5 years from today, which stocks will have the highest returns on capital?
It isn't every day you meet an investor with an Honours Degree in Scottish History. However, I recently spoke with Iain Fulton, the Edinburgh, Scotland-based portfolio manager of the Nikko AM Global Share Fund.
Fulton and the team at Nikko AM have diverse backgrounds that combine specialist knowledge with specialists from a range of industries. But for Fulton, the ability to filter large volumes of information, and to identify signals and trends that might present opportunities, is the most vital skill he's drawn from his academic experience.
He is undoubtedly drawing heavily on these skills as the global economy groans under the abrupt reversal of central bank policy settings. This policy shift coincides with
- the move away from globalisation,
- a volatile energy transition, and
- growing concerns around food security.
In the short term, Fulton points to the ISM Manufacturing Index (the key indicator of US economic activity) and concludes we're heading into a recessionary environment "of some description." He also expects earnings downgrades to flow through the market – especially for stocks that have benefited from the circa US$1 trillion raised by tech startups over the past three years.
But what the next six to 12-months will look like is anyone's guess. Fulton is more interested in thinking about sectors with strong five-year outlooks and then identifying companies that can deliver market-leading returns on capital.
"We want to have businesses that are sustainably above that 8% level, usually 12, 14, 15%. That would put it in the market's best quintile of return on capital," Fulton says.
"If you can find those businesses that can make it into that area over that five-year period, you tend to outperform. That's what the historical data suggests, and that's what we are trying to do."
In the following interview, Fulton details his insights on the current investment landscape, explains why tech sector earnings are facing a crunch and discusses three sectors and a cluster of stocks he believes have a bright medium-term outlook.
- 1:48 – Managing global equities in the face of rising inflation
- 4:49 – The indicators that matter most for investors
- 6:29 – How valuations and earnings outlooks are shifting
- 10:58 – The sectors and stocks that can thrive over the medium to long term
- 15:18 – The investment thesis behind food security
- 17:39 – Companies with pricing power in the face of rising recession risks?
- 19:00 – The big shifts away from technology and towards energy transition stocks
- 20:59 – A stock that Ian is excited about in the current environment.
A background on Ian Fulton
The company I started working for was a global equity fund. They were specifically looking for people from many different backgrounds, and I share the view that investment expertise is not just about being an economist or a business major. We've got a geologist on our team. We've got accountants, economists as well, we've also got historians like me. History can provide a bit of context and some insight when you look back, it doesn't repeat, but it does rhyme. Also, the skills of taking a lot of information, distilling it down into an argument and trying to make some sense of it. I think we do that every day as fund managers.
Managing global equities in the face of rising inflation
From an inflation point of view, we're probably at a peak level and potentially past that peak. But the question is how things settle down and where the new long-term inflation expectations are. That's because it has a crucial implication for valuations within the market at the end of the day. Additionally, in the last 20 years or certainly our entire career, it has basically been built on disinflation and forces that were driving globalisation and inflation to come down.
There are some signs that there are much greater restrictions in the global economy that could hang around for longer than we expect.
Whether that's around commodity markets or the supply of labour, the flexibility and movement of that labour, for example immigration policies, that tightness and shortage that exists within many areas of the global economy, and also restrictions on the flow of capital, these are more inflationary back settings than we've had that could stick around for a longer period of time. We'll talk about how we shift away from fossil fuels into other new forms of energy. As a human race, we've never done that before. Going from a power source that was perfectly good and very efficient to something that is probably less efficient. So, there are inflation forces around that, and we think it's a different backdrop long term in terms of what level of inflation will be. But we're probably past the short-term peak for now.
In terms of recession, you look at the ISM Indicators, particularly the new orders component. That's flagging pretty clearly that we're headed towards a recession of some sort and the cost of the impact on consumption within that. The Fed has made it pretty clear that they're going to move on within increasing rates, as far as they have to, to stamp out that inflation and pressure that we see. That will have a knock-on impact on housing markets and credit markets as well. So, I hate to be bearish so soon on the call as well, but I think it's important to understand that there are headwinds. So focusing on quality, sustainable cash flows, and high profitability that you feel can endure through this difficult time, that's what we need to be doing as investors, and that's certainly what we are focusing on within portfolios.
The indicators that matter most to investors
We're bottom-up investors so I would say that, first and foremost, it's about earnings, and it's about the multiple that you pay for that. But clearly, the market runs on a narrative and the narrative is often influenced by these leading indicators that you're talking about. I think that ISM Series and the manufacturing new orders component that you can look at over time, that's had a pretty good track record of suggesting where things are primarily headed. So, we would track that pretty carefully. In terms of inflation, the other aspect to be mindful of are the inflation expectations. This is because if these high levels of inflation start to embed themselves in actual activity, wage agreements, people's savings patterns, or consumption patterns and spending, then that becomes much more of a problem on a longer-term basis. Because you're embedding that higher rate of inflation. So we think those inflation expectations and how that plays out through the various wage rounds etc. are pretty important to keep an eye on. But for us, it's all about the bottom-up industry dynamics that are going on, and we can pick our way through that from an earnings and valuation perspective.
