After starting with speculative mining stocks in Zimbabwe in the 1990's, today Bob Desmond works as Head of International Equities at Evans and Partners in Sydney. In our latest Livewire Q&A, Bob shares some lessons learned from the 'Zim' days, before looking at how the E&P global fund has stayed so far ahead of the pack, including avoiding most of the pain investors everywhere felt in 2018.
We also explore the 5-step screening process that shortlists 70,000 global names to an 'A-list' of 40 excellent companies, hear about the latest addition (and divestment) from the portfolio, and the one stock above all others that he would hold for five years.
Q: You started out in funds management in Zimbabwe, which must have given you a fairly unique perspective on markets. Can you tell me about those early days?
I started working in 1994, and Zimbabwe had just been opened up to foreign investors so it was a very exciting time. Zimbabwe is actually quite an an old stock market, and it was quite developed. When I first started, however, no one did serious research. It wasn’t really until foreigners came in that brokers started serious research. We also invested in wider Africa which was even less picked over. I remember buying East Africa Breweries on 4x earnings, which was a great company and controlled by a global brewer.
It was interesting when I went to London in 2001. I thought, "Oh, London, the big smoke," but it wasn't actually that different, it was just that the numbers were much, much bigger. Zimbabwe had 60 or 70 companies listed on stock exchange, but you could probably only invest in 12 to 15 because they were just so illiquid. Good companies we bought were often a monopoly. There wasn't a lot of competition, so you'd find these businesses earning great margins and high returns on capital.
Can you remember the first stock that you bought?
I can. It was a stock called Bindura Nickel. It didn't work out very well. I got the nickel bit right, but I got the currency wrong. That was one of the rare times the Zimbabwe Dollar was strong. That was interesting because it taught me that if you buy commodity stocks, you’ve got to get the commodity right AND you’ve got to get the currency right.
That was the last commodity stock I ever bought. I just thought it would be easier to start buying compounders instead.
Did that trade shape the way you invested going forward?
It was very instructive. I was lucky in that I got a portfolio to manage a year after I started. One of the guys left and the next thing I knew I was running a portfolio at 27. It had 60 stocks in but within a year we focused it down to 12 high-quality companies. That was based on how I think about markets today, pricing power, balance sheets and cash flow management.
Then Zimbabwe ended up with quite bad inflation, you probably know about the $100 trillion notes. You would look at a company and they would be making massive accounting profits because all the inventory was being marked at effectively the wrong price because prices were going up so quickly. You'd have a really good accounting profit, but when you looked at the cashflow statement, when you had to replace that inventory at today's prices, the cashflow was terrible. Intuitively you'd think if you're in hyperinflation, you want to hold something that's got assets. It was actually the exact opposite. You wanted to own a business that was very capital light, because as inflation went up, your capital needs went up, and then your balance sheet deteriorated really quickly.
Even now I stick to that more often than not, businesses that are capital light, require little amounts of capital to grow and have really strong cash flow and balance sheets. We try and look at businesses that will endure in the worst of times. Even in the worst of times in Zimbabwe, owning good businesses got you through that in OK shape, and that focus on quality has stayed with me ever since. Every stock we look at, we go back to the financial crisis and say, "Well, how did they go through that?" Because if you can find a stock that will get through the worst of times, you can just actually take that off the table and stop spending your whole day thinking, "Is there going to be a recession? Is there going to be fast growth or slow growth? What’s the Fed doing?" Because in the end for us, it’s the earnings going up over 10 or 20 years, that's going to make the real difference. You think about Google. All the time that people have spent since Google listed, analysing what the FED's going to do, has made absolutely no difference to Google's profit growth.
The fund has been top quartile over all time frames, including being the best performing global equity fund over the past year, but something that really struck me was how much better you came through 2018 than most (outperforming BM by 6%). What do you attribute this to?
We're always focusing on reducing risk. We're trying to look for the businesses that are really resilient, especially in down markets. Towards the end of the year, risk off was the trade. Everyone started selling off Asia, selling off European cyclicals, European banks. We're just not in that space. When you're in that type of market, we tend to do quite well, but then the price of that is that when things snap back you tend to lag, but we're happy with that. That's the price we pay, because the nice thing is that when the world is risky and everyone's feeling nervous, you know that those businesses you're in are very resilient and so you don't spend your day going, "What's happening to the macro? What's happening to Chinese growth?” all those things that are really hard to predict. You're just looking at the businesses and knowing that they're going to be okay. I always think of a quote from Warren Buffett when he said
“Never risk money you need for money you don’t”
What are the biggest risks of running such a concentrated portfolio?
Well obviously if you get it wrong, because our biggest positions are 9 or 10%. More often than not it’s going to be the business model is wrong and there’s competitive fade. If you get that wrong, the stock can go down 20% really quickly and then suddenly you've lost 2% performance. That can be the difference between a good year and a bad year.
The good side of that is that when things do go wrong, you tend to cut positions really quickly because you just can't have passengers in the fund.
You can't hide if you’ve only got 10 to 15 stocks.
A lot of people think "oh well, it's down 20%. It's only 1% of the portfolio so I'll just leave it”. But if you're in the 10 to 15 stock portfolio you’ve got to get rid of it quickly and bring in another high conviction idea.
Your investment universe is vast, so how do you filter down 70,000 potential stocks to just 15 names? What are some of the screens that you use to identify opportunities?
We're looking for reasonable sized companies, so we screen for stocks with a market cap greater than $3 billion.
