns at a pretty respectable level would be our conclusion here. The entry price for this level of quality is a FCFY of 2.5% or if you prefer PE, 2021/2022 PE of 33/7x/30.2x.

To understand what the market is seeing in these high-quality companies, we observe two well known and very successful fund managers whose process is explicitly quality in nature. Each has strict criteria for what constitutes quality, and we use their universes as a screen of sorts to help us understand markets better. We are a bit nosy and keen to learn from successful investors as well as wanting to invest in this group of companies if the valuation of any stocks came into our range.

We track a universe of the 45 or so European stocks they hold and/or have held, hereafter referred to as the High Quality Basket or HQB. The names included will be familiar – it includes LVMH and L’Oreal as well as other consumer goods companies (e.g., Hermes, Essilor, Nestle, Unilever), high quality industrials (e.g., Kone, Schindler, Atlas Copco), pharma & medtech (Roche, Novo, Coloplast), testing companies (e.g., SGS, Bureau Veritas) and stocks from a wide range of other sectors.

To avoid data overload, we will just now focus on CFROI. The average CFROI profile and valuation for these 45 companies, arguably the crème-de-la-crème of what Europe has to offer is as follows:

Source: Factset, Chelverton Asset Management 

Source: Factset, Chelverton Asset Management

To access this HQB with a 10-year average CFROI of 28.0% you will receive a lowly 3.3% FCFY. Of note is that because many of these stocks dominate the market indices, the market FCFY on the same methodology is 3.7%.

How does our portfolio compare to these metrics?

Source: Factset, Chelverton Asset Management. Note we have taken out banks and companies with limited history – still over 85% of portfolio included. We would argue that the companies excluded will add to, rather than detract from CFROI over time.

Source: Chelverton Asset Management

Our portfolio is delivering a 10-year average CFROI of 24% with a not dissimilar level of consistency to the HQB. The big difference is the valuation we are receiving, a FCFY of 6.1%, close to double the HQB with a PE nearly half the HQB. Valuation matters.

There are many conclusions or comments that could be made on these sets of data. We would make 3 underlying points:

• Just because we don’t mention quality in our headlines doesn’t mean we don’t consider it
• The valuation the market is attributing to many of Europe’s high-quality business looks very high. Even if you don’t agree with that, there are many companies with comparable returns on capital and growth prospects further down the market cap spectrum - on much lower valuations
• We believe we have a portfolio of undervalued quality – we just don’t refer to it this way often
  

What of Quality? Part 2

In Part 1 we argued that the market is overpaying for large cap quality growth stocks. Our portfolio has similar growth characteristics to the ‘market darlings’, only slightly lower quality metrics but is demonstrably cheaper in cash flow terms.

Here we deconstruct our portfolio with the objective of helping provide a bit more colour and understanding to what we own.

As the reader is hopefully aware, we have a large cluster of IT Service stocks. This is how we play digitalisation and is, in our view one of the few cheap ways left of getting technology exposure into a portfolio. We currently have 25.6% of the portfolio across 16 holdings here.

We also have a collection of holdings which can broadly be categorised as Defensive in nature. These stocks help provide balance and diversification to the fund and we would expect them to help protect capital in the down part of a market cycle. Most of these stocks have lagged the market rise over the last year or so and we have had to work hard to keep weightings up as we believe they will play their part in long-term performance. This cluster includes all our pharma holdings, consumer staples (Danone, Unilever, Essity), food groups (Ahold, Acomo) as well as Zardoya Otis, Tieto, RELX and Artefact, the latter being the subject of a bid and trading as quasi-cash. This group of companies is currently 31.8% of the portfolio.

Focusing on Cash Flow Return on Capital Invested (CFROI) of the different parts of our portfolio yield the following returns:

Source: Factset Prices and Chelverton Asset Management 

The portfolio overall has 10-year average CFROI of 24.0%. Perhaps not surprisingly, the defensive cluster has an above average 10-year CFROI of 28.3%. The other big cluster in the portfolio, IT Services has a 10-year average CFROI of 24.6%. Interesting to compare these numbers with the 45-strong European High Quality Basket (HQB from Part 1) average of 28.0% - not really a million miles from the portfolio average.

Our Defensive cluster then has the same quality characteristics as the High Quality Basket. The overlaps between what we own and the HQB is primarily found in the pharma sector via Novartis, Roche and the exceptionally high returns from Novo Nordisk. RELX at an 27% average CFROI and Unilever at 25% are two others in common. Interesting to note that Nestle’s 10-year average CFROI is 19.6% and is valued on a FCFY of 3.4%. Unilever’s FCFY is 5.1% and this discrepancy explains our preferences and why we have recently been adding to Unilever.

Our holding in Zardoya Otis (elevators) is notable as a single market elevator company in the most densely penetrated elevator market in the world (Spain). It’s 10-year average CFROI of 52.4% is appreciably higher than the more widely held and much more expensive Kone and Schindler who return 42.7% and 30.0% respectively. Danone at 13% and Acomo at 18% bring down our average but we are happy they are moving in the right direction.

In our IT Service cluster there are 2 broad types of business – firstly traditional IT service companies which rent out their consultants to clients as well as write some software and secondly value-added resellers (VAR’s).

VAR’s re-sell other people’s hardware and software to clients usually with some form of implementation consultancy added in. The latter category has traditionally been viewed as ‘low quality’ but as an asset light model able to help clients negotiate (e.g.) big data management and shifts to the cloud, they have earned their place. The pure VAR’s we own (Proact, Atea and Digital Value) earn returns of between 27% and 45%.

If you get the pure consultancy business right, very high returns can be achieved. Bouvet (recent addition), CTAC, Siili and Infotel all earn CFROI’s above 30%. Our holdings in Novabase, Innofactor and Ordina are on this journey from a much lower base, i.e., they are turnarounds.

The sharper reader will notice we haven’t addressed c.25% of the portfolio with a below average return profile. This is for another day but with an average CFROI of 19.8% they are still paying their way and compounding in our favour.

Dredging for ideas – Boskalis

At the heart of our process is a free cash flow (FCF) discipline. The reason is relatively simple – as an investor your returns come from a combination of capital appreciation and income from dividends. If a company has FCF it is able to reinvest in its business to generate long term growth which should lead to capital appreciation; and/or it can pay dividends. So, we would argue that the existence of FCF is the underpinning of shareholder returns.

We are an unconstrained investor but our focus on FCF tends to lead us away from asset intensive, cyclical and leveraged businesses and towards more asset light, unleveraged, good cash converting sectors. However, this is not a hard rule and occasionally we come across exceptions. Boskalis, the Dutch dredging company is one of these. It is quite asset intensive; it is cyclical but crucially has significant net cash pile and good cash management.

Boskalis is one of the 4 Benelux dredgers (along with Deme, Van Oord and De Nul) who collectively have 70-80% share of this global market. It is a €3.5bn market cap company, listed in Amsterdam. The main assets of these companies are vessels (cutters & hoppers) which remove sand, silt, clay, and other layers from the seabed/riverbed and reuse it elsewhere for coastal protection or land reclamation. Landmark projects for the company (often in JV with its peers) include reclamation of land in Singapore, Chep Lap Kok in HK, Suez Canal widening, Palm Islands in Dubai and a lot of coastal protection work around the world. In 12/20 Boskalis were awarded the biggest contract in their history, €1.5bn Manila Bay Airport land development project.

Source: Boskalis

As seen in the slide above, the industry tends to work in long cycles and projects can take years to complete - Manila Bay will be executed 2021-2024. The industry experienced a long upcycle peaking in 2014/2015 when the last Suez Canal widening took place. Interesting to note that the GFC barely impacted the industry financial performance as supply/demand balance stayed positive throughout.

The crux of our investment case is that we are on the cusp of another positive cycle. In an up-cycle, fleet utilisation increases as the supply/demand balance shifts to the operators who will have pricing power. Experienced and senior industry figures have recently been talking openly about “extreme tendering activity,” which seems to be substantiated by the following projects. As well as the Boskalis award in the Philippines there are numerous large opportunities which could tighten pricing significantly:

• Further widening of Suez Canal
• Huge demand for offshore wind expanding out from Europe to rest of world (dredgers involved in seabed preparation, transport of structure and installation of cabling)
• Abu Qir Port land reclamation project in Europe
• Artificial renewable island – recently approved by Denmark to install offshore wind turbines that will generate 10GW, enough energy for 10m households

There are many more opportunities including at the more speculative end of the spectrum (e.g., offshore mining, Bosphorus canal replication) which may require significant supply from an industry which has not increased its capacity in recent years. Awards to any one of the companies in the sector benefit the economics for all.

Our in-depth cash flow work suggests a potential range of cash flow outcomes as follows:

Source: Chelverton

To ensure we have the context right for cashflows we always check that the conversion of sales into FCF looks appropriate relative to history – not because we think we can estimate a cycle accurately, more to ensure that the average conversion levels look sensible. That can be seen here:

Source: Chelverton

The enterprise value of Boskalis is €3.1bn and close to the trough of the cycle they delivered €400m of ebitda last year, an ev/ebitda of 7.7x (market is 10.7x). With reference to the slide at the top, if the cycle plays out as we expect, reaching the ebitda peaks of €800-€900m is possible and the valuation would fall to a lowly 3.6x. Just as importantly, the downside scenario is limited, helped by the €400m of net cash the company has. On a FCF basis, they delivered €484m last year (thanks to a surge in working capital and cut in capex), a historic FCFY of 15%. We do not expect this level of FCF to recur for a few years but think it likely they achieve this level again as the cycle progresses.

Our view on Boskalis is that the risk/reward is very much skewed in our favour at this point in the cycle. We have taken a 2% position and are reviewing related opportunities in the sector.

Small is beautiful – another example of why

We have often talked about the opportunity to take advantage of the “smaller company effect”, the basic investment observation that smaller market cap companies tend to outperform larger companies.  Investors who have seen our presentations will know that this is one of our four broad investment philosophy tenets.

It is our belief that the smaller company effect has been exacerbated by Mifid 2, resulting in the reduction of sell side coverage of smaller companies. This is creating significant valuation anomalies and hence opportunities for us.

To put some numbers on this, we provide the following:

Source: Chelverton Asset Management

From the table above, it can be seen that over 70% of the companies by number in our European universe are sub €2bn market cap. Our opportunity is that many of the top performing strategies of recent years have grown to a point that we believe they are priced out of the most exciting and inefficient part of the market. Looking through our prism of valuations, we find it hard to believe there are materially undervalued large cap growth opportunities in current markets.

Dale and I recently attended a conference which affirmed our enthusiasm for smaller companies.  The Oddo Nextcap forum provided a great opportunity to meet a number of smaller companies (sadly still virtually, but we are now Teams afficionados along with everyone else!), mostly on a 1-1 basis.  In total, we saw 19 companies in two days between us.  We came away genuinely excited.  Although a lot more in-depth work would be required, we could easily see how a number of these companies could become holdings within the portfolio over time.

Our enthusiasm can be understood by considering where on our growth/freecashflow yield spectrum these companies sit.  The average freecashflow yield of these companies is 5% (versus market on 3.7%).  Decent, but perhaps not exceptional?  But it must be considered in the context of growth. Growth is a critical component in the calculation of value.  The average growth rate of these companies is expected to be over 16% per annum for at least the next 3 years (versus market on 7.3% expected growth per annum).  So, a 5% freecashflow yield for 16% growth starts to look much more attractive.

Source: Factset/Chelverton Asset Management

To show how growth compounds the free cashflow yield of companies, consider the following.  If we look at the predicted average free cashflow yield of these companies in year 2, the average free cashflow yield is expected to be above 7%. This is delivered by a combination of operational leverage and good revenue growth.  The market free cashflow yield in year 2 is expected to rise to just below 5%.  The valuation gap opens further in our favour.

As stated earlier, the hard work on these companies is now just beginning.  They must pass all the qualitative and quantitative elements of our process before they can be considered for investment, and it’s a narrow and competitive funnel.  Most of these companies will end up being discounted as investments or placed on a “watch and see” type list.  We can afford to be patient, and often it takes the analysis of several sets of company results to convince us that companies are good investments.

However, one of the 19 has already made it through the full process.  We had a head start with CTAC in terms of analysis. CTAC is an IT consultant – an area readers will be aware we know very well.  Operating in the Dutch market, the valuation metrics of CTAC stood out for us, even compared to our existing holdings (which we think look very attractively valued already, on a 6.5% average free cashflow yield for over 8% expected growth).  CTAC is currently valued on an 8% free cashflow yield, growing at 8% to 10% organically.  We have subsequently initiated a holding in CTAC.

Small remains beautiful

Cliq Digital – A Stock Review

With markets having a few red days last week a couple of our stocks have seen a bit of profit taking. Cliq Digital is one of these, c.25% off its peak levels. This diary entry reviews the investment case for this €220m market cap German company.

Cliq provide a streaming service which for an all-in-one price of €14.99 a month gives the user access to music, games, sports highlights, series, movies, and audiobooks. They are a global business, c.50/50 US/Europe. The all-in-one price is the latest evolution of their offering and is in the process of being rolled out currently. They do not own or produce content; it is all licensed from content owners. As is noted in the slide below, a significant step for the company was shifting its subscriber acquisition activities (‘direct media buying’) in-house – this is the step that gave them more control – and higher returns – from their proprietary business intelligence platform.

Source: Cliq Digital

The company is positioning itself as a cheaper, one-stop alternative to all your various Netflix, Prime, Spotify, Amazon Audiobooks etc subscriptions. You get 5 logins for all family members and can use on all your devices simultaneously. You will not get the latest films, detective series or live sport but you will get a value package of decent and cheap content.

Source: Cliq Digital

The business is growing very rapidly. In 2020 sales grew 69% with margins doubling to an operating level of 14.2%. As a scalable and asset light business this means the company is very cash generative. Following an attractive minority interest buyout, in 2020 the company generated €12.4m of FCF, a historic FCFY of over 6%. For 2021 the company forecast 30% revenue growth and slight margin expansion, acknowledging the cost investment. In Q1, sales were up 49% and FCF was €5m. The company has no net debt.

Valuation summary

Source: Chelverton/Factset. * Chelverton methodology

Stating the obvious perhaps, but it is unusual to find a combination like this - very rapid growth and very cheap cash flows.

So, what is the catch and what are the risks?

The most obvious concern is around barriers to entry and the strength of competitors. With no proprietary or ‘live’ content they may be able to gather some subscribers through judicious marketing but unless they keep improving content, they may end up on a hamster wheel of high churn, high cost to replace and declining returns. Shorter term risks include rising costs of expansion and continued marketing success.

It is of course not easy to quantify these risks, and this is why our in-depth work always looks at three different scenarios, so we avoid any sense of ‘false precision’. In a worst-case scenario for Cliq we have to account for business model failure. The comfort factor is that this is an unleveraged, asset light company – if marketing or product is not working they cut back and refocus – this might not be disastrous for their cash flows, but market will likely judge first and ask questions later – so significant downside can be expected.

