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Two household names to delight investors with their earnings streams

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It's not earnings that drive share prices but surprises in earnings, says Alphinity global portfolio manager Jeff Thomson.

In this episode of Expert Insights, Thomson takes us inside Alphinity's approach to investment strategy.

"It's that surprise in earnings, where earnings are not only higher than the market expects, but also persists for longer," he says. "And that is the lens we use. And we're looking for quality companies within that.

"In terms of the way we position, it's a stock-specific view. We tend not to take that top-down, thematic perspective."

Thomson gives two examples of current Alphinity holdings. One, Microsoft, is an old favourite. The other, Universal Music, was recently spun out of Vivendi and is new to the portfolio.

Thomson says Universal's existing business is outstanding, but licensing to alternative media such as Tiktok should prove immensely lucrative. Expecting growth of up to 10 times over the next decade is not unreasonable, he thinks.

Edited transcript

What areas and companies look undervalued to you at the moment?

What we're looking for is that undervalued, earnings upgrade cycle. I think we've all heard the expression "Earnings drive share prices". In our view, it's not really earnings per se; it's not even earnings growth.

It's that surprise in earnings, where earnings are not only higher than the market expects, but also persists for longer. And that is the lens we use. And we're looking for quality companies within that.

In terms of the way we position, it's a stock-specific view. We tend not to take that top-down, thematic perspective. The way we position is, we've got our favourite growth names.

These are exceptionally high quality businesses that are compounding growth in a very persistent way, and we think will continue to do that and surprise positively on that.

We have many of the technology names that you'd recognise, but Microsoft (NASDAQ: MSFT) would be one name I'd call out. But the one I want to talk about today is a recent addition to the fund. It's Universal Music (NL: UMG) — possibly the world's leading music publisher.

It recently got spun out of Vivendi, so it's a relatively new listing. The core of the business is obviously streaming — selling the catalogue through to Spotify. That business is phenomenal.

It's a subscription business, growing at high single digits. But at the same time you've got this amazing new opportunity in terms of these alternative media platforms, the TikToks of the world, the YouTubes, et cetera, which is just a huge new monetisation opportunity for a lot of these music publishers, and we see that.

Currently they earn about 400 million Euro from these sources. We think that could grow to as much as 4 billion up to 2030, in the context of a business where total revenues are about 9 billion. That's phenomenal growth.

We also think there's margin upside. This is a business that's very under-leveraged. It's got almost no debt: 1 times debt to equity. We think there's a buyback angle there.

The icing on the cake, so to speak, is it trades at a 20% discount to the biggest or the closest competitor, which is Warner Music (NASDAQ: WMG) in the US.

Universal is a company that we think is almost a must-own for growth investors in Europe, and I think is still relatively undiscovered. It's a recent addition that we feel quite excited about.

What warning signs are you seeing?

I think we'd all recognise you had this phenomenal rally in risk assets across the world. It's pretty much every asset class, every geography. It's the rally of everything.

And we've got to the point now where everything certainly doesn't look cheap, and it's obviously been driven by this extraordinary level of monetary stimulus. But if you look forward, I think the areas of caution for us would be that we think growth is probably as good as it gets.

And to be clear, we're not calling a downturn or a recession. It's just we are looking at that margin, the delta, we don't think global growth is going to accelerate from this point.

If anything, it's going to marginally decelerate into next year and the year after. We also think, obviously, monetary policy, a big driver of returns in the recent past, that's also clearly peaking at the moment with the news that the Fed is going to start tapering this month. Valuations are close to historic highs, margins are close to historic highs.

We are not calling the timing of it, but for us, those are signs of caution. The way we look at it at Alphinity is really through an earnings lens. That's the primary way we interpret and look at the macroeconomic data.

We've got an internal database of 5,000 companies which we look at and look at the corporate earnings on a weekly basis. One of the signs that we look at is where the leadership is on a sector basis. And what we're looking for is signs that that leadership is changing from cyclicals back to defensives.

The short answer is, at the moment that is not happening yet. There's perhaps some broadening out, but the cyclical sectors are still by and large leading.

If you look at the leadership through the recent earnings season in the US, energy, financials, materials, industrials are still somewhat leading, and the more defensive sectors like staples are lagging. And that's probably one sign.

The other sign is just credit spreads. I was a financial analyst for many years and worked as a financial portfolio manager through the financial crisis in London, and I've been schooled in the importance of credit spreads.

At the moment, there's no warning sign per se, except to the extent that spreads are certainly tighter than they were pre-COVID, and almost in some cases approaching GFC levels.

We'd characterise this as as good as it gets. It might continue for longer, but I think we are certainly cautious.

And I think the way we're interpreting that is starting to pare back on some of the more expensive stocks which have run really hard, and looking for those pockets of value where we can find them, on a stock-specific basis.

Given today's inflationary pressures, who do you see as winners and losers heading into 2022?

It's clearly something top of mind for us in terms of selecting the stocks that we have. And I think there's some industries that just got a historic track record of coping with inflation well, and then there's also companies that clearly have pricing power.

In consumer staples, for example, food manufacturers, generally speaking, have a poor history of passing on inflation. This is something they really battle with.

If I had to call out one reason, it's the impact of private label and the ability to pass on prices at the supermarkets. Generally speaking, it's not something they've been able to do in food inflation, logistics, et cetera.

Many of those food manufacturers we are cautious about, and we are seeing that in our earnings data. On the flip side, any company with very high margins, more on the luxury end of things, has got that pricing power.

For example, L'Oréal (XPAR: OR) and Estée Lauder (NASDAQ: EL) — premium skin care and fragrances — this is affordable luxury, so to speak. They typically have pricing power; they have the margins to cope with inflation.

Also, a Nestle, for example, within food manufacturers is better placed. They have Nespresso, a big coffee business, which is highly growing — the ability to pass on prices there — premium pet care, nutrition and healthcare.

Even within that, there are some companies that are better positioned, but yeah, clearly this is something top of mind that we are focused on.

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