How valuations and earnings outlooks are shifting
First and foremost, we've obviously seen a pretty significant compression in multiples, so the valuations have come down and we've seen a spread in valuations. At the end of last year, we had these enormous wide spreads, where the most expensive real growth areas of the market were driven by that cheap money and the hope of market share gains with no profits. That was the disruptive innovation part of the market, rather than the technology. That, and the fact that the market was willing to sustain these massive losses for a long period of time. We've seen that collapse and that's gone and probably not going to come back. Now, it's about sustainable profitability and cash flows and how that plays out.
We've seen the contraction in valuation and valuation spreads, and they're now somewhere in the middle, which is neither particularly cheap nor massively expensive. So, the direction of earnings really starts to matter. Unfortunately for probably the next six months, that is going to be really challenging.
There are downgrades that just have to come through, but some of that is reflected in the moves that we've seen already. But I think that the areas that we're most worried about from an earnings downgrade perspective are areas like digital media, especially. So, if you think about Google or Facebook, and you think about the amount of capital that was raised in new tech start-ups. I mean, in 2021, you had $650 billion raised in new tech funding for start-up companies. In 2020, it was just over $200 billion and each year prior to that, it was about $100 billion. So arguably you've had something like $850 billion to $1 trillion of capital in a very short space of time, that's been raised in these tech start-ups and what do they do with it? Well, number one, they buy cloud infrastructure. Number two, they pay themselves a lot of options and they get rich. Then number three, they buy digital media for customer acquisition.
And so I don't think there's any way that as that funding and that financing dries up, that it's not going to feed into significant earnings downgrades for these companies over the next six to 12 months. The estimates are for these companies to continue to grow at very rapid rates and that just seems wrong.
But the market is telling you that. I think that the valuations on something like Meta platforms are already almost single-digit if you're looking a year out. Clearly, the earnings numbers are wrong. It's the scale of the downgrades that we'll need to get through, to see how things settle out. So, we are focused on more defensive areas and that higher quality. Hence healthcare has been a very important area for us. Also, thinking about the next five years. If we're looking for improving returns on capital in the next cycle, where's that going to be? It's probably not going to be in technology. We've solved many of the problems of how we're entertained and how we communicate. The bigger issues probably lie with some of the major environmental challenges that we face as a society. So how do we shift away from fossil fuels? How do we move to better forms of energy? How do we reduce the cost of healthcare sustainably, to make it affordable, given the demographic challenges that we face?
These could well be the defining factors over the next cycle. We're trying to position ourselves for that, but also make sure that we stay defensive and sustainable through this quite difficult period that we're probably going to have for earnings.
The sectors and stocks that can thrive over the medium to long term
We look for businesses over a five-year timeframe that can have the best returns on capital within the market and average levels of return on capital in a business, usually about 8%. So we want to have a business at the end of that five-year period, that's sustainably well above 8%, usually 12-15%. That'll put it in the best quintile of return on capital on the market. If you can find those businesses that make it into that area over that five-year period, you tend to outperform and that's what the historical data suggests and that's what we're trying to do.
Explain return on capital and why you prize it?
It's about the efficiency of the asset, how the company is using their assets. As we've seen in the technology sector, you can throw money at things and gain market share, but not make any profits. And that's really inefficient and unsustainable. But if you've got a business that can earn profits on more of a fixed asset base and those profits grow, and the asset base grows more slowly, you get that improving return on the capital that you're putting into the business. Those businesses are quite unique in the sense that they need a sustainable competitive advantage. They need to be doing something different that is earning the right to have those improving returns on capital over time. So it is the relationship between your balance sheet, the size of your business and the profits that you're generating and how the management is investing in those assets, to improve those returns with each project that they do.
So it's not just about growth, it's about the quality of that growth over time. That's what we think really differentiates those winning businesses, from others. That's something we're aiming to do.
In particular, the energy sector, the actual commodity producers themselves, through the cycle they'll tend to earn a peak. If you looked at 2007, the last peak in the cycle that we had, they would earn about an 8% return on capital, just about getting to average. And in the last few years they've been earning 1-2%, they moved to 4-5% now, and they're probably going to get towards 8% in this cycle. But it's not good enough for us to really make that a sustainable area to invest in. We were talking about how we face these challenges of shifting to more renewable sources of energy and changing the way that we power our economy, if you think about the scale of the infrastructure projects that are needed and the scale of the capital investment that's required in terms of both emissions reduction and in the transition towards new forms of energy, whether that's solar, renewable, hydrogen etc. The engineering expertise that's required and the construction that's going to take place within that is actually a much larger market than it has been in previous cycles. Examples are engineering and construction firms like Jacobs Engineering (NYSE: J) and KBR (NYSE: KBR), whose heritage is in oil and gas and materials. But they're moving out beyond that into broader consulting and even working with companies and the public sector in emission reduction and how they move to more sustainable environments for a whole range of end-markets. They have the potential to grow that addressable opportunity and those consultants in the last five years have been underutilised because there wasn't a whole lot going on in this area. Now that there's about to be a real explosion of activity, and with a fixed asset base with improved pricing and a bigger market to address, we think they're pretty exciting funds to be involved in.