The best-case scenario needs to also be considered and here the business continues to scale at the current pace and with over 2bn people currently streaming they have effectively an unlimited addressable market from their current size. Even a year of delivering at the current pace we suspect will have us revising upward our scenarios. In reality they can grow rapidly on what is just a few crumbs from the table of the big boys. This is our overall assessment of the upside/downside:

Source: FactSet

These scenarios will continue to evolve. However, the way we look at the world, Cliq has a very good risk adjusted chance of success. Whilst its valuation implies very little probability of success we will continue backing the company and buy into periods like the recent weakness.

The value dilemma – what to do now?

The rotation in markets over the last four months has seen value as a style outperforming growth.  In simple terms, this should mean cheaper companies doing better than more expensive ones.  We welcome a degree of valuation discipline coming into the markets.

However, rising tides tend to lift all boats, with some structurally challenged businesses also performing strongly.  Headline valuations such as PE ratios at these companies appear superficially low, but do not reflect their poor long-term outlook.  In other words, there is a higher risk of being caught by value traps.

We recently considered an investment in Publicis, a traditional media company. However, we were wary. There are many structural headwinds facing businesses like Publicis. Omnipresence of platforms and social media, changing venues for advertising – especially online and the rise of data-focussed digital agencies to name but a few.

Publicis is listed in Paris, and currently capitalised at €13bn.  It is an advertising agency owning brands such as Saatchi and Saatchi and Leo Burnett, responsible for characters such as Tony the Tiger and The Marlboro Man.

It looks to be a cheap stock.  On a forward PE basis, it is on 11.9x, versus the European market on 18.3x.  It offers a prospective dividend yield of just shy of 4%.  On our preferred metric of multi-year average free cashflow yield its headline number 9%, versus the European market of around 4%.  Granted, prospective growth for the next 3 years is forecast to be quite pedestrian, at under 2%, versus the European market at over 6%, but apart from this, on the face of it, Publicis appears inexpensive.

However, we chose not to invest in Publicis.  Publicis has a number of unattractive attributes which we outline below.  Publicis may be able to turn its poor multi year operating performance around, but we are not convinced and see there being a high possibility that Publicis is a value trap.

Instead, we invested in Artefact. With a market capitalisation of €145m, also listed in Paris, Artefact is a data specialist, focussing on digital marketing and technology-driven solutions and platforms for data mining, advertising and marketing campaigns – the very areas of business which are disrupting Publicis’ traditional business lines.  It has already secured projects with significant clients such as Accor Hotels, L’Oréal, Sanofi and Europcar.

Artefact is profitable, cash generative and has no debt.  At its results presentation last week, it guided the market to expect organic revenue growth to be between 15% and 20% until 2025. In terms of cash generation, at its current valuation, free cashflow yield is expected to top 10% within the next 2 years.

Artefact for us has a very attractive combination of high growth and strong cash generation, which is currently being undervalued by the market.  To us, investing in Artefact rather than Publicis was a very easy decision to make.

Comparative valuation

Source: Factset/Chelverton

We are always considering the trade off between free cashflow yield and growth in our investment process.  Here, we consider a 6% free cashflow yield at Artefact, for over 15% revenue growth to be very attractive.  We are less convinced that Publicis’ headline freecashflow yield is actually being delivered (see below), and are sceptical of even the low expected growth rate being achieved organically.

Potential value trap signals

Publicis has reacted to the aforementioned disruptive headwinds by making significant acquisitions.  Since 2015 it has spent almost €7.5bn (2/3rds of its current market cap) on Sapient (2015) and Epsilon (2019), plus a further €1bn on smaller deals.  All deals have been focussed on these disruptive areas such as digital consultancy and big data specialisation.    But has it worked?

At best, the jury is out. From the graphs below, since 2015 despite this very significant acquisition activity, revenue growth has stalled, as has operating profit, while debt has risen significantly.  No growth, no improvement in profitability, significantly higher debt – the flags all point to Publicis potentially being a long-term value trap, despite its best efforts.

Source: Factset/Chelverton

Publicis’ annual spend on acquisitions since 2010 is graphed below.

Source: Factset/Chelverton

Cashflow analysis for a serial acquirer such as Publicis must assume that the acquisition trend continues. Acquisition capex is excluded from headline reported cashflow numbers generally.  Adding them back historically shows a much poorer level of cash generation:

Source: Factset/Chelverton

Cash generation has been poor, with acquisitions included. 2020 shows a significant improvement but we would advise caution since this included an abnormally positive working capital movement in excess of €1bn (almost 3x higher than previous peaks in recent years), leading to cashflows from operations being more than double that of stated operating profit – we would suggest that this is anomalous. These numbers indicate a much lower free cashflow yield than the headline numbers suggest – closer to 7%.

And  now?

Despite the concerns outlined above, buying Publicis at the start of the value rally in November 2020 would have been a profitable exercise.  Since the end of October 2020, Publicis’ share price has rallied over 80%.

However, over the same period, Artefact is up over 90%.

So what now?  The structural headwinds facing Publicis have not abated.  Growth, and cash generation are still largely elusive.  Artefact, on the other hand has very attractive prospects, and still looks very appealing from a valuation perspective.  For an investor holding Publicis, it must be tempting to take profits here.  This is the dilemma for many traditional value investors, following the recent outperformance of the style. However, for investors in Artefact, it is still easy to make the case to buy more. It still appears to be very attractively valued.

Publicis and Artefact in the Growth/Value debate

We do not see value and growth as distinct, but inextricably linked.  Growth is always a component in the calculation of value.  We are always looking for a favourable trade-off between the two.  The graph below shows our interpretation of this trade off – with the Y axis being our measure value/valuation - free cashflow yield of a given investment, and the x axis being the corresponding 3 years forecast sales growth.  We look for companies in the upper right quadrant, where free cashflow yield is above market levels (cheap cashflows) but growth prospects are healthy.  We will hold some companies in the area we have labelled Value – still growing, but less quickly, where the compensation is a higher free cashflow yield.

Where we do not invest is in out and out growth areas – low or zero free cashflow yield (bottom right quadrant) for very high growth – that’s not our skillset.  Crucially though, we also do not want to be investing in the top left area, labelled Deep Value.  It is here that the likely value traps reside.  We have plotted Publicis and Artefact on this graph as an illustration.  The respective arrows show the direction of travel for each investment. In the case of Artefact, growth and free cashflows are accelerating.  In the case of Publicis, although at face value attractive, we feel it is clearly heading into/may already be in the deep value area – little or no growth, and lower free cashflow yield than might be suggested by headline numbers.

Source: Chelverton

KnowiT – Consolidation in action

Readers will know that we are fans of the IT services area.  We currently invest in a number of companies where we see an attractive trade off between value and growth.  The current holdings have an average growth rate of over 8% for free cashflow yield in excess of 6%,  compared to the broader market on growth of 6.4% for a free cashflow yield of 3.8%

One of our core holdings in this area is KnowiT which we have held for over two years.  KnowiT is a Scandinavian IT services company with 3 divisions.  The Solutions Division is pure IT consultancy, focussed on a range of services assisting both public sector and private sector digitalisation.  Experience is a digital agency business focussing on e commerce and new media channel exploitation.  Insight is a high-level IT based management consultant.  Knowit guides for revenue growth of between 5% and 10% per annum depending on acquisitions and has a net cash balance sheet.

Knowit is firmly in our sweet spot for investing, with a free cashflow yield of over 5%, for 8% revenue growth.  Our modelling suggests that there is good upside to the shares if the company continues to execute on its strategy:

Source: Chelverton

The graph shows that with modest incremental growth there is risk-adjusted upside to the valuation.  Importantly though, there appears to be little downside, even in the event that cash generation stalls.

This morning, Knowit announced the acquisition of Cybercom, a Scandinavian-based business focussing on cyber security, connectivity, and cloud services.  This will become the 4^th division for Knowit, and the cross-selling/growth opportunities are significant.  In conjunction with the acquisition, Knowit issued revised growth and profit guidance – revenues are now targeted to grow at 15% per annum, and operating margins are now targeted to exceed current levels.  Crucially though, Knowit will also keep net debt at modest levels, and is also aiming to payout 40-60% of net profit as dividends.  An attractive combination of returns we feel.

The transaction size is significant for Knowit and will increase the overall business size by over 40%.  Knowit has a good track record of integrating bolt on acquisitions, but on the conference call, management acknowledged that they will need to take their time here.  The opportunities are very significant though.

The bulk of the transaction is being financed by share issuance.  Net debt to EBITDA post transaction is still expected to be a very modest 1x.  More importantly, the vendors of Cybercom are long term investors, and are taking their payment in Knowit stock – they will own over 20% of Knowit post transaction.  This is certainly a strong endorsement of the deal – the main players are not cashing out.

Plugging some initial numbers into our models, shows that the upside increases significantly.  This is the power of compounding high cash returns, combined with higher assumed growth.

The best case scenario incorporates the company’s  medium term growth of 15%. The other two scenarios assume a lower success rate of execution resulting in more modest revenue growth.

Source: Chelverton

With some modest deal synergies assumed, the free cashflow yield for the combined Knowit group next year should be around 6%, and this for projected 15% growth.

We have noted a number of consolidating transactions in the IT services area.  In the last 12 months we have seen at least 4 IT service businesses in Europe succumb to takeovers.  Given the structural tail-winds facing these businesses (digitalisation, big data, cloud storage, app development etc) this is not surprising. We have long said that the valuations of smaller IT service businesses appear to be anomalously cheap, and these transactions to some extent bear this out. Knowit’s move appears well timed, paying sensible multiples (all headline transaction multiples for Cybercom are below Knowit’s current valuation metrics), and importantly, the structure of the deal, with little debt and a long-term equity buy in, should ensure that the transaction is successful.

We expect to see further consolidation in this sector.  Our holdings are well capitalised, and able to take advantage of opportunities such as this, enhancing their prospects.  We do wonder whether, as a larger business, Knowit as the hunter may just start to creep onto the radars of larger, deeper pocketed predators.

Bottom fishing for a cold chip

We have commented before that the semiconductor sector has been a sound contributor to performance for us over the last few years. The sector has been strong due to demand for chips for everything from consumer devices, cars, and medical equipment to internet of things applications, for 5G networks, for the management of big data and AI amongst other. This has led to comments around a supercycle being (well) underway. Our observation earlier in the year was that valuations were commensurate with this supercycle and we reduced our weight from over 8% to c.3%.

The chart below shows the performance of some of the larger European chipmakers and suppliers of chipmaking equipment. They have been outstanding performers over the last 5 years with appreciation between 436% and 691%. And then there is €4.5bn market cap AMS – formerly Austria Microsystems – down 2% over the same period.

AMS was a successful manufacturer of sensors for use in consumer devices (think your current iPhone model), automotive, industrial, and medical applications. Then 2 things happened, firstly an over-reliance on Apple hurt them when they lost a contract and simultaneously they launched an unpopular bid for Osram Licht, a Siemens spin out. Osram is an industry leader in opto semiconductors – a crucial element in lighting, visualisation, and sensor technology. This acquisition has proved protracted and still not settled – they currently own 72% and have just launched a tender offer for the balance. It was only on 1/3/21 that they got full control of Osram and have started to integrate the company.

To use a technical term, it has been a ‘messy’ bid and in fact I think we can say AMS itself is a challenging investment case.

Leverage may peak at c.3x nd/ebitda, supply chain distortions may persist for some time and there is a complex integration and deleverage process ahead.

So why then did we buy a 1% position in March and have subsequently topped up our position, including today on publishing of Q1 results?

What we see is the long-term potential. The combined AMS/Osram will pursue (or retain) market leadership:

Source: ams Q1 presentation 4/5/21

On our current technological trajectory, it is very difficult to see a world without a lot more sensors – in the cars we drive, the devices we use/wear and right across industry and medical devices. Osram strengths are in illumination (emitter technology) and AMS core competence is in IC-based optical detectors and algorithms. Both companies use the same semiconductor processes offering considerable production and R&D synergy. But the real case is about growth.

The company see the combination as a double-digit top line growth company operating at an adjusted 20-25% operating margin. In our scenario analysis, we view this as the best-case scenario, depicted via the green line in the chart below. As can be seen, there is very significant upside if they are able to achieve this. Our worst-case scenario below (red line) is commensurate with the company only reaching c.€230m of FCF in 8 years’ time - compared to over €200m for AMS stand alone and below the >€500m FCF consensus expects over the next few years. Really what we are saying with this worst case is that the integration goes badly, and debt becomes such an issue that equity needs to be raised. It should be noted that whilst leverage is flirting with the very top end of our comfort zone, the company has termed out debt at a blended cost of 3% - we think it is a manageable risk.

So, our risk adjusted investment case shows very substantial upside. Yes, there are issues to overcome and yes, trading could be choppy for a few quarters. Patience may be required but the potential prize is a big one. Synergy targets have just been raised, they have acknowledged the loss of some Apple business (now c.10% of pro-forma group) and are focused on cleaning up the portfolio, a speedy deleverage and improving profitability and free cash flow.

This is a very unpopular stock right now (PE 10x 2021, 7.6x 2022) and an unusual case for the chip sector – unloved, leveraged & slightly messy. However, looking through the shorter-term issues we see a company capable of growing its top line at double-digits with a double-digit FCFY – firmly in our sweet spot. We acknowledged the higher-than-average risk profile by initiating with a 1% position and have now topped up to 1.4% following release of today’s results which confirms to us that the long-term investment case is intact.

Digital Transformation – 3 new holdings

Our diary is not short on positive comments on the biggest ‘cluster’ in our portfolio, IT Services. The reason is relatively straightforward. The group of companies we have invested in have both structural tailwinds from technology investment manifesting in visible growth as well as cheap cash flows.

At the start of January, I attended a conference where I listened to a handful of speakers talking about Digitalisation in Spain and how the EU Recovery Fund can help. The speakers included a politician from Brussels as well as the Spanish Minister responsible for Digital Transformation. As a result of the Recovery Fund the Spanish Minister would have a budget 10x the size of the normal level.

The c.€700bn EU Recovery Fund is the first time the EU will collectively borrow money and use the proceeds to boost economic recovery. Italy and Spain are the biggest beneficiaries and Green Energy Transformation, and Digitisation are the 2 biggest areas of investment.

In Digitisation the strategic priorities are:

1. IT Infrastructure – technology backbone, cloud investment
2. IT Skills – enhance basic IT skills for everyone
3. Digitisation of business
4. E-government

Whilst you always have to be careful about interpreting political pronouncements from the EU and this is not a done deal yet, we felt that message was not only very strong, but all this (potential) investment is incremental to the investment cases of all our existing holdings – in other words, free optionality.

