Our global equity team has an investment philosophy that’s centred on the search for Future Quality in a company. Future Quality companies are those that are able to attain and sustain high cash returns on investment. To provide some insights on how we uncover our most compelling ideas, I sat down with the team to discuss the key themes shaping our current outlook, why we are so excited about the healthcare sector and a selection of companies that tick all our boxes.
How do you identify key themes?
Our portfolio construction process is done on a bottom up-stock basis. All of our companies are researched and modelled by one of our seven sector analysts within a flat team structure. As they do their due diligence and model out the company over five years, they can identify other broad-based ideas, applicable to other companies or industries; what we refer to as second and third derivatives.
Once an analyst has identified the potential for a thematic, like healthcare cost containment or the industrial Internet of things, they ask: “Is this thematic giving me a rising tide that lifts all boats in that thematic or is it something that will uniquely benefit only company X or company Y?”
That’s when your skill as the sector analyst comes in. You need to work out which stocks impacted by that theme best fulfils our Future Quality criteria: quality of franchise, management and balance sheet. Just as importantly, it can’t already be fairly valued.
This was the case for the healthcare cost containment theme we identified, which built up organically from doing work around stocks like ICON, LabCorp and Phillips. As we did our analysis on these stocks, the scale of the cost challenge facing global healthcare payers became increasingly obvious – as did a list of exciting companies that would help meet these issues head on.
How do others in the team contribute to stock or thematic ideas?
We’ve all got a richness of experience and have covered a lot of sectors having spent 20 plus years in the industry. So, ideas can come from anywhere. Sometimes a passing comment can remind you of something that drives you to go deeper.
For example, when my colleague Iain Fulton returned from the US after meeting with Quintiles (now called IQVIA) — one of ICON’s biggest competitors in the contract research space —he was discussing his trip and it triggered a memory of a meeting with ICON management in Dublin in the mid-2000s. At that time, the market was obsessed with drug price reform in the US and its potential impact on the biotech industry. Our view was that drug developers faced a stark choice: innovate or die, as commercial and political pressure likely intensified. Contract research organisations like Quintiles, LabCorp and ICON stood out as businesses that could help deliver this innovation more cost effectively. Both LabCorp and ICON really stood out for us, because they had a notable valuation discount relative to the other contract research organisations, like IQVIA.
What was the process you went through to arrive at the key theme of healthcare cost containment?
The US healthcare market is often a ‘proving ground’ for new healthcare technologies; partly because they have the largest budgets to pay for them. These budgets can’t grow forever though. The US already spends about 20% of its GDP on healthcare and that’s forecast to rise to 25% over the next five years. Cost control is urgently needed but this can’t be at the expense of innovation.
When we started working on this theme (in late 2015), the focus was (and is now) on drug price reform. Our view was that this focus was too narrow, with drug spending only 10% of healthcare spending. We believe that any regulatory action here may present opportunities, rather than just downside risk. New drug development is taking place at an accelerating pace as new tools improve our understanding of science and health. Any pressure on pricing would only intensify the need to bring this innovation to market, as quickly and cost effectively as possible.
Outsourced research & development looked like one such opportunity. Running the clinical trials needed for any new drug is cost consuming and ICON have a proven ability to manage these trials faster and up to 30% more cheaply than the in-house teams of other drug companies. This industry is growing 4 – 6% every year as a result and ICON had potential to grow even faster.
From there, we looked at other areas, where new technologies were opening up even more meaningful savings. One key area is better healthcare information technology. This takes many forms, from better managing patient health data, to enabling patients to be treated as well in their own homes as they are in hospital. This led us to do more work on companies like Phillips, LHC Group and others, including ResMed. Patients are becoming ever more engaged in their own care and payers are increasingly aware of the better health outcomes and lower costs delivered by this engagement. As a result, we remain very confident about the long-term growth in truly connected healthcare.
Technology in itself is only part of the solution though. You need to make sure that these innovations will actually get paid for. To do this, they will increasingly need to deliver a demonstrable value for patients. Managed care organisations like Anthem are at the forefront of this switch from the old, inefficient ‘fee-for-service’ model to value-based care.
Although the US is a poster child for this issue, we’re confident it’s going to spread to other parts of the world —you can already see it happening in Japan and France, which recently moved to reimburse the connected care capabilities that ResMed offers for sleep apnoea. While the structure of who’s paying for healthcare may be different between commercial payers, government payers, etc., as we move from country to country, the technologies are going to be similar across the world.
How do you decide which healthcare stocks to invest in?