The investment thesis behind food security
It goes back to the point of constraints and challenges, whether it's in labour markets or whether it's in what's happened with fertiliser prices and the challenge that this brings for the farming sector around the world. Food shortages cause major problems, and they cause people to get very upset and they cause governments to get in real trouble. Essentially with food security, if more localised production takes place, then there's more of a premium placed on that supply into your local economy. If you put on top of that some of the environmental objectives that are being put in place by the EU, where they have the Farm to Fork strategy, and they want to reduce the use of fertilisers to move towards more organic solutions, there are developments that need to happen to really make that more productive. If we don't make it more productive, along with all these shortages and constraints that we have, it's another inflationary force that will be out there. Essentially, we're really looking for businesses that can help make that farm more productive. For example, companies like Deere & Company (NYSE: DE) provide precision agriculture machinery to help the application of fertiliser be more efficient. So they're not just spreading it everywhere, they're trying to target areas and be a little bit more frugal with how that's put down. Then these companies can thrive, but there are some challenges with that as well, because while the farmers are doing well with higher, soft commodity prices, the cost of them doing business from an energy point of view etc. are obviously pretty crippling as well. So we've got to really balance some of these issues in the near term right now.
Companies with pricing power in the face of rising recession risks
Companies in consumer staples areas, for example, like Diageo (LON: DGE), which has good pricing power within its spirits businesses, whether that's tequila in the US, or their global whiskey franchises, and their long-lived inventory, some of that inventory's been sitting around for 10 years. With that asset base, you're selling the product at a higher price and the inventory is a little bit more historic, which can be quite beneficial. Companies like Coca-Cola (NYSE: KO) put through 8% pricing increases in the last quarter but actually saw 8% volume growth as well as people are more active and out and about.
Finding that combination of good pricing power, with good volume growth and a sensible valuation, that's your sweet spot right now. But those businesses are a little bit few and far between.
The big shifts away from technology and towards energy transition stocks in your portfolio
The main difference today in our portfolio is we have much less investment in technology and communication services. In the digital media area that we spoke about, we previously owned Meta platforms (NASDAQ: META) and Tencent (HKG: 0700), and we had a bigger weighting in technology. That's changed quite materially, as we've shifted towards companies in the energy transition that we think can deliver that in the next cycle. Typically, in a year, we would turn over around 30% of the portfolio, but that's not really been any different in this past while. The changes look bigger, but we're always changing stocks within that.
Perhaps the sector positions have shifted a little bit more because we got this very extreme situation from a valuation point of view, around about 12 months ago. That was a pretty clear signal that we should start to shift away from some of those areas.
So we try not to change for change's sake, but equally, when the environment changes and the facts of your investment case change, you need to make that change and that's a big part of fund management; really knowing when you're wrong and admitting when you're wrong. We have a good team structure that allows us to do that and make sure that we can replace those ideas that might be more challenging with something that's new and has the potential to deliver what we're looking for.
A stock that Ian is excited about in the current environment
The consumer sector is one we're particularly quite excited about, particularly the catering company Compass Group(LON: CPG). Its food-related and relates to some of these challenges on inflation, both in labour markets and also in the food sector. The companies that Compass take catering contracts from such as hospitals, universities, soccer stadiums, or AFL stadiums etc. The catering is more often than not run by a contract caterer like Compass. In an environment like this, where you've got labour cost pressures, you've got food price inflation that's really dramatic. A university or hospital really doesn't need the headache of running a canteen, when they should be making people smart and making them better. So the rate of outsourcing in that outsourced catering industry is actually double the rate now than it was pre-pandemic.
Compass would typically generate about 3% revenue growth just from net new businesses. It's currently running at about 6%, and all of that is coming from new first-time outsourcing from the US. So there's an acceleration in that trend which we think has really got further to run, as well as that volume growth from people being more active, back to work and things being more normalised.
Compass is a business that in the recession in 2009 actually continued to grow. So it is recession resilient, but also a beneficiary of higher growth from that more challenging inflation rate environment that we have, and at a valuation which is pretty sensible. It's a 20% return on capital business long term, but it's been impacted by the pandemic. So, it's currently earning about, I think, 12-13%. There's a lot of room for that to improve and the valuation is around the market multiple. We really are quite excited about things like that. This is maybe an industry that people aren't talking about so much because it's a pretty mundane industry, but we like that. We like improving returns and sensible valuations and, hopefully, Compass has got some of that.
Iain and his team seek to uncover Future Quality investments – businesses that can attain and sustain high returns on invested capital to deliver better performance for shareholders over the long term. To find out more, visit the Nikko AM Global Share Fund profile below.
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