This led us to re-double our search for other investments in the area, specifically in Spain, Italy, and Germany where we felt we could have more exposure. We looked at about 20 names, half of which we knew already and were ‘re-reviews’.

We ended up adding 3 new holdings in Q1:

• All For One – German IT consultant focused on the mittelstand
• Innofactor – Finnish company which is an integrator of Microsoft software – was not in our ‘target’ area but looked too cheap
• Digital Value – Italian IT infrastructure provider – started life as a VAR (value added reseller), selling hardware/software but has moved up market and now provides managed services as well as DBT (digital business transformation) services
• We also added Indra Sistemas in Spain, but we do not consider it a pure IT services provider as it operates in other areas – so is not in our cluster). There was less investment choice in Spain

Digital Value (DV) recently reported an impressive set of full year results. In a pandemic affected year they reported 21% organic growth (2019/2015 organic sales cagr was 26%) as well as rising margins. DV is a €450m market-cap company and has c.€30m of net cash. We met with the company after results and some of their slides made interesting observations:

Source: Digital Value March 2021 (Gartner Market Forecast IT Services and vertical forecast, IDC Worldwide, Black Book Forecast 2020, Assinform 2020).

The above slide tallies with what we see anecdotally, namely there is a structural under-penetration of technology investment in Italy, but also Spain, France, and Germany. The following slide is the first time we have seen one of our holdings include more granularity on how potential EU funds could be disbursed:

Source: Digital Value March 2021 (Draft of Piano Nazionale di Riprese e Resilienza, ANSA; Lit Research and Expert Interview).

DV is clearly in a very sweet spot at the moment – sales are growing at 20% with multiple drivers and this is before any EU Recovery Fund disbursement. DV has c.40% exposure to the public sector so we would expect them to disproportionately benefit from any Fund investment.

Crucially we are not having to overpay for this premium growth. The company is very focused on profitable growth and cash conversion. In a rapidly growing company such as this it is difficult to separate out growth and maintenance investment, in other words be specific about free cash flow but we think we are paying a c.5% FCFY for this growth. It is not our favourite metric, but the 2021/22 PEs are 16.4x/13.7x. Following the meeting we added to our initial ‘toehold’ position, taking the position size over 2%.

DV is yet another example of what we see at the very small end of the market-cap spectrum. Two of the closest comparables in terms of specific areas of operation to DV are Sesa (Italy, €1.5bn MC) and Bechtle (Germany, €6.8bn MC). Sesa is forecast to grow sales at 18% and Bechtle 10%. The difference is valuation. Sesa/Bechtle both trade on sub-3% FCFY’s and 2021 PE’s of 27x and 32x, respectively.

The main difference is size, and this is our current opportunity.

Why Europe?

We are often asked the question why one should invest in Europe. After discussing the pros and cons of the macro environment the answer we most often come back to is we invest in companies, not countries.

Europe is rich in its diversity and when you dig deep down into the small cap universe it is also rich in undervalued growth opportunities completely overlooked by the market due to their size.

The best answer we have to the question then is by example. Here we consider our top 10 holdings and the opportunity presented by them. We include our assessment of Free Cash Flow Yield (FCFY) and sales growth rate of each company to give a flavour of valuation opportunity. For comparison, the market is trading on a 4.0% FCFY for a (cyclically boosted) 5.7% sales growth. Position sizes and valuation as at 22/3/21.

*Source: Source: Chelverton AM. Definition of FCFY: average of FCF 2019-2022 inclusive. Definition of sales growth: average of consensus 2021-2023.

We have no predictive power over the short term but are confident that we can make very respectable returns from all these companies over a 3–5-year time horizon.

New holding: Kering

Our readers will be familiar with our description of certain companies being “market darlings”.  These are high quality businesses, with generally deep competitive moats, often having strong brands, which, due to share price outperformance versus the market over a number of years, are simply too expensive for us to own.  We admire these companies, but the trade off between free cashflow yield and growth leaves them in the unattractive Overvalued Growth quadrant of our growth/value axes:

Source: Chelverton Asset Management February 2021

Although the market darlings are from various sectors, there are a number of luxury goods companies within the category.  Global powerhouses such as LVMH ( with its flagship Louis Vuitton goods, Moet champagne and Hennessy brandy), Moncler, and Prada all have enviable luxury brands.  Another name in this area is Kering, whose brands include Gucci, Saint Laurent and Bottega Veneta. This is generally an area we consider interesting – there is likely to be pent up demand for luxury goods given higher savings ratios as a result of lockdowns.  Also, this sector provides an opportunity to access the long-term dynamic that is Chinese aspirational consumption exposure.

In recent months, the share price of Kering has underperformed its luxury peers on both an absolute and relative basis:

This has led to the trade off between growth and value at Kering becoming much more attractive.  In numeric terms, Kering is now expected to enjoy double digit topline growth over the next 3 years, but is valued at a slightly higher free cashflow yield (3.8%) than the market (3.7%). In other words it is now in our investment sweet spot.  This is the first time since we launched the fund that this has been the case, so we have added a holding.  All four companies are expected to grow significantly faster than the market, but the much higher free cashflow yield at Kering looks anomalous to us.

Source: Chelverton Asset Management February 2021

Occasionally we get the opportunity to improve the quality of the portfolio when we get valuation opportunities such as this.  Over the last 12 months, we have been able to buy three previously highly rated companies opportunistically.  These include Reply (highly regarded Italian IT services company), Adidas (global sportswear branded goods) and Moncler (clothing luxury company).  In all 3 cases, the stocks had entered into our sweet spot of having a higher free cashflow yield plus better growth prospects than the market predominantly as a result of share price falls.  In all 3 cases, subsequent to our purchase, the shares in each company were re-rated, the stocks returned to their former “darling” ratings and we exited.  The holding period in each case was under a year.  This is a shorter holding period than our usual 3-5 year horizon.  However, these companies had entered our sweet spot by virtue of a pricing anomaly, which subsequently corrected.  In other words, they had not become “cheap for a reason”, they were simply mispriced. Our investment decisions are based on a strong valuation discipline first and foremost, not time horizon.  This is relevant for both our buy and sell discipline.

Source: Chelverton Asset Management February 2021

We believe that there is a similar opportunity for re-rating with Kering.

SAP - A Growth Trap?

SAP is one of Europe’s technology success stories. It’s enterprise resource planning (ERP) software has become ubiquitous in its use by medium and large sized corporates. With this rarity value comes an expectation of continued success and strong execution.

On the evening of Sunday 25^th of October, SAP released its Q3 results alongside a strategic update. Expectations for growth and recovery in profitability were pushed back by a number of years.  Part of the issue was blamed on Covid and short-term demand.  However, the larger issue surrounds the transition facing software businesses such as SAP as it migrates from a license-based (up-front payment) model to a full cloud solution and Software as a service (annual payments).  The result was a 25%+ fall in the share price. 

We have looked at SAP on a number of occasions. It has a number of attractive qualitative attributes, the most significant being the enviable global position it occupies as the supplier of ERP products.  However, despite admiring its market position, we have found the valuation too rich for the fundamentals and last week’s dramatic share price fall reminds us that when stock market darlings are priced for a very optimistic future, the risks can be stacked uncomfortably against you.

A number of characteristics in our analysis of SAP beg significant questions.

Starting with valuation.  SAP, like a number of large companies, followed by a range of analysts, suffers from a divergence between what the company reports, and what analysts forecast.  For example, SAP reported operating profit of E5.6bn in 2019, while analysts saw EBIT at nearer E8bn.  It is not readily apparent to us why there should be such a differential, and although a red flag for us, it’s not the main factor. Our investment process is anchored in free cash flow analysis. It is therefore not subjected to the vagaries of profit and loss interpretations. We prefer analysis based on fact (cashflow) rather than opinion (profit).  We can say with confidence the amounts of free cashflow SAP has generated over the years, regardless of opinion on profitability.

Readers will know that we plot all of our investments on a blended free cashflow yield/revenue growth trade off. Prior to the share price fall, SAP was valued on a free cashflow yield (FCFY) of 2.4%, with a blended growth rate of 5.8%.  This compares with the overall valuation of the fund of 7.1% FCFY for 4.6% sales growth (as of 4^th November 2020. Source: Chelverton Asset Management).  Further, our IT services cluster, which represents approximately 20% of the portfolio is currently on a free cashflow yield of 6.9% for almost 7.6% growth.

The simple conclusion from this comparison is that we can do better in our selection of growing companies. SAP’s cashflows are too pricey.

However, our reticence on SAP is not limited to valuation alone. What is more concerning for us is our analysis of a number of long-term trends at SAP. One of our favourite ratios is FCF to sales over time – what proportion of sales does the company convert into FCF. Here is SAP:

Source: Factset, Chelverton Asset Management

This is not a good trend.  SAP has enjoyed compound annual topline growth of over 8% per annum since 2007.  However, its conversion of these sales into free cashflow has been on a consistently downward trajectory since 2009.  We usually see this deteriorating pattern of declining cash conversion manifesting itself in structurally challenged value traps. We are surprised to see it with a global software titan with good growth expectations.

The main culprit has been declining operating margins (whatever definition of operating profit we use).  Below shows the company’s definition of operating margin since 2005 – again the trend raises questions, namely has SAP been over-earning historically and has it been structurally found out?

These trends have led to an anaemic growth in free cashflows in absolute terms over the last decade:

Source: Factset, Chelverton Asset Management

So far, there are a number of questions emerging about the underlying performance of this growth company.  And this is before we raise the question of acquisitions.

Since 2010, SAP has spent over EUR 26bn net on acquisitions, c.20% of current market cap.  Over the same period net debt has gone from zero to over EUR 10bn currently.  All this for very modest growth in cashflows.  We wonder what the true organic growth rate of the business actually has been.  Alarming to think that free cashflow growth is basically static over this period, without including acquisition costs.

Our analysis suggests that SAP has a lot of questions to answer.  A 25% plus share price fall in a market darling will always pique our interest and it does look like the headline valuation has got cheaper – FCFY now 3.4% compared to 2.5%, but revenue growth for the next 3 years is now just 2.4%. Post downgrades, this still feels rich to us given the underlying question marks. 

New Holding: Kardex

Kardex offers us the opportunity to get exposure to a number of interesting themes at a sensible valuation. Kardex is the world’s leading provider of automated storage, retrieval and material handling systems. Demand for its machines and storage construction will be strong going forward, benefitting from factors such as increased e-commerce, the need to optimise storage space and efficiencies from automating previously manual tasks.

The company has a very strong balance sheet with a healthy net cash balance. It has been investing in recent years in new facilities in order to cope with expected uplift in demand. It also has a strong order book and services/recurring revenues form a significant proportion of sales and profits.

Kardex will obviously have been affected by the Covid lockdown, but it is well equipped not only to weather the storm, but also to come back even stronger as businesses return to operations. Normalising the recent expansionary capex means that the company is on a 5% free cashflow yield, growing at 8-10% organically in the medium term – an attractive combination of growth and value. The last tick in the box for us is that it is 23% owned by its chairman.

Monitoring Portfolio Activity

When markets are exceptionally volatile as they have been it can often provide a higher than normal number of opportunities. This can lead to elevated turnover levels as valuation anchors we use help point us to opportunities. There is a risk though that in markets such as these you could end up being ‘whip-sawed’ by the market. It is vitally important that you monitor the performance of your activity to ensure you are acting ‘on-process’. As a matter of course, we monitor all our decisions whether its outright buys and sells or top-slices / top-ups. This is crucial to learn not just about company level decisions but how you behave in different market environments – ie what are you good at and should do more of,  and what are you bad at – cease & desist!

Turnover has been higher over the last few months and this note reviews our activity since the market peaked on 19/2/20 (was that really less than 3 months ago!!). In general, our strategy has been to buy cheap high-quality into the initial market weakness and to sell lower quality names into the more recent rally. Reviewing activity over such a short time periods might be considered futile but the size of share price moves can often deliver 3-5 years ‘normal’ return in a matter of weeks. It can and should pay to be active during periods like this. Here are the results to date, split into 4 categories of decision.

Source: Chelverton Asset Management

As cash is typically flat, it is the gap between purchase/sale and the gap between top-up/top-slice which is the KPI. It is too early to draw conclusions from this period of course but monitoring activity in this way is important for us to understand which bits of our process are serving us well and how have our behaviours matched up to what we say we do.

New Holding: Ahold

As the market has risen sharply from the lows, we have been, at the margin, looking to reduce some of our cyclical exposures and we have been researching stocks with steadier cash flows but still on reasonable valuations. Ahold is one such stock.

Ahold is a top 10 global food retailer with c.60/40 NA/Europe split. After much consolidation over the years they have #1 market position for 70% of their sales and #2 for the balance. Sure, there are threats to the traditional food retail business but with (soon to be) €7bn of online sales, including bol.com the Amazon of the Benelux, Ahold is well positioned to deal with the challenges. Since its merger with Delhaize (Belgium) it has generated a pretty consistent level of FCF, and the investment case is about delivery of a TSR comprised of dividends of buybacks which in total we think can be 6-8% pa in total. Conventional valuation is 8% FCFY for c.2-3% growth, a PE of 12.4x 2020 (upgrades currently) and DY of 3.6%. Solid rather than spectacular.

The charts below show firstly how it compares with global food retail peers and secondly on our own assumptions noting that we think it converts sales into FCF at lower rates than history and is still decent value. We purchased 1.5% ahead of results tomorrow and hope it slips a bit so we can take position up to 2-2.5%.

Source: Chelverton Asset Management, 6th May 2020

Portfolio Activity

We have continued to be active as the combination of volatility and our company valuation anchor gives rise to opportunities. We have had some strong ideas on the buy side (existing holdings and new) and we have funded these with a reappraisal of a few of our smaller position sized holdings.

Within the IT Services sector we have sold a smallish position in Bouvet and purchased Ordina. Bouvet (Norway) has returned 38% in a short period and has run out of valuation support. Ordina (Benelux) has fallen sharply and is clearly in the value camp trading on a 10-15% FCFY for what should be c.5% growth. Net cash balance sheet. We have been following this one for a few months and having just reported we feel it is de-risked and a good switch from Bouvet in a long-term theme we like very much. These are Ordina’s conventional metrics:

Source: Chelverton Asset Management, Factset, 27 April 2020

We have consolidated 2 industrial holdings into one position. We had 2 small holdings in Imerys and AMG. Both companies had different catalysts but are exposed to industrial activity. Both share prices have been hammered in the downturn. Given that a worst-case scenario is unfolding (from where we were 6 months ago) we have a clear preference for Imerys on account of its better diversification and crucially a much cleaner balance sheet.