Every stock that goes into the portfolio must have a path to attaining and sustaining a high cash return on investment. Our hurdle for this is 10 - 12%. There are a lot of companies that can deliver a 10% to 12% return for a couple of years if the economic wind is in their sails or they can borrow cheaply and do a couple of transactions or pursue a very aggressive restructuring program. But if ultimately their industry structure or the franchise quality of that business isn't strong enough to support that improvement or return in the medium to longer term, then they tend to disappear very quickly.
Empirical evidence shows that companies that get to that 10% to 12% and stay there generate even stronger returns than businesses that started above that level and stayed there. Setting the bar here also gives the chance for those improving fundamentals businesses to come through. This represents roughly 25% of our portfolio, which traditional quality growth managers perhaps wouldn’t own, but which give our portfolio a certain richness of opportunity. The crossover between our funds and other quality growth managers has always been pretty low.
We tend not to spend too much time trying to gauge where we are from a top-down perspective, but rather focus more on other considerations. So, where the company’s returns are realistically shaped by what’s going at a macro level, whether it be interest rates or commodity prices, that’s not something where we think we have a real edge over the competition so we’ll tend to focus on stocks that have that franchise quality and management quality — two of our Future Quality pillars — which means that the path to Future Quality is more in their own control.
We’ve spent a lot of time working out the common characteristics of the businesses that we like to invest in as a team, which includes a lot of empirical analysis. These common characteristic that we look for in a company include:
- companies that are in good industries and enjoy a sustainable competitive advantage
- high quality management teams, suitably incentivised to drive growth and returns
- strong balance sheets.
But just as importantly we need an attractive valuation. We don’t want to buy quality at any price. We focus on cash flow based metrics as we won’t buy companies that look like the ‘next big thing’ but are unable to fund themselves if the credit cycle turns against them.
We tend to wait until the technology is verified by real commercial application and a tipping point has been reached in terms of profitability and cash generation. It is at this point that returns typically move higher and we firmly believe that share prices follow returns.
Facebook and Amazon are good examples of our approach in action. Although Amazon had been a popular share before we bought it in early 2018, we didn’t want to own it as very high levels of capital spending meant that they were seeing declining cash returns on investment. We only stepped in once we felt they were starting to harvest the benefit of their investments. Until that point, we had preferred the profile at Facebook. At the same time, ironically, it was becoming clear that they needed to aggressively increase their investment in the business and that this would pressurise returns — for the short to medium-term at least. We sold Facebook to fund the purchase of Amazon.
What about healthcare in China?
Life sciences research is likely one of the key battlegrounds between the US and China as each tries to assert its power over the other in the long-term. China is committing a lot of capital, deploying newer technologies like artificial intelligence and machine learning to try and bridge that gap with (and ultimately overtake) the US as the global leader in life sciences research and development.
Further evidence of this ‘arms race’ is found in the rising number of young Chinese enrolled at high quality universities around the world. Those young adults will likely return to China to help drive the next leg of innovation for the Chinese healthcare industry.
The challenge for us is trying to find the right investment opportunities to participate in because often those stocks in China are very aggressively valued. The other challenge is that carrying out due diligence on those businesses, which is something we always do before we commit our client’s capital to them. Although not solely for this reason, we have recently recruited a mandarin speaker to the team and this should help us do the detailed stock level research that we need to do before risking our clients’ capital.
How do you integrate ESG when building portfolios?
ESG has been a key bedrock in terms of how we invest. If you look at our portfolio, in particular the sustainability of those higher returns (or high cash flow returns), one of the ways that returns can become unsustainable is if management is underinvesting in the quality of their business.
Generally speaking, extractive industries and energy have been structural underweights for us too. Mostly because of the volatility of their returns. But also because we hold concerns about the long-term cost of clearing up some of these industries and the impact that would have on cash flow returns in the medium to longer term. That means they don’t really fit our criteria for Future Quality.
We have a very low carbon footprint relative to the broader market and I don’t imagine it's ever going to change. And we’ve always been very serious about corporate governance and that won’t change either. For us, ESG isn’t a new thematic because that’s what our clients want us to talk about; it’s pivotal to the way we invest.
There’s no point having excellent investment performance if it isn’t built on sustainable grounds. The real win-win situation is if you can deliver excellent investment performance, but also engage with the companies that you’re investing in to try and make the world a slightly healthier and more inclusive place.
The future return on investment and the growth of a company's cash flows are key focus points. Our team seek companies where the future is not reflected in today's valuations. To stay up to date with our latest insights hit the follow button below.
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