We are looking for companies with good balance sheets, screened net debt to EBITDA of about two and a half, so that removes a big chunk.
Our definition of a good company's quite simple. It's just what return on tangible capital does that business earn? That's over 10 years through the cycle. Once you screen on that basis, an average return on tangible capital of say 15%, that will drop most businesses, especially through the cycle.
Then, we screen out businesses that have excess growth, that have done lots of acquisitions and their balance sheets have ballooned from a heap of goodwill, or they've issued shares.
We screen industries that are either commodity or capital intensive, so banks, oils, gas, anything that's cyclical, capital-intensive and lacks pricing power.
After all of that, you're down to roughly 200 companies. Most of these are like old friends that we have visited over the past 5-10 years, so we know them well. We then concentrate on 40 stocks.
That's what we call our A-list, and out of that, we'll choose 15.
Can you take us through the most recent additions to the portfolio?
Our most recent addition was Booking Holdings (booking.com), and we think they can grow their top line by 8%pa (travel grows at 2 x GDP and offline to online adds at 2-3%). They've got 2.2 million properties on their website, they're in 230 countries, in 40 languages, they’re open 24 hours a day and you actually feel safe giving them your credit card details. If you want to go and book a boutique hotel in Paris, there's a time difference, you've got to either speak French or hope they speak English, you've got to hand a stranger your credit card. If you turn up on the day and there’s a cockup, then the holiday is ruined and there's no one to phone.
For consumers' point of view, booking.com is very attractive, and from the hoteliers' point of view, they want to be part of the most visited travel website in the world.
It's got that lovely thing of the network effect of having both sides of the trade. That's a hard competitive advantage to break. I don't know if you've booked holidays, and you see a name you don't recognise, you just instinctively go, "I don't know. The price looks good, but it might be a bit dodgy. Let's just go with the one we know." There's a lot of built up trust that goes into that. Then, when you translate that into the economics, going back to those things I said in the beginning, margin and capital light, it's earning a 39% EBITDA margin, which is double Expedia.
The faster they grow, the more cash they generate, and their capex is like 3% of sales. They absolutely print cash, and will be looking to buyback 10-15% of the company over the next few years at what we consider very value accretive prices. Free cash flows over 100% of profit. It's got all those attributes we're looking for, big addressable market, competitive advantage, great business economics.
The CEO and chairman have been there for 20 years. The CEO was instrumental in buying booking.com in the early 2000s. They paid 150 million for it, and it's now worth 90 billion.
It's probably one of the best Internet acquisitions right up there with YouTube.
We only paid 17 times earnings for it, and that's probably a low double digit to mid-teens grower. It really ticks all our boxes.
What about a stock that you've recently sold?
We recently sold out of Experian, which had been in the fund since the early days. It was very much an old friend so we were sad to let it go, but at 28 times forward earnings, it was sold on valuation grounds. We'll just keep it on the watch list.
I noticed you recently increased your holding in Alphabet. What’s the thesis there?
It's probably one of our worst performing stocks over the last year, driven by two disappointments. Firstly, they missed their sales target because they only grew 19% in the last quarter, which is a hardly terrible result for a $780 billion market cap. The market didn't like that. That to us is just the market being really short term, and we prefer to look 5, 10 years down the road.
Then secondly there was the antitrust investigation that they could be open to. Firstly, it's still a potential investigation, one hasn't been announced yet. Secondly, they were investigated by the Federal Trade Commission and cleared of antitrust behaviour in 2013. We really got some marker there.
We do a lot of background checks and talk to legal experts, et cetera. Most of them have said, if this goes to court, it's going to be in the court for years. It's going to get bogged down. That's one thing to think about.
We would say it's unlikely that Alphabet is going to get broken up, especially given the tech war with China.
If you strip out the cash, the business is trading at a very reasonable multiples. It's the cheapest stock on our watch list, so as the shares went down, we just topped it up. Think five or 10 years out, what is the chances there'd be a different search engine to Google? Pretty slim.
If the market closed today for 5 years and you could own one stock what would it be and why?
It would probably have to be Visa. When you think of that business model, it's just got such an array of competitive advantages. Visa's the most trusted brand in the market. They have 16,000 banks that issue their cards, 54 million merchants that take their cards, and they have three and a half billion cards in issue. That's been built over 50 years. That's incredibly difficult to replicate. Then, the economics of the business are incredible. They're taking only pennies on the transaction. Again, they're very, very small part of the cost, but they are a massive part of the value.
If that network's not working, commerce just comes to a grinding halt. If you look at the economics, 65% operating margins, again, no working capital. Capex is only 3% of sales, 100% of profit's are being converted to free cash flow, and they give back 100% of that every year. There's very few businesses in the world that can grow at 15% per annum that are giving back all their free cash flow to shareholders.
It's incredible that even now, 85% of transactions are still done in cash and cheque. That’s a long runway of potential growth for people using cards online.
What keeps you busy outside of your work as a fund manager?
I like to read. I tend to read biographies, history books or sport. That's my go to. Occasionally, I read a novel. I just read Tiger Wood's book which was amazing. I'm also a big fan of Niall Ferguson, and 'Ascent of Money' is one of the best books I've ever read. As for a history book, 'History of the English-Speaking Peoples' by Winston Churchill. That's a good book.
Want to learn more about accessing the 'A List'
Evans and Partners International Fund is a high conviction portfolio of value-creating businesses at reasonable prices. They consider themselves true stock-pickers and look to avoid owning businesses that depend on a benign or favourable economic environment. Find our more by clicking 'contact' below.