We sold GAM Holding. The investment case on GAM was around the stabilisation of AuM, the consequent return to profitability, the strong performance of the AuM and the prospects for M&A. The results show that the first 2 have disappeared and the third is surely a more distant prospect in this crisis. Cost cutting is too slow to ensure profitability will be reached before the balance sheet doesn’t provide support. It was always a higher risk/reward proposition and after a strong bounce and rising on the morning of results we sold the shares as our case was changed and we didn’t feel confident in a new one.

Company Updates

We have been encouraged by the willingness of our holdings to discuss the current environment. Here is an update from 4 of our smallest companies. Following the updates, we have topped up the first 3 positions and sold the last one.

Ringmetal – German company and global leader in the niche packaging segment of chemical drum clamping rings and closing systems with c.70% share. The clamping ring costs c.4% of the drum cost but its purpose ie prevention of leaks is clearly important. Their position in food and chemicals supply chain mean they continue working with both supply and demand relatively unchanged due to defensive end-industry nature (food, beverage, healthcare, DIY sectors). This is a company we think can do €6-10m of FCF and its market has cap fallen to c.€70m. Just looks the wrong price. Patience will be rewarded. Buy

CPL Resources – Irish recruitment services firm which as well as temporary staffing have a business called Covalen which manages the outsourcing of a clients logistics. For example, they manage the staffing for a Tesco distribution centre in the West of Ireland – unsurprisingly booming at present. Overall, the company are pinching themselves as they haven’t seen much Covid19 impact yet on business volumes. Their clients tend to be multinationals whom they partner with when they enter Ireland and grow with them. Examples include J&J, Pfizer, Microsoft, Tesco. Even if (when?) they encounter some trading issues they have €40m of net cash. They expect to pick up business as they have proven they can execute complex contracts which smaller peers can’t. €15m of FCF is do-able for CPL on a market cap of €170m & an EV of €130m. Another one which is way too cheap with a long-term takeout possibility. Buy

Siili – Finnish IT Services company. 100% of their staff in Finland were working from home within 24 hours. Remarkable. Similar to what we have heard from our other IT services holdings is that many verticals including public sector, financials, services (they don’t have hospitality, tourism exposure) all holding up well. Impact being felt in industrial/auto but reluctance of clients to cut back on investments crucial to their long-term future. The Finnish employment laws are very flexible allowing them to lay-off within an 11 day consultation period and re-hire within 7 days with the government paying in the interim. They do however not expect to make much use of this. Company have just sold their stake in Robocorp. Robocorp was a start-up established by an ex-employee and they sold it for €4.8m from a €200k investment for a 30x return in less than a year. Now a net cash balance sheet. This company thinks a bit differently with its core/portfolio approach to allowing fast growing units (>20%) extra autonomy and eventual realisation outside the group. Expect it to be back growing at 10%+ pretty quickly. €60m MC and capable of €5m+ of FCF. An attractive equation. Buy

Lastminute.com. We have talked often of lastminute and their asset light, cash generative model serving the travel industry. The investment case was based on online growth in travel bookings, strong technology platform, net cash balance sheet and M&A prospects. The travel industry has been turned upside down and when we examine the case now we see:

• uncertain business volume for at least a 12 month period (bookings down 95% at moment),
• a technology platform which has failed to deal with the crisis and will cause brand damage
• an unprecedented swing in working capital from big inflow to big outflow as customers demand repayments
• a balance sheet which has gone from €60m net cash to arguably €100m net debt (context is €200m market cap now) with no visibility over how they can refinance this. Even if they can agree refinancing, the capital structure case has disappeared
• M&A prospects have gone from front foot to back foot

The equity has become highly speculative with a refinancing needed. We have many better rebound candidates where we can see sales and cashflow recovering and crucially balance sheet strong enough to support the recovery. This is one of the very few companies in the portfolio where Covid19 has caused the investment case to be completely changed.

New Holding: Prosus

Prosus is the €100bn market cap European e-commerce company nobody has heard of. It is the European listing of the Naspers investment vehicle. It was listed in Amsterdam in Q4 2019 and the main purpose was to diversify investors from the Johannesburg stock exchange. Its NAV is dominated by one of the most successful technology investments ever - a $33m investment made 30 years ago in Chinese internet giant Tencent. The stake is now worth over $100bn. The NAV of Prosus is dominated (c.85%) by its 31% economic interest in Tencent. The rest of NAV is made up of unlisted assets as well as stakes in Delivery Hero, Ctrip, Mail.ru and net cash of €5bn.

Since listing the vehicle has slipped to a 35% discount to NAV. Hence the potential investment case is simple – does it make sense to buy in to Tencent at a 35% discount?

Qualitatively, Tencent has built the biggest communication and social platform in China. It is the leader in many areas including smartphone community, online gaming, video by mobile, mobile payment. It is the leading provider of apps and the number 2 cloud services provider. It has been investing whilst simultaneously monetising these unique positions for a long time now.

Quantitatively our standard cash flow graphs are below. Crucially, Tencent converts sales into FCF at a prodigious rate. This is not a jam tomorrow story in terms of cash flow delivery. The second chart shows that on balance there is a significant margin of safety even if we rapidly fade the current 20% growth rate down to 5% over 8 years and beyond. On conventional metrics it trades at c.30x. Due to high cash conversion of profits this translates into c.3.5% FCFY on our metrics. This is before the 35% discount, so a 4.7% FCFY on a look through basis. Alternatively, the 30x PE at a 35% discount is a c.20x PE. Consensus has the company growing at 20% for a pretty close to (European) market FCFY – this is a very attractive equation especially compared to our European universe. We bought a 2.5% weighting.

Source: Chelverton Asset Management, 16 April 2020

Trusting Management to Allocate FCF Sensibly

A core part of our qualitative analysis is reviewing how management allocate capital / FCF. The options for management with free cash flow are:

1. Retain funds to support organic growth
2. Make acquisitions
3. Return capital to shareholders – dividends, buybacks
4. Paying down (or take on more) debt

Our whole approach to managing money is based around being agnostic as to how we receive our total return. For some companies the total return may be wholly through dividends and for some wholly through growth and therefore capital appreciation. Many will be a balance of the two of course. When a company gets into our portfolio the message is ‘we trust management with the way they are allocating their free cash flow’. Often we co-invest alongside management for exactly this reason – alignment of interest.

The widespread cancellation / postponement of dividends as a result of Covid19 makes this very pertinent. The reasons for these cancellations are perfectly understandable:

• Preserve liquidity for worst case scenario
• Provide firepower to acquire
• Provide working capital to either restart operations or relax payment terms to/from creditors/debtors. Doing so builds loyalty with employees, suppliers and customers
• In taking support from government bodies in various forms it is inappropriate, in many circumstances, to be handing money back to shareholders right now

All of this means that the investment case on many companies will change.

Most of our financials (c.10% of the fund) got into in the portfolio as mature companies to provide a steady dividend income. At purchase this ranged from c.5-8% dividend returns. At the regulators' behests, dividends have now been cancelled across the sector. However, with the shares falling sharply it means is that our total return shifts to coming from price appreciation. We are perfectly happy with this changed expectation.

As an example, ING Bank is one of our worst performers, down c.50% YTD. The initial case was based around the c.7% dividend yield which we felt was adequately covered by income and balance sheet strength. The dividend has gone as part of the short-term case. ING Bank though now trades at a lowly multiple of 0.4x its tangible book value. We view a range of 0.6-1.0x BV as appropriate meaning before BV reduction there can be share price upside between 50% and 150%. A total return made up entirely of capital appreciation anywhere in this range will of course trump a 7% DY.

We expect the vast majority of our holdings to emerge from the crisis in a stronger competitive position. In part this is due to financial strength. Pre-crisis our portfolio had ND/EBITDA metric of 0.3x against the average for the market of 1.6x, so our average portfolio holding has considerably more Balance Sheet breathing space than the market.

Whilst there are larger questions around government intervention in sectors and equity risk premiums, we are agnostic as to how we receive our total return and back our management teams to allocate resources effectively. It will be a relative opportunity for most.

Portfolio Activity

We have been active. We believe this is our job and when price moves are so violent, and we have an anchor on a company’s valuation we believe we should act.

We have not tried to use cash levels as a tool and have consistently aimed for 2-4% cash levels throughout, but we are using opportunistic price limits a lot more than usual on both buy and sell orders.

(In his later years as an investor, Sir John Templeton used to place orders on all his stocks at the start of the quarter and go to the beach. I’ll buy stock X at P-30% and sell it at P+40% - unfortunately I don’t have a beach nearby. Although Gareth does!)

On 28/2/20 we posed ourselves the question: Can we improve the quality and long-term growth of the portfolio at a reasonable or even excellent price?

Our activity over the last 3-4 weeks can be summarised as follows:

1. New holdings We have added 3 new names in last few weeks: Moncler, Adidas and Reply. All 3 of these companies were trading at or about market FCFY but will deliver materially higher long-term growth. See 28/2/20 post for detail on Moncler. Adidas was a ‘market darling’ who fell 45% and we were ready to act. Reply is another IT services company we have been tracking for a while and adds to our significant cluster in this area
2. Top up of existing holdings - we have been ‘promoting’ the following holdings into material weakness. Specifically: Infotel, ASM International, BESI, Arcadis, Sword, D’Ieteren, Signify, Kaufman & Broad, Knowit, CPL
3. Complete exits. The day the oil price fell 30% (9/3) we responded very quickly with a number of opportunistic top ups, funded by 2 complete sales. The sells were made much easier by the large number of clear buy ideas we had on the other side, see names added to above. We held 2 oil service stocks and sold one of them – Subsea7. It was the more asset intensive company of the two (TGS is the other) and we quickly realised that the new scenario could lead to big losses as so many of their projects would be uneconomic for their clients. Balance Sheet was strong but could be overwhelmed by cancellations. We also sold Santander. We were looking for another holding to sell, and Santander was our bank with the least strong capital position. A few days later we sold Swedish Match. It had been a fantastic performer and was our most expensive holding on many metrics. Note, we also subsequently topped up Total on the belief that like in the last cycle the oil majors capital discipline could lead to outperformance.
4. Top slice of existing holdings When things move very rapidly, relative performance and relative valuations are crucial to follow. So, we have been rotating out of our strongest relative performers into the names listed above, Stocks in this category include: SEB, Novartis, Roche, Danone and CPL (prior to sharp fall)

The reader will be well aware of the sharpness of the share price moves but here are some examples of the above 4 categories:

Of course, our objective is to buy undervalued cashflows from healthy companies and our sweet spot is cheaper cash flows than the market AND better sales growth than the market. The following chart shows how in our process we have been behaving:

Source: Chelverton Asset Management, as of 23 March 2020

Red dots are stocks we have been reducing. Green are the new buys and Yellow are the names listed above we have been adding to.

So, what’s next for the portfolio?

To date we are very comfortable to have improved the quality and long-term growth of the portfolio at somewhere between good and excellent cash valuations. We have specifically targeted consumption exposure and technology exposure. All the new names we have added have net cash Balance sheets. So far so good, so safe. No shortage of additional names under review with more of these characteristics.

Probably the best investment decision I have made in my career was the most uncomfortable at the time. At the end of 2008 it was very easy to feel safe in the telco/healthcare/utilities which had massively outperformed. However, process and valuation discipline dictated that a switch into more growth and cyclical areas was warranted. Recall the deflationary spiral, global depression, financial market meltdown fears at the time.

The real debate now will be when to ‘go ugly’. Many traditional value names and sectors have been crushed, even the ones with some growth or cyclical growth. Usually leverage is the culprit for the more extreme performance but whole sectors such as auto, banks and industrials have been hit very hard. Duration and severity of the recession are the missing inputs in the assumptions, but our feeling is that we will nibble in small ways with our own favoured holdings & pick off anomalies in these sectors as they get sold off. We do not need to be radical here though. We have enough valuation discipline baked into our process and portfolio without needing to try and time a ‘deep value’ buying spree.

Banks do present an intriguing dilemma at present. Valuations (and prices) are at multi-decade lows, at least as low as the GFC. Valuations such as P/B of 20% or 30% are common as are PE’s of 3x/4x and DY’s of 15-20%. Our view is that the latter 2 metrics are less relevant now. P&L’s will be shot in the short term and most banks should cancel their dividends out of common sense. Balance Sheet ratios such as Core Equity Tier 1, Liquidity and Loan/Deposit ratios are what matters. What is intriguing is that the bank sector enters this crisis with capital levels 3-4x the level of 2007/2008 and arguably banks are part of the solution this time around, not part of the problem. Watch this space!

Before taking any major steps though, we need to be thinking about how the world emerges from this crisis. For sure the storm will pass but what sort of world will we inhabit?. Decisions being implemented overnight are fast-forwarding processes and debates which have been in place for years, even decades. Citizen empowerment v totalitarian surveillance and nationalist isolation v global solidarity (Yuval Noah Harari poses these questions in the FT) are two fundamental questions which I for one can’t answer right now but will have material implications.

Investment Behaviours & Process

I have written an investment diary for most of the last 20 years. The reason stems from a Behavioural Finance observation that to learn from your decision-making process you need to document at the time of writing what you were thinking and why you took certain decisions. Otherwise, hindsight conceals the real reason and you never learn the real lesson. With markets as stressed as they are, writing anything today can look pretty stupid tomorrow, but the discipline suggests we should carry on. So here goes..

Firstly then, some thoughts around process and executing it in today’s markets. The next post is about our execution.

The majority of these observations are relevant to all market environments but feel to us especially pertinent right now:

• Having a clear philosophy & process to follow doesn’t half help our ability to navigate. Our process is part qualitative, part quantitative, part common sense. It is all underpinned by a strong belief in the lessons of Behavioural Finance, the details of which can be found in our presentation. Right now, how we are behaving emotionally carries more weight than anything
• Short-term numbers come with a huge caveat right now – one-year forward PE’s and DY’s are completely misleading at present. However, long-term cash conversion trends and balance sheet headroom are vital safeguards/anchors we built into our process and have helped us enormously both hold our nerve on stocks and find new ideas. The folly of reliance on single period metrics is crystal clear in markets such as these. Focus on long-term trends in conversion of cash flow and consider likelihood these levels will be resumed after the crisis
• There is no substitute for knowing the fundamentals of the companies you invest in. Having the basics of a company’s business, its investment case, its risks, its cost structure (fixed/variable) supply chain, working capital, balance sheet etc all documented is crucial to refer to at these times. Porters 5 Forces and SWOT analysis may have been around for a while but are timeless concepts in understanding how your investments might be faring
• We try and keep a healthy buy list full of good ideas. A ‘strong squad’ Gareth calls it. We want to have 80-100 names competing for 40-50 spaces. We work VERY hard at this. ‘Tough’ sell decisions (usually selling something after it has fallen a long way) are so much easier when there is a high conviction ready made buy idea ready to go in its place. I have never not managed a portfolio where I had 3/4/5 names I have long term doubts about and grasping the nettle by selling these is normally the right thing to do
• Price and value are two very different concepts and gaps can become very significant very quickly. Important to remember this simple concept when your favourite stocks are getting completely crushed! The value of a big net cash balance sheet company has not fallen by 50% just because Mr Market decides that is the short-term price
• Warren Buffet has 3 investment trays: ‘Yes’, ‘No’ and ‘Too hard’. It is ok to admit to the latter at the moment

Importance of an Investment Library

I’ve never been much of a gardener. So, in 2002 before I joined Edinburgh Partners and was on gardening leave I outsourced the garden to someone better qualified and went to the library. In the library I read the best part of 50 or so investment books, many of them the classics. I took liberal notes and quotes and refer to these often. At times of market stress, it is great comfort to know that it is perfectly common to question everything you hold dear!

As I was flicking through my notes here are 10, which stood out as useful reminders for these times:

1. ‘The investor should wait for periods of depressed business and market levels to buy representative common stocks, since he is unlikely to be able to acquire them at other times except at prices which the future may cause him to regret’ Benjamin Graham (1934)
2. ‘It takes a great deal of discipline to stick to value convictions, especially when the share price declines after you buy them. If you focus only on share price, price declines can be devastating emotionally. For long term investors who evaluate price relative to business value, price declines can represent tremendous opportunities’ Charles Brandes
3. ‘Never dig so deep into numbers that you leave common sense at the door’ And: ‘Whenever calculus is brought in, the operator is trying to substitute theory for experience and usually also to give to speculation the deceptive guise of investment’ Both Benjamin Graham
4. ‘Only own a stock you’d be comfortable owning if they closed the stock exchange for 3 years tomorrow’ Warren Buffet
5. ‘Maintain the emotional stability to act diametrically opposite to the masses. It is difficult to part company with the crowd to buy when everyone is bearish but that is precisely what must be done to produce superior returns’ Ned Davies
6. ‘Do not bask in the warmth of being different. There is a thin line between being contrarian and being just plain stubborn. I also concede at time, the crowd is right’ John Neff
7. ‘The best investors are those that can keep their emotional reactions to loss in check’ James Montier
8. ‘The most extreme and enduring crisis that capitalism had ever experienced..eventual discovery of the severe mental and moral deficiencies for those once thought endowed with genius’ JK Galbraith (talking about 1929)
9. ‘An investor will succeed by coupling good judgement with an ability to insulate his thoughts and behaviours from the super contagious emotions that swirl the market place’ John Templeton
10. ‘Interesting to reflect that whereas 3.9m shares were sold yesterday, there were 3.9m shares bought yesterday; and possibly the purchasers may be more intelligent than the buyers’ John Templeton. (Don’t you just love the brokers oft-repeated ‘well owned stock’ nonsense!)

Coronavirus Impact - An Example

As an example of our stock work, here is our research comment below on our most exposed company: lastminute.com. (For previous diary entry see 18/6/19)

(Prior to the last few weeks we had made a 60%+ return on the company as they started to deliver on their significant software investments of recent years. The other significant thing which has happened is that the company had announced they were in talks about a possible corporate transaction. As of a few weeks ago forecasts were for the company to generate c.€50m of FCF).

It is easy to see a scenario whereby travel generally, and holiday plans in particular are severely disrupted for the short term.  We re-ran our model on LM to reflect the possible effects on the  valuation from the company experiencing a very poor 2020 in terms of business activity.  We worked through various sales drops and margin falls with the following outcomes:

• In the best case scenario, we assume that there is no profit, and a E35m cash outflow, which reduces the current net cash from 65m to 30m.
• In our central scenario, there is a loss at the operating level, leading to a 65m outflow of cash.
• In our worst case scenario, the losses would be more substantial and there would be a 75m cash outflow. Crucially the Balance Sheet would go from significant net cash to a forward nd/ebitda of <0.5x

We assume a return to more normal levels in the following year. This could be viewed as conservative - if people miss a year of holidays, then the pent up demand could be substantial.  Also, lastminute is, as the name suggests, capable of turning around very quickly, so any suggestion that the coronavirus threat is subsiding could encourage a late surge in bookings as holiday-makers scrabble to get their trips.  For now though, we are happy to be more conservative.

The upshot is that our margin of safety / upside falls from 68% to 41%.  This means the cash flows are still very cheap. Lastminute is certainly exposed, and we can understand why the market is pricing in such pessimism (shares 30% off the top).  Part of our thinking is that the likelihood of corporate activity, which was already high, has gone up. The company’s key asset, its dynamic packaging application will be an attractive bite sized opportunity for larger players in the OTC business which are currently licensing LM’s software.

The well capitalised nature of LM gives us confidence that it can weather some pretty extreme adverse trading conditions.

Source: Chelverton Asset Management

Coronavirus Strategy

We are now well into correction territory as the markets react to coronavirus and especially the more recent spread to Europe and the US. Markets have been very sanguine for a very long time so a sharp correction should not necessarily be seen as a bad thing and of course we have encountered these many times before, albeit in different shapes.

We have no greater insight into the duration or severity of the economic or corporate impact. However, to work through implications we need to have a base case and we think it appropriate to be considering a couple of quarters of severe impact on economies and our holdings.

We are going through our holdings and our models and addressing the following:

• Supply-side issues, ie supply chain issues
• Demand -side issues – fall off in demand and whether likely temporary or permanent
• Balance Sheet impacts. This is the critical piece in the analysis – can the BS take the strain of what may be significant short term losses
• Likely rebound in activity towards back end of the year

We have categorised the impact into high, medium or low impact. So far the sell-off has been reasonably indiscriminate but as time passes there will be more differentiation and our categorisation will allow us to identify over/under reactions and respond accordingly.

At the portfolio level a key question we ask ourselves in a period such as this is:

Can we improve the quality and long term growth of the portfolio at a reasonable or even excellent price?

Sometimes market dislocations throw up opportunities in good companies that have been out of reach and often you only get one chance so you do have to be ready and react. This could be via new holdings or it could be within the existing portfolio. With some of the more value areas or cyclical areas often you get a number of chances so there is less need to react in the same way. We don’t know the duration either so should you make a change you should not go ‘all-in’ - make a change and keep some powder dry as more opportunities may arise. Buying something you really like long-term at a great - reasonable valuation even if you are a bit out with the timing is rarely the wrong thing to do. As long as you hold your conviction and average down if necessary.

Coronavirus - Portfolio Activity

We have just added a new holding which is Moncler the Italian luxury goods company. It is our first purchase of a company with these characteristics – strong long-term demand driven by aspirational consumption. It’s a small company (sales <€2bn) and has lots of room to grow geographically as well as diversify product range from the eponymous jacket to related areas such as knitwear and shoes. It is also a possible takeover candidate and this point is a key feature of why we bought the shares as we feel the downside should ultimately be protected by this feature. The company has communicated a range of measures to deal with the spread of the virus – from a marketing freeze, rent renegotiation, slowing of buying and delay in store openings- in other words everything they sensibly can. We don’t know the exact magnitude of the hit but here is our estimate of the ranges of cash flow profile at a 7% discount rate:

Source: Chelverton Asset Management

On our value/growth trade off there is market FCFY but with sales growth a multiple of the markets growth rate and this is an equation which is very attractive to us. A similar proposition to Sword (see 17/2).

Source:  Chelverton Asset Management

We have also added to Sword, Signify and Novartis and taken some money out of CPL Resources and Swedish Match, both of which have been very strong of late.

Coronavirus - Our Process

We have built a robust process and valuation discipline. This should serve us well in normal market conditions but should come into its own at times like this when markets are highly volatile. The process we have built allows us to quickly figure out impacts on our holdings and gives us a ‘valuation anchor’ on what a business is worth as we seek out big margins of safety against rapidly moving prices.

Whilst the market doesn’t always price this in immediately we take great comfort from the deliberately low leverage of our portfolio relative to the market – 0.3x geared (nd/ebitda) compared to the market on 1.6x. This lower leverage will give our holdings much more Balance Sheet breathing space and flexibility than the average company in the market.

Looking at our portfolio metrics today is encouraging in relative terms but increasingly in absolute terms too. The recent additions of Sword and Moncler in particular have made a notable to difference to the sales growth premium we now have over the market.

Source: Chelverton Asset Management

Cheaper cash flows. Better Growth. Lower financial leverage.

Purchased: Sword, Signify

As mentioned on 23/1 there were 5/6 names we wanted to add to the portfolio but for a few we wanted to wait until they reported until we acted. The following 2 companies have now reported results and we have added 1.5% positions. They have different characteristics, but both are very interesting investment cases. We will likely build the position sizes up reasonably quickly.

Sword is another fast growing French IT services company which came from the screen. Data management is at the heart of their service offering which covers Governance, Risk and Compliance – all growth areas. It has good diversification across client and geography, see below. They have close to a 2-year orderbook with double digit growth looking very likely. Results showed that working capital had reversed recent trend and we are paying a slightly sub-market FCFY for this double-digit grower. In-keeping with our small-cap (€340m MC) policy, management own 34% of the equity including the Founder/CEO 17%. Another strong net cash Balance Sheet, 3.5% dividend yield for this growth is also pretty attractive and explained by no major capital intensity. Some background on Sword:

Source: Sword company presentation

Signify was spun out of Philips in 2016 and is a global leader in Lighting. It has been managing the huge transition from incandescent light bulbs to LED. Five years ago LED bulbs retailed at $15, today a 40W equivalent sells for 90c. LED is hence approaching price parity with traditional bulbs. Signify’s business mix has changed significantly as a result and now the ‘good’ businesses (LED, Professional, Home) are over 70% of FCF, so the dilution to group growth levels is disappearing from traditional Lights. We think the company is probably a 1-3% grower but also has significant self-help potential. This is added to by the recent acquisition of Cooper Lighting (from Eaton), an acquisition which transforms the company is the US professional market from sub-scale #4 to industry leader alongside Acuity. As can be seen Signify has more the characteristics of a value stock:

Source: Chelverton Asset Management

A double digit FCFY for c.2% growth is an equation we are very comfortable with especially as dividend yield is over 4% and buybacks could provide another 2% of total return pa.

Spotlight: Leverage

The topic is leverage and the dangers of it. Akka is a company we had held and the investment case around the growth in outsourced R&D services was strong. The company though made an acquisition too many and we started to get concerned about the Balance Sheet so we sold the shares in 9/19 as part of our risk discipline. Interesting therefore to observe reaction to their results today where a small earnings miss and what would have maybe been a 5% down move in the shares translated into a 15% fall as market fretted about Balance Sheet. We noted something similar with another former holding, ISS which is now struggling with its Balance Sheet management. It was also behind our decision to sell Fresenius, see previous entry.

It all reinforces the introduction of our risk discipline. To reiterate, we don’t believe that to outperform longer term you need to take excessive financial leverage. We codified this as one of our 2 ‘hard rules’ at the portfolio level, namely the portfolio will always have lower financial leverage than the market as measured by ND/EBITDA. As of the time of writing we have portfolio leverage of 0.4x with the market at 1.6x.

Purchased: AMG, Imerys, Nokian Renkaat

One of the strengths of our process is idea generation - generating and researching new ideas is one of the most enjoyable parts of the job. We have no shortage of new ideas currently and rather than keep some of these names on the sidelines we have made a conscious decision over the next few months to expand the names in the portfolio from 44 towards 50 which is our maximum. We will utilise 1% positions a bit more. In recent days, we have added 3 new 1% positions and have a couple more ideas to add but want to see results first.

The 3 names we have added are:

• AMG – an industrial company which processes critical materials which enable CO2 reduction & fuel efficiency – supplying the aerospace & auto industries as well as recycling spent catalysts for the oil industry. Capex expansion means this is a 2021/22 cash flow story and in addition there is a break up angle partially related to the CEO nearing retirement
• Imerys – another industrial company which makes mineral specialities for industry focusing on performance materials and high temperature solutions which also help clients with energy efficiency. Is a new management and turnaround story for which we receive a well covered 5% DY and 8% FCFY whilst we wait
• Nokian Renkaat  - winter tyre specialist. Company has been investing in capex so cash flow has be pushed out and has a mild winter. We’ve felt that this company which has always been well manged and in a profitable niche could/should be part of a larger tyre company. After falling share price we are now receiving a 6% DY which on an ungeared BS we think will be honoured. This gives us a good backstop whilst earnings recover or if not they’ll attract the attention of a suitor. A good each way proposition.

To fund these purchases, we have sold our position in Fresenius AG. Stubbornly high leverage is the reason, at 2.5x ND/EBITDA it is at the higher end of our tolerance and we think the above combination of new ideas gives us better upside potential with lower risk profile. The new ideas have deliberately been sized with potential to add into weakness but giving us a healthy starting weight in case they start to move.

Some interesting features of the new purchases:

Source: Chelverton Asset Management

Above is AMG’s free cash flow relative to history. The big investment program explains the uplift in FCF going forward – we note the company already has agreements in place which secures supply and demand for its new plants at a decent return. We believe consensus has this wrong and is incorrectly penalising the company for its measured investments.

Source: Chelverton Asset Management

Above is Imerys conversion of sales into FCF. Excepting volatility around the GFC its been reasonably stable but we’d hope management action lifts this long run average although as can be seen this is not needed for the shares to be cheap. Upside/downside in these 3 scenarios is respectively 116%, 41% and -45% - a good equation and comfortably offering good upside at a 9% discount rate.

Source: Chelverton Asset Management

As can be seen from this chart Nokian’s cash conversion has been an order of magnitude better than its larger mass market peers. Given that the strategy of the big 4 (Continental, Michelin, Goodyear and Bridgestone) as well as the Korean/Chinese is to get into the niches Nokian operate in, we think this might lead to corporate action.

Switch Dometic into Fenix Outdoor

We have switched our Dometic into an initial 1% position in Fenix Outdoor. Dometic is a market leader in replacement (ie recurring) parts for the camper van market. We have owned it since fund inception and this year is one of our strongest contributors (+70%). We have been getting uncomfortable with the valuation equation particularly on account of the stubbornly high debt, ND/EBITDA (2.7x) especially as new CEO clearly wants to make acquisitions. We are happy to step away here.

Fenix Outdoor is also Swedish and has a portfolio of outdoor equipment and clothing brands. Best known for FjallRaven (first product was the backpack, see below) but also Tierra, Primus, Hanwag, Brunton, Royal Robbins and NaturKompaniet. All the brands have premium positioning and are sold multi-channel. The valuation equation is very similar to that of SEB (see 11/11/19) ie double the market growth at cheaper cash flows than the market.

Source: Fenix Outdoor

In Depth: ASM International

The topic is the semiconductor stocks, specifically ASM International (ASMI) and how keeping on top of stocks and updating the analysis is crucial. Our 3 sector holdings here, BESI, ASMI and ST Microelectronics have been 3 of our biggest contributors this year. 2019 looks like marking the bottom of the semi-cycle and the stocks have reacted to this very positively. When we first bought these stocks at the end of 2018, start of 2019, the exact shape of the cycle was unclear, but we felt based on possible ranges of outcome, the risk reward was strongly in our favour.

Take ASMI as an example. When we first purchased ASMI (see diary entry 16/1/19) there was 56% upside based on the following blended FCF profile: (€m being the y-axis scale)

Source: Chelverton Asset Management

As there was significant upside and not much downside we weren’t too concerned about the precision of the cycles. The conclusion based on our qualitative work and this in-depth analysis was - ‘too cheap’.

ASMI is a leader in proving ALD (atomic layer deposition) equipment to the big chip makers (big 3 being Intel, Samsung &TSMC).  Our initial case was based on a general improvement in the semi-cycle, i.e. more demand for ASMI equipment but also specifically the ALD segment out-growing the industry as the increasing demands on miniaturisation of the chip leads to increased intensity of usage of atomic layer deposition as a stage in the chip manufacturing process. The pressure on the chip makers to pursue Moore’s Law is intense and this has manifested in significant demand for ALD, this year, way earlier and in bigger size than we had anticipated. This is what has driven the shares – they have nearly tripled from the bottom this year.

As the year has gone on we have made 3 changes (all upgrades) to our scenarios. Our current range of outcomes for ASMI shows over 20% upside and looks like the following:

Source: Chelverton Asset Management

As the facts have changed we have changed our scenarios, to adapt Keynes oft-repeated maxim. Note the change in the scale of the Y-axis on the 2 charts.

To summarise:

• At the start of the year we thought that by then end of the competitive advantage period (CAP) ASMI would deliver €79m of FCF in the worst-case, €114m in the central-case and €157m in the best-case scenario. On this basis there was 56% upside ie the stock was very cheap, and we bought it

• By year end we now think ASMI will deliver FCF of €152m in the worst-case scenario, €260m in the central-case scenario and €489m in the best-case scenario. Notwithstanding the sharp rise in the shares there is still over 20% upside

The change in ASMI estimates have been as dramatic as any I can recall in the period of a year and are a testament to managements long executed strategy to invest in staying ahead of its peers in a market niche they felt would always garner a more significant share of client capex.

At the start of the year there was minimal expectation of ASMI executing. Now there is a higher level of expectation that they will execute. We have top sliced ASMI but still retain a 2% position. The case is supported by our belief that ASMI may be involved in industry consolidation scenarios.

ASMI is a good example of what we always say about our in-depth analysis - it is never about precision of forecasting or specific price targets/upsides. Our analysis at the start of the year suggested this was very cheap with low expectation. Now there is sufficient margin of safety to keep holding the stock, but we need to be aware that expectations are considerably higher than they were. 

Please note the following definitions of some of the acronyms used:

FCFY – Free Cash Flow Yield, FCF – Free Cash Flow  (see post of 5th June 2019 for Chelverton’s exact definition), DY – Dividend Yield, BS – Balance Sheet, EV – Enterprise Value, SOTP – Sum of the parts, TR – Total Return, EBITDA – Earnings before interest, tax, depreciation and amortization, ND – Net debt, PE – Price to Earnings Ratio

Purchased: Groupe SEB

Today we have purchased Groupe SEB. We had been tracking the shares for some time and met the company in Edinburgh recently. SEB is a French company and is a global leader in small domestic appliances such as toasters, kettles, frying pans, coffee makers. Brands include Tefal, Rowenta, Moulinex, Krups. In 2007 they acquired a majority (now 81%) stake in Supor, a Chinese listed manufacturer and China now represents over 30% of profits growing comfortably into double digits.

The stock is nicely in our sweet spot of cheaper cash flows than the market and better growth than the market. This can be seen below:

Source: Chelverton Asset Management

The stock has underperformed of late and brings something a bit different to the portfolio, consumer exposure but not at the 20+ PE, 3-4% FCFY’s that many staple-like companies trade on. SEB trades on an FY1 PE of 14.6x and as can be seen below the PE rarely trades as low as this relative to the market. Interesting entry point, 2% initial position with scope to add more.

Source: Chelverton Asset Management

European Telecoms are potential value traps

We don’t own it, but interesting to note Deutsche Telekom ('DT') cutting their dividend today, albeit not materially from 70c to 60c (a 4% DY). The telecom sector has many of the characteristics of an obvious value area with sensible PE’s (11-15x) and decent dividend yields (4-6%). FCFY to equity even look interesting (6%-12%). Note I am quoting an average of DT, Orange and Telefonica ('TEF')here.

So far so good. The problem is growth and leverage – not enough of one and too much of the other. Growth rates are anaemic (-0.5% to 2%) and leverage (2.6x – 3.4x) is too high. Yes, interest rates are low and there is no obvious refinancing issue however cash flow has been consistently under pressure. This has caused a combined 8 dividend cuts from these 3 companies over the past decade and leverage has barely budged from these levels despite targets to cut them.

We have two underlying observations which when combined explains why we haven’t got involved in a sector we still see as a value trap. Firstly, capital intensity and secondly cash conversion.

Capital intensity is persistently high, i.e. investment requirements just to stand still in this business are significant and take priority over dividends. We often find a correlation between asset intensive companies and cyclicality, regulation, indebtedness and structural challenges. Although we have no hard rules around asset intensity specifically, asset light businesses tend to generate cleaner FCF and hence show up better in our process.

Here are the fixed asset intensities of the three companies: (Orange, DT & TEF respectively). For reference our portfolio fixed asset intensity is around 20%.

Source: Chelverton Asset Management

This leads onto the second observation which is that every pound of sales generated by the sector is translating into less and less free cash flow. FCF underpins dividends. The combination of high asset intensity, low growth, high leverage and falling cash conversion is why we have seen the dividend cuts and sector underperformance. The following chart show that the decline in cash conversion is a sector phenomenon which every year analysts forecast will turnaround in the current year. We are not as confident and think this is a good example of analyst positive bias, following company guidance.

Source: Chelverton Asset Management

When we were devising our philosophy and process, one of the challenges we were keen to address is the fine line between value and a value trap. It is ‘easy’ to screen for and spot value but when is it a value trap? To address this, one of the key tools we created was a chart analysing the % of sales that is getting turned into FCF. It’s a relatively simple ratio but very powerful when looked at over long periods of time. Many value traps convert an ever smaller % of sales into FCF over time. Even if the company manages to keep earnings up through ‘accounting’ (i.e., ‘cheap’ PE) it is much harder to obfuscate FCF. In our current modelling we go back to 2005 and when valuing a company, we always add on the same ratio in the DCF forecast period so we can see how our assumptions compare to history.

The following two charts are of Telefonica. The first shows three scenario for TEF’s future FCF spliced onto history & the second puts it in context via absolute numbers.

Source: Chelverton Asset Management

Source: Chelverton Asset Management

Due to leverage we use a 9% discount rate to discount TEF’s cash flows and based on this blend of scenarios there is 25% downside. These stocks and the sector may well have their day in the sun, and we will keep revisiting them, but we don’t see them as attractive long-term investment propositions.

Our portfolio is a balance of value and growth at an appropriate risk profile. Whilst we might own the occasional deep value stock which looks like this our portfolio in aggregate is unlikely to look deep value over the cycle.

New Position: Heidelberg Cement

We have started a position in Heidelberg Cement. Germany based, it is a global cement player with a developed / emerging mix of c.75/25. It ticks a lot of valuation boxes including 10.6x PE, 80% of BV and FCFY of 8.7% for 4.7% growth. Its earnings estimates have been going up and despite this the stock has been de-rated very sharply. This can be seen in the graph below:

Source: Chelverton Asset Management

Leverage at 2.5x is right at our ‘glass ceiling’ but from a portfolio perspective we don’t have a leveraged cyclical like this and our portfolio ND/EBITDA at 0.6x is considerably lower than the market at 1.5x so plenty of scope to add a bit of measured leverage without compromising our risk objective. The investment case is around earnings progression based on the footprint seen in the slide below. Portfolio optimisation, as has been the case across the cement industry, would be the icing on the cake.

Source: Heidelberg Cement company presentation

Often with cyclical stocks you are paying a high multiple of trough earnings anticipating recovery, here you are paying a low multiple of trough earnings. This and the other valuation metrics offer a considerable margin of safety, even at a higher discount rate. 2% position to start.

Europe Outperforming the US, in the short-term at least !

Little comment is needed alongside this graph. Many investment managers have never seen a period of Europe outperforming the US. You need a magnifying glass to see the recent relative bounce!

Source: Redburn

Sold: Bravida

Today we sold Bravida. Bravida is a leader in the fragmented Nordic technical services market. One or two minor niggles emerging over organic growth and acquisitions but really its all about valuation which is now moving into expensive territory (we had top sliced prior to here). It is one of our best performers since inception, >60% TR. Handful of top ups with the proceeds.

Wirecard: The latest 'Market Darling' to disappoint

As we have commented before, one catalyst for the Value/Growth axis to shift is for the ‘E’ of the growth stocks / market darlings to disappoint. Today Wirecard, very much a market darling of recent years has fallen sharply as its ongoing spat with the FT took another turn with publication of material suggesting a significant percentage of its profits have been fabricated. For what its worth, our Fitness Test does show a company which has been generating FCF in recent years however the valuation being asked to pay for this has been way too high for us so we would not have been able to invest, probably not since 2015/16.

So, to the list of market darlings which have disappointed materially we can add Wirecard to the list which includes Ubisoft and Amadeus in Europe and various high-profile loss making or ‘long-duration’ companies, mainly in the US. The list doesn’t yet contain European market heavyweights such as Nestle and L’Oréal but as the air of invincibility is lifted from other darlings it is likely that investors will start questioning the valuation equation they are invested in.

IT Services cluster & addition of Recticel

In our IT services cluster we have two French companies with an overlapping exposure to the domestic economy and in particular the financial services vertical. Aubay has performed decently (20% TR) and now has marginal upside (4%) whereas Infotel has slipped a bit and with c.45% upside and is appreciably cheaper. We have topped up Infotel and removed Aubay to diversify the portfolio with the purchase of Recticel.

Recticel is small Belgian company with a comparative advantage in the processing of polyurethane. In laymans terms this is a foam which goes into insulation and various consumer (bedding) and industrial applications. The group used to be a larger industrial conglomerate and is slimming back to insulation which is the jewel in the crown, driven by environmental regulations. Plenty of operational and strategic catalysts here.

Valuation is a 7% FCFY with 3-4% growth and >40% upside using a 9% discount rate.

The following graph shows Recticel’s troubled history but also its potential to raise its cash conversion to the level of its peers as it divests of non-core divisions:

Source: Chelverton Asset Management

Reduction in Semiconductor stocks and new positions in Bank of Ireland, Salmar & D'Ieteren

We have nearly 8% of the portfolio in three semiconductor stocks. ASM International, BE Semiconductor and ST Micro. The sector has been a very strong performer and the first two stocks are our biggest performance contributors year to date. The clear valuation support at time of purchase is disappearing rapidly as the stocks move well ahead of what we expect to be a very strong cycle. However, risks are always present in this sector and trade/investment sentiment can swing just as hard in a negative way. We have a number of good ideas for new money and have decided to reduce sector exposure back to c.5%, taking money out of all 3 names proportionately. Small top slices of Sanofi, Zurich and Siemens into strength.

Reinvestment is as follows:

New holding in Bank of Ireland ('BoI'). Due to a combination of Brexit, recession fears and interest rate concerns, BoI trades on a deeply discounted valuation, akin to financial crisis lows but with much better BS buffers in place. Whilst there are many uncertainties, BoI is an interesting play for us on Ireland and a post Brexit relief bounce and at a stretch, any relief from relentless rate declines. Start at 1% with a view to averaging in to a 1.5-2% position

Source: Chelverton Asset Management

We have re-entered the salmon farming sector with a position in Salmar. The long-term supply-demand dynamics for salmon are good and with a pull-back in the short-term salmon price, an opportunity has opened up. Ideally the sector keeps coming back and we can add to Salmar and one of the smaller peers too. Whilst it is some years away from making a material impact on supply, Salmar is a leader in deep offshore salmon farming technology:

New holding in D’Ieteren. I had a long history with this Belgian holding company, at times becoming exasperated with their style. Things have changed for the better in the last 3-4 years. They have sold a stake in their main asset Belron to CD&R, a US private equity house. This will bring a more intense focus on cash generation and a likely US listing in the next 3-5 years. Additionally, there has been management change, change of family Chairmanship and a share buyback for the first time. All these changes are welcome and makes a SOTP type valuation a lot more valid. The group is ungeared, trades on an 8% FCFY with roughly market growth. No shortage of catalysts in this uncorrelated position. D’Ieteren’s key asset is Belron, a global leader in VGRR (Vehicle Glass Repair & Replacement). It trades in the UK as Autoglass and in the US as Safelite where it has c.40% market share and is the biggest profit contributor to the group. Long term growth includes the company performing the calibration that is required in vehicles fitted with Advanced Driver Assistance Systems (ADAS).

Top up of Infotel to 2.5%. Stock slipped after recent results, valuation still very attractive.

Addition of Valmet and portfolio tilt more towards cyclicals & away from defensives

We bought the shares in Valmet. It is a Finnish company which we met a few months ago. Valmet was demerged from Metso in 2013 and is a servicer of capital goods equipment. It is still treated by the market as a capital goods cyclical and this has provided us with a good entry point. FCFY nearly 8% for c.5% growth means the company is firmly in the sweet spot for us. As can be seen below conventional valuation also attractive for the relative stability offered:

Source: Chelverton Asset Management

Part funded by taking some money out of Danone. After strong relative and absolute performance, the presence of both Danone and Unilever just into the bottom left quadrant of our value/growth chart continues to ask questions of us. These stocks are increasingly becoming sources of cash as we can see below:

Source: Chelverton Asset Management

Another month where market rewards security and visibility over cyclicality. This coincides with wide discussion of recession and whether we are in one or heading for one. Our view is that some countries in Europe are either very close or likely in a technical recession (Italy and Germany most notably). What is clearer both from the top down and the bottom up, is that a recession is becoming priced into many valuations.

Our feeling is that we should be tilting the portfolio a bit more towards cyclicals and reducing our exposure to some of the defensive stocks which have done very well for us. This feeling is supported by the valuations of the respective stocks.

Accordingly, we have:

• Reduced exposure to Danone, Unilever and RELX by 2%. Reduced Akka as concerned going into results.
• Increased exposure to banks (Nordea, Santander) and preferred cyclicals Valmet (not a deep cyclical but treated as one), Siemens, Hexpol and CPL

The net net of this is a c.4-5% shift in the portfolio towards more cyclicality/obvious value. Our FCFY goes up to 6.6% (6.4%), PE falls to 14.0x from 14.2x and DY increases from 3.5% to 3.6%. Sales growth falls from 4.7% to 4.6% ie not massive changes but all increasing our valuation support. Note no change to Net Debt to EBITDA.

Quality Growth valuations

Two research headlines caught my attention this week:

1. from JPM strategist: ‘The bubble of low volatility stocks versus value stocks is now more significant than any relative valuation bubbles the equity market experienced in modern history’;
2. from strategists at Oddo: ‘At over three standard deviations from the 10-year average, the PE value-growth gap has never been so great’

Quality-growth outperformance of all other factors is not new news but as it is continuing and even accelerating, valuation tension gets ever greater as noted by these headlines. Of course, we would all like to know when this reverses. The timing and catalyst questions are never easy, involving the future as they do. In the big picture, monetary policy normalisation looks unlikely and it’s never been a comfortable equation betting on European growth accelerating especially without help from elsewhere.

This brings us back to companies. Most of the quality growth / stable earners are very good companies with very solid trends. However, the valuation tension can only last if they keep delivering.

Three of the best known ‘market darlings’ & their valuations are:

Source: Chelverton Asset Management

It does indeed feel like a valuation bubble in the making.

Companies failing to reach lofty expectations is one obvious way that market leadership will change. SAP is very much a market darling with similar characteristics to those noted above. It missed its numbers this week and the shares pulled back 7%. The market darlings have earned their sobriquets and their premiums, but they all have issues and challenges. As valuations march ever higher for this group of companies, the risk of disappointment and a change in market leadership gets ever greater. History tells us that valuation discipline will ultimately be rewarded.

We are not at the deep value end of the spectrum, but we do have a strong valuation discipline which mandates us to always have a significant FCFY premium to the market at all times. Accordingly, we won’t fall into the trap of chasing this theme. We have an attractive blend of valuation support and superior sales growth which collectively will be rewarded when the market starts thinking about valuations again.

Here we can see Nestle’s re-rating despite earnings being downgraded:

Source: Chelverton Asset Management

Addition of Infotel & Swedish Match, sale of Leonardo & ISS

Another two new ideas which enhance the portfolio.

Infotel came straight through the screen and having had a conf call with management it ticks all the boxes. It screens with a 7.5% FCFY for 6.7% growth and a very significant net cash Balance Sheet, witness the 9.2% FCF/EV ratio. It is another IT service provider, mainly in France and have worked with their large corporate clients for decades on a multitude of projects – so good visibility. Founders are still active in their early 70’s but a bid not out of the question. 4.2% historic DY. It’s a small company so below the radar of most, €256m Market Cap. 1.5% position to start.

The following extract shows the cheapness of the cash flows especially taking into account the Balance Sheet strength.

Source: Chelverton Asset Management

Swedish Match we had been watching for a bit longer. SM is a leading supplier of snus/snuff and as such has the financial characteristics of tobacco company’s pre-disruption. The company have launched tobacco free nicotine pouches and we see the company as a defensive cash generative company with a growth option. Valuation is 5.3% FCFY for 8.3% forecast growth, again in our sweet spot. Cash conversion is high and steady in the low 20% range. Another one where it wouldn’t be a surprise long term to see it as part of a larger tobacco company.

We sold 2 holdings for different reasons:

Leonardo is the Italian defence company. We have made a c.35% total return and valuation at 5%/5% FCFY/Growth whilst still ok is not attractive enough given the risk profile. Happy to move on to better ideas.

ISS is a company we have hitherto viewed as a solid company with good cash generation and steady dynamics (facilities management – mainly cleaning). Our attention has been drawn to the companies increasing use of factoring and reverse factoring. These are perfectly legitimate financing tools but on closer examination they really accelerated their use of them at the last year end. In the absence of this, leverage would have gone from 2.1x to 2.4x and cash conversion (a key management incentive) would have fallen from declared 101% to 64%. It feels like working capital and hence cash flow pressures are building. We lowered our cash conversion assumptions and the shares look less attractive. Selling the shares is less about valuation and more about a revised ‘smell test’. Want to learn from the past where too often it was easy to dismiss early warnings of issues and backed management when in many cases it is not justified. Our process is very clear here..if there is significant doubt, sell and move on. This is made much easier by having strong new ideas. We have made a small loss on ISS so this feels more proactive than reactive.

Also, small top ups of CPL and Nordea.

Two new holdings: lastminute.com & Bouvet

Lastminute.com is a name many UK portfolio managers will recall from the dot-com boom. It has changed hands a few times since and most recently was acquired in 2015 by a Swiss listed online travel agency (OTA) which subsequently changed the group name to lastminute.com. It is present all over Europe with various brands including lastminute in the UK. Its key asset is a technology which enables customers the ability to ‘dynamically package’ last minute holidays utilising cheap inventory at hotels and airlines which won’t be officially discounted but can be in a packaged price. The company have been building this technology for the last 3 years and it is gaining traction rapidly and should be entering the cash monetisation phase. Particularly encouraging is the licensing of this tech to booking.com, the $70bn global leader. Ultimately we think LM combines with another company to make a much larger OTA concern. Net cash BS, negative working capital, PE of 11x and FCFY 9% with 4/5% growth. Over 50% MOS on a 9% discount rate. Attractive on all our metrics so we initiate with a 2.5% weight.

Source: Lastminute.com company presentation

We also add to our IT services cluster with an initial position in Bouvet (1% to start). We’ve been tracking the company for a while and it had a minor pull-back. Unlike many of the IT service companies it doesn’t make acquisitions and has a net cash BS with a 4.5% historic yield. On our in-depth analysis it has a 28% MOS at a 9% discount rate and as indicated below a 7% FCFY for double digit growth, both appreciably higher than the market.

Source: Chelverton Asset Management

Making way is the balance of our holding in Ageas (see above) as well as selling out of JM, and top slices of strongly performing Dometic and Novartis. JM is the Swedish housebuilder. It’s a well-managed company and we bought it when it was flat on its back due to concerns over the Stockholm (especially) property market. It was on a 10%+FCFY but with revenue growth negligible. We did have a decent MOS and a 6% dividend yield we felt was secure. We’ve since had a 30%+ total return. The concerns over Stockholm haven’t really gone away and we feel with the FCFY nearer 7% we have much better ideas now.

We also top-sliced TKH which has a 30% move around its CMD as the company announced the shift towards higher growth verticals would accelerate. We like this but the strategy will not execute overnight. FCFY slips below market to 4% which is OK for 7% growth but we need to be mindful of position size so reduce to 2% from 2.9%. Small top ups of BESI, Capgemini, Roche and Novo.

Observations from Scandinavian small cap conference

Attended Scandinavian small cap conference in Stockholm, organised by one of our sell side suppliers, Handelsbanken. These conferences provide a great opportunity to meet with companies, both at the group presentation level (especially to hear new investment ideas which we may not be familiar with), and also to meet management of existing and potential new holdings on a 1-1 basis for more in-depth Q+A.  Won’t go through all of the presentations, but there were a number of noteworthy ideas and updates. 

Met with Subsea 7, one of our oil services holdings.  Got a good update on capacity of their vessels and services which is starting to fill up nicely, and pricing is starting to show signs of firming up. Although we are less attracted to asset-intense companies we are always open to exceptions.  Subsea 7 has a very strong balance sheet and we are happy with the investment at this stage in the oil capex cycle, which is starting to recover. 

Of the new ideas, Harvia was especially noteworthy. Harvia is a global leader in sauna component manufacture. The majority of its business is replacement in nature, hence is not particularly cyclical.  A free cashflow yield approaching 7% and growth prospects well ahead of the market, with a relatively asset-lite model it ticks a lot of boxes for us, and it goes onto the buy list as a strong candidate for investment.  These conferences also provide opportunities to check out competitors of our holdings.  To this end, I listened to the presentation from Sweco, an engineering consultant which operates in the same area as Arcadis, which we hold.  It was a strong presentation, and the conclusion was that the valuation of Arcadis looks increasingly anomalous, both in absolute terms and relative – it is on over double the free cashflow yield of Sweco (9.7% vs 3.6%).

A very worthwhile conference, meeting some 15 different companies over the two days.

Free Cash Flow Yield: Our definition and importance

We are pulling together the slides for our presentation currently. As noted above, in the same way that an income fund manager will always look to trade at a dividend yield premium to the market, our objective will be to always trade at a material FCFY premium to the market.

The basic reason for this is that we believe buying undervalued cash flows leads to better total returns when the market realises it has undervalued those cash flows.

Our definition of FCFY is the average of FCF from the last 2 years and the next 2 years / market cap.

So, the ‘ideal company’ for us is one which may look like this:

Source: Chelverton Asset Management

Currently the market FCFY is 5% and market sales growth is 3.8% so this company is growing quicker than the market, has stable and growing FCF which is valued cheaper than the market. Company A, subject to more in-depth work, is in our ‘sweet spot’.

The question naturally arises over what types of companies we will and won’t own in our process.

Company B is in a turnaround situation:

Source: Chelverton Asset Management

To date, company B has only delivered €2m of FCF. There is a lot of ‘hope’ that they can double and double again their FCF. However, we like the revenue growth dynamics and we like the sound of the investment case. In this situation we need to do more in-depth work. This will incorporate an analysis of the past as well as peers. If we find that, for example, the company’s FCF/sales conversion at €8m is still half the level of its peers and we feel the actions taken can help the company get to €16m then this might make this company a buy. The crucial point here is that we cannot and will not own too many companies like this because the FCFY is only 3.8% and we have a clear objective of a portfolio FCFY of materially >5% (the current market level). As a result, our portfolio will not have a high number of turnarounds or cyclical stocks unless they are backed up by current or actual FCF generation. This of course prevents us, at the portfolio level, from being too early.

Company C is a high growth company. Sales are forecast to grow at 8%pa and with operational leverage of 1.3x, FCF growing at just over 10%pa.

Source: Chelverton Asset Management

Are we willing to pay a 1% lower FCFY than the market for more than double market growth? Intuitively, probably.

We can be more specific than this though because we have to know where to draw the line in what to pay for growth. If the market FCFY of 5% grows at 1.3x the sales growth, i.e. 4.9% then by t+5 the FCFY will be 6.3%. Company C starts with a FCFY of 4%, if it grows FCF at 10% then by t+5 it will be on a FCFY of 6.5%, a slight premium to the market. This involves a fair amount of hope and execution however, so the decision will again rest on our in-depth analysis. Once again like the example of company B, whilst we may own Company C, we cannot and will not own too many companies like this because at 4% the FCFY is significantly below the market and this will drag down our portfolio FCFY.

Investors have through history typically overpaid for growth. This may well be happening again. Our natural valuation discipline encoded by our FCFY objective will prevent us from being too high growth in our approach. Applying the thinking behind Company C does however allow us to consider trading some value for growth at the company level, always subject to more in-depth analysis.

Currently the portfolio FCFY is 6.5% versus the market on 4.9%. This meets our definition of being a material premium. One way of thinking of this is that it may allow us to buy one or two higher growth companies as it will not dilute the material FCFY premium of the portfolio.

Tweaks to the portfolio

Markets have given back some of the YTD gains on economic and trade related concerns. Whilst we have a handful of decent ideas on the sidelines our preference right now is to top up some of the portfolio holdings which have come back. We have topped up TKH, (see above) UBS and ASMI. Source of cash is Ageas, the Belgian insurer. The long-term case is around their Asian assets. More recently capital allocation decisions appear to favour investing in Europe which we’re slightly disappointed by. Stock has been a decent performer in market context so we view it as a source of cash especially as DY has now fallen below 5%. Take 1.2% out for now. 

New Position: Saras

After a portfolio review we have decided to top up four of our favoured holdings by 0.5% each. Akka, Kaufman & Broad, Arcadis and Hexpol.

We have also decided to re-initiate a position in Saras. We sold it last year after good performance. Whilst it is an oil refiner with cyclicality it has a big structural positive ahead of it, namely the shift to lower sulphur bunker fuel which the rules change for in 2020. Even on a 9% discount rate there is a 70% margin of safety. Market has lost interest in this one but it has an ungeared BS and a 5.7% historic DY. Buy a 1% position ahead of results with a view to topping up.

The source of these purchases is the sale of Renault and Inwido. We have got both of these wrong. Renault we had the added dimension of dealing with Carlos Ghosn incarceration in Japan but on reflection our ownership of it was more to do with its value status (low PE, high DY etc) and on closer analysis the cash generation and leverage concerns overpower the earnings-based valuation. Inwido is the Swedish window manufacturer which (a bit like Renault) displays the hallmarks of a value trap. Debt is at our ‘glass ceiling’ of just above 2.5x with the new CEO insistent the roll-up strategy continues. This is an uncomfortable equation as is the persistent competition the company is on the end of in its main markets. Like Renault, we have better higher conviction ideas elsewhere.

New Holding: Novo Nordisk

We completed the repositioning of our energy exposure (see 21/1/19) with the last sale of Tenaris. We also have sold Tessenderlo. We have become frustrated with lack of communication from the company and when combined with the lack of progress on their liquid fertiliser initiative we have much better ideas at present.

We have observed the pharma stocks underperforming as markets have rallied this year. We have topped up our positions a couple of times but have decided to add to the ‘defensive’ exposure by buying Novo Nordisk. Novo is the clear leader in diabetes treatment, sadly a long-term growth sector. Its cash conversion is exemplary and although on a lower FCFY than Roche/Novartis it deserves this and is on a slight FCFY premium to the market on 5.2% but for 7% compounding growth..an attractive combination. A stock which merits its 7% discount rate driving a positive margin of safety, as seen below. The DY pick up from Tessenderlo which didn’t pay a dividend is also helpful.

Source: Chelverton Asset Management

New Position: Arcadis

A stock we have been monitoring for some time is Arcadis. It is a Dutch engineering consultancy and can be considered a play on many environmental trends in infrastructure and buildings. It has 2/3 legacy issues over the last 18 months to surmount and recent results suggested the worst is behind the company. It should be a steady grower with strong cash conversion characteristics as an asset light business. As well as offering a significant margin of safety on our detailed work (>40%), it trades on an appreciable discount to its peers (see below) for not dissimilar cash conversion. Can see this one being a core holding. 2% initially with view to taking to 2.5-3%.

Source: Chelverton Asset Management

We had bought a 1% position in Bpost on 13/3 ahead of results. Shares bounced 27% and with the valuation less attractive and little short-term chance of topping up below our initial buy level we have sold the shares. Slightly unusual situation but a nice problem to have. We also decided to top up PostNL ahead of their CMD as stock has drifted and the company should have a good story to tell with the integration of Sandd as well as the long-term growth in Parcels.

Selling VAT Group and buying Hexpol

Switch of VAT Group into Hexpol. VAT Group is one of our semi supply chain companies. It is an excellent company, dominating its niche of mission critical vacuum capacitors. It has always been at the upper end of our valuation tolerance however and with the very strong move up in the shares across this sector this year we are taking the opportunity to sell and switch into a better idea whilst locking in some profit in the strong sector move YTD. A not unrelated observation is that whilst market momentum is behind the idea that the trade talks are going well and we seem to be benefitting from this, these discussions are finely balanced so taking some profit makes sense.

We owned Hexpol at the inception of the fund and sold it when it bounced strongly. It has subsequently underperformed on the back of a poor quarters results. Hexpol is a leader in polymer compounds and is a very strong and consistent cash converter. We see no reason this won’t continue but the market is again undervaluing these qualities. Bought on a FCFY of 7% for market like growth it can be considered a switch from Schneider in terms of broad industrial exposure. 25%+ margin of safety. 1.5% position initially as it has fallen sharply of late.

Schneider holding sold

Sale of Schneider. French electrical goods company which is effectively a GDP proxy. Shares have been very strong and now down to a market FCFY which whilst not egregious, we have much better ideas. Margin of safety has all but disappeared too. For some time we have looked at our holdings of Siemens and Schneider and realised we only need to hold one of them as we can add more value elsewhere. Also, top slice of Ringmetal, a small German fasteners company which has had a very strong bounce this year.

Q1 in Brief

Writing a Q1 performance report it was interesting what drove European markets up. When markets move up as sharply as they have, this might normally be associated with a value or cyclical rally. This is not what happened in Q1. The big outperformers were the consumer non-durable ‘long duration’ stocks led by Nestle, L’Oreal, and LVMH. Whilst we had a good quarter overall, in the quarter alone there was c.2% of headwind from the outperformance of high-quality growth stocks such as these. The top 10 funds since we launched are all variations of high-quality growth styles.

Looking at these companies through the prism of some of our metrics we find that we can understand their valuations, but they are still the wrong side of fair value on BOTH the FCFY/Growth axis as well as overvalued on our more detailed DCF work. We are confident we can find materially cheaper cash flows elsewhere without chasing these stocks.

New positions in STM and BPost

Two new holdings. STM is Europe’s largest chip maker and as such is a play on the big technological trends we have referred to many times. It also has an ongoing self-help dimension as returns have been well below where they should be for the volume of chips sold. Sales growth is 4.6% and FCFY is 3.8%. Both these numbers are held back by current slowdown. The FCFY is 4%/6% next 2 years and we expect it will grow from here. Similarly, sales growth this year is 0.6% followed by 6.6%, 6.6%...again we see upgrades as the cycle progresses. This illustrates that whatever the choice of metric and period used there will always be stocks that initially don’t pass but after more detailed analysis we are happy there is a significant margin of safety. (If this relies too much on forecasts coming through of course we can’t own many companies like this as our portfolio MUST have a FCFY premium to the market overall).

We have been looking at BPost for a while, the Belgian postal operator. Whilst there is no doubt there are underlying issues these appear fully discounted in the 11% FCFY, the 10% DY and the moderately geared BS. A 1% position here ahead of results with a view of topping up on weakness.

Bounce in markets

One of the key drivers of the bounce in markets has been interest rates. The response from the Fed and the ECB to weak economic data has led to a change in the expectation for the future path of interest rates – namely lower for longer. This is not insignificant and could lead to the lower for longer interest rate scenario being the central case for the coming years, essentially covering our investment time horizon.

As a result of processing these implications we are switching Unicredit (Italian bank) into Danone (French food group). Danone has a 5.5% FCFY for market growth and at a 7% discount rate offers a c.20% margin of safety. It shares the characteristics of most of the food groups, namely stability of cash conversion. Danone hasn’t performed the same way as its peers and hence how we are happy it is ‘overlooked’. The lower interest rate scenario is incrementally negative for all banks and we have decided to reduce our exposure to the one with the weakest Balance Sheet in the weakest economy.

Here is the summary of the Danone assumptions underpinning our confidence:

Source: Chelverton Asset Management

Research: Acando

Following our purchase of 2 new IT service names on 6/3, interesting to observe that Acando, KnowIT’s direct peer in Sweden has been purchased by CGI, the Canada based IT services group. The premium is 44% with the Board recommending. KnowIt was trading at a discount to Acando pre the bid. Whilst the bid is helpful to our view it’s a bit frustrating right now as we wanted to get a bigger position in the sector via topping up KnowIT as well as keeping our eye on other names such as Bouvet which has also moved up on the news. We will keep looking here as it is a sector where we can see the right combination of growth and value.

Building exposure to the IT Services sector

We have been building up our exposure to the IT Services sector where we like the medium to long-term dynamics. The companies are helping their clients implement the big technology trends such as AI, IoT, Cloud, Big Data and general digitalisation. We have found another couple of holdings to invest in. Initially 1.5% weightings with a view to topping up. Gareth met Aubay in a trip to France and have been monitoring since. Stock has underperformed of late and at a 6% FCFY for 5-6% growth is a nice clean play on the trend. Similarly, KnowIT in Sweden where the stock has gone sideways for the last year and valuation very similar to Aubay. Both come out the in-depth analysis with good cash conversion trends and sound margins of safety.

Funding comes from sale of Data Respons in the same sub-sector. We had a call with management here and after reviewing y/e BS the liability from earn outs for recent deals is higher than we anticipated leaving leverage an uncomfortable 3.5x. Hence the switch can be seen as a good risk-adjusted one. Also: top slice of Inwido after post results relief bounce, Leonardo ahead of results stock has been strong and ING/ Bayer both of which have had good bounces this year.

Reducing our position in PostNL

Reduce our position size in PostNL, now our biggest portfolio holding. Stock has bounced after results and news they are buying Sandd, their obstinate competitor. Long term valuation looks ok but experience with PostNL suggests nothing happens in a straight line. Small top ups of Kaufman and Unilever amongst others.

Sold: Kion

A handful of trades in recent days. We have sold two stocks and topped up a handful of holdings. A meeting in London with ICF Group revealed the company to be having issues in its (core stable) consumer division and this has undermined our confidence. We can revisit this company as they report and make acquisitions and delivery of cash flow becomes clearer, but we don’t need to take the risk right now. We have also sold Kion after further analysis. The initial case was around the automation of warehouses however we are concerned about the ‘hidden’ nature of leverage as the company finances the sale of its forklift trucks in the same way as many car companies do. We crystallise a loss of c.30% on both these sales. With reference to our process enhancements noted above, neither of these holdings would have passed our new criteria. (Postscript, Kion trade completed early March).

On the buy side we have topped up Novartis, Unilever, TKH, Santander, Siemens, Unicredit and Kaufman & Broad. Part of our current thinking is an objective to top up some of the more defensive positions as they have been underperforming into this strong market rally and valuations especially in the pharma sector look very sensible.

Research: Thyssen Krupp

Had a close look at Thyssen Krupp. It’s the classic deep value stock and in a previous life would have ticked a lot of boxes around reversion to mean and traditional value metrics. The case is around the twin pillars of Elevator (jewel in crown) consolidation and activist involvement encouraging restructuring / break up. There are a lot of moving parts including liabilities (pension and cartel fines) as well as the fact that the core business barely generates cash flow ex-elevators. However, a disposal of elevators at a reasonable multiple would solve the Balance Sheet and give significant equity upside. Could be worth a 1% position as would be at the more speculative end of the spectrum. Decided to wait and see how the next BS looks.

Re-positioning our exposure to oil

One of the areas we came unstuck in Q4 was our oil exposure. We took on too much operational and financial leverage and suffered when the oil price fell sharply. We have been analysing our holdings here and into the current bounce we will be repositioning our exposure. The objective is to maintain the oil service/capex play as a theme in the portfolio but with less risk profile. We have started the process with the reduction of Borr Drilling and Fugro. We have set price limits, and these will be disposed of over coming weeks.

To retain our exposure to the sector but with a more appropriate risk profile we are buying TGS-Nopec. TGS has the largest seismic data library. It operates an asset-light multi-client business model. It doesn’t have financial gearing but should still be operationally leveraged when clients are looking for seismic data. It trades on a 6%+FCFY with double digit growth forecast for the coming years. It has a comfortable margin of safety on our in-depth analysis also as well as 3% DY.

The following charts neatly encapsulate the oil service opportunity / investment case:

Source: Company Presentation

Postscript: We completed this oil service repositioning at the start of May with the final purchase of TGS to a 2.5% weight. Tenaris was sold completely due to the asset heavy nature of operations obscuring FCF and Borr/Fugro sales were completed. Leaves us with Total of the majors as well as Subsea and TGS, total exposure of c.7% - where we can add into weakness but still benefit when the expected cycle kicks in.

Also, worth noting that both Borr and Fugro would not have passed our new criteria had we had these in place a year ago.

New Position: ASM International

We have switched our CRH into ASM International. ASM International is a semi-capex play. ASMI (not to be confused with ASML) dominates the supply of atomic layer deposition tools, a niche segment of the wafer processing market. It is a beneficiary of Moore’s Law as more of its tools should be needed as node transitions to smaller sizes. It also has the possibility of M&A through its stake in ASM Pacific as well as even being a target itself. FCFY is 6% (but note this should be into an upgrade cycle) and growth should be double digit in the next cycle. A significant margin of safety (see chart below), the only challenge being the timing of the upcycle. 1.5% weight for now with a view to topping up into weakness. CRH looked less appealing fundamentally due to its reliance on acquisitions and the difficulty of analysing how ‘clean’ its organic free cash flow growth actually is. 

Here we can see the summary of our proprietary valuation work on ASMI. The first graph we can see our long-term cash conversion assumptions don’t appear aggressive relative to history. Below, we use absolute numbers and even in a pessimistic case there is little downside. This is quite rare! Blended upside is 56% using 30/40/30 probabilities for the 3 scenarios.

Source: Chelverton Asset Management

Value and Growth are inextricably linked

At this time of year as well as looking forward it is a time to reflect, and as a relatively young business, think about process enhancements.

We have been reflecting a lot on the whole Value/Growth dimension. We are both in agreement that this is a distinction that has been created by the industry and that growth and value are inextricably linked. Warren Buffet (as often) puts it best: “..many investment professionals see any mixing (of value and growth) as a form of intellectual cross-dressing. In our opinion the 2 approaches are joined at the hip – growth is always a component in the calculation of value”.

In our screening and our stock picking this is something we have been intuitively doing, i.e. always trading off value and growth but we will be placing this a bit more front and centre going forward using the following format:

Source: Chelverton Asset Management

We are both convinced of the importance of placing free cash flow analysis at the heart of what we do. FCF drives the 2 components of an investors total return – income and growth. FCF gives a company ability to 1. Pay dividends and 2. Invest in (self-funded) growth which drives sustainable capital appreciation. Specifically, we will be simplifying our screening by giving Free Cash Flow Yield and (Sales) Growth more prominence. FCFY will become our principal portfolio valuation metric as it captures, for us, the most important measure of a company’s performance, FCF, and divides it into a measure of the market’s valuation of it. We have decided to codify this by ensuring that our portfolio trades at a material FCFY premium to the market at all times. In simple terms we will pay significantly less than the market for cash flows. This will ensure we maintain a valuation discipline we both feel strongly about.

The traditional value sectors (banks, insurance, retail, auto, telecom, utilities, energy) share some common characteristics. Not always, but typically these include: capital intensity, cyclicality, structural challenges, leverage and often regulation. The other common characteristic is that free cash flow generation is harder to come by in these sectors.

Combining the observations of the last 2 paragraphs means we will be more demanding before traditional deep value stocks come into the portfolio.

A further update we are introducing relates to the discount rate we use in our DCF work. The discount rate is probably THE key valuation input in financial markets. Hitherto we had been using a standard 8% rate across all companies and then making risk judgements about whether the upside was sufficient depending on the nature of the company and volatility of FCF. We believe a better methodology going forward is as follows:

The discount rate can be considered the required rate of return. This is a key tool for us in assessing risk profile. In our valuation of companies, we will use either 7%, 8% or 9%. Intuitively it is reasonably obvious, namely we demand a higher/lower return from higher/lower risk profile, but guidelines are as follows:

9% discount rate – we use this category where there is any combination of leverage, asset intensity and cyclicality. We also use it where cash conversion has been poor/patchy or limited history. All small and micro-caps are also 9% stocks. Example is Leonardo – Italian defence contractor in turnaround mode.

7% discount rate – where the company has a long history of stable cash conversion with little cyclicality. Limited or moderate financial leverage. Example: Unilever, Roche, Novartis.

8% discount rate – everything else

The objective is to create a level playing field for all candidates for the portfolio. The different discount rates hence operate akin to a golf handicap system, allowing Leonardo to be compared to Unilever to KnowIT, a small-cap Swedish IT service company.

The valuation work we do is never about precision of valuation it is about ‘direction of travel’ but we feel this will help us capture opportunities more effectively.

We will use a sensitivity table in our Valuation Summary where we look at how sensitive the valuation is to discount rates between 6% and 10%. An example of Infotel shows the upside opportunity at different discount rates:

Source: Chelverton Asset Management

When we do our in-depth analysis, we have also realised we need to broaden out our understanding of the DCF outcomes which underpin our ‘margin of safety’ calculation.

In a ‘normal’ DCF, the value of the company typically breaks down into 3 segments: firstly, the next 8 years, commonly referred to as the competitive advantage period; secondly years 8-30 and lastly the terminal period. In very approximate terms the discounted value of a company’s cash flows is spread 30%/50%/20% between these 3 periods.  We have been too focused on the first segment when most of the value is elsewhere. Our analysis now includes a graph of a company’s cash conversion of sales both historically as well as during the first 2 future periods. This places cash conversion in a much longer timeframe and ensures that we don’t ‘capitalise’ a peak especially in the crucial yrs 8-30 period. An example as follows for Kaufman and Broad where we are comfortable that our assumptions are reasonable in context of both history and the environment we see going forward:

Source: Chelverton Asset Management

This achieves another important objective, namely that any valuation tool should have one foot in the past. Philosophically this is due to a belief that we should not be making decisions exclusively on forecasting alone. This change to our process is in part a response to realising that some company valuations were ending Year 8 with a high rate of cash conversion relative to historic levels and assuming that these elevated levels of cash conversion were sustainable therefore, potentially overvaluing the company.

Lastly we have been reflecting on risk in terms of financial risk. Neither of us believe that it is necessary to take on extra financial risk in order to consistently outperform. We have decided to use a ‘hard rule’ at the portfolio level whereby we will always have a portfolio which has less financial leverage than the market (using ND/EBITDA as our definition). At the company level we will work with a ‘glass ceiling’ of ND/EBITDA of 2.5x. For reference our current portfolio has leverage of 1.0x ND/ebitda and the market is at 1.4x.

All these process enhancements are an evolution of what we have been trying to do all along namely trying to find undervalued cash flows from healthy yet overlooked companies.

I would expect that turnover will be elevated for the next few months as we look more critically at a handful of holdings which do not fit or conform to the new criteria, or more likely we can find better alternatives which tick more of the boxes.