Commentary
Summary
The fund fell 1.6% in the second quarter of 2024 while the MSCI World Index rose 2.6%. The largest positive contributors to performance were BT Group, Lloyds Bank and Henkel. The largest negative contributors to performance were Middleby, Walt Disney, and easyJet. We made a new investment in Whitbread, the UK based hotel operator during the quarter.
Despite the indices being driven by higher and higher valuations we remain committed to our approach of investing in companies that are attractively valued and we believe this is being recognised with four of the holdings in the portfolio over the last 6 months receiving investments from activist or strategic investors.
The weighted average upside of 54% is well above the long run average. We are even more excited on a relative basis. The broader market is trading on a price-to-earnings multiple of 19 times; this is nearly a 100% premium to the portfolio.
Overview
Warren Buffett’s advice for investors is to be fearful when others are greedy and greedy when others are fearful. Greed is often associated with markets that are trading at all-time highs but today we believe it is fear, the fear of missing out, that is driving markets to all time highs. The posterchild of this fear is Nvidia, a company that has risen over 30 times in the last five years to briefly become the world’s largest company, as measured by market capitalisation (but little else).
Nvidia is valued at 40 times trailing sales and 70 times trailing earnings. People may well point to the growth and suggest the 45 times forward earnings is more acceptable, but this is based on 54% net profit margin, which is unlikely to be sustainable. Microsoft is valued at 13 times forward sales and 38 times earnings with a record 35% net margin. Apple is valued at eight times forward sales and 32 times earnings also on a record 26% net margin. The three largest companies in the world are larger than the entire S&P500 was just over a decade ago and they are trading at record valuations on record margins. The operational performance of these companies is obviously exceptional, however, their beatification may be premature.
The Halo Effect, a book written by Phil Rosenzweig, perfectly highlights this risk. The star of that book was Cisco whose story looks remarkably like Nvidia’s. In 1999, Cisco was a leading networking company which was going to play a dominant role in the prevalent technology of the next decade or two. Cisco had a margin of 16%, a net cash balance sheet and had doubled revenues over the previous two years. Over the next 25 years revenue rose five times and earnings seven times. Today the share price is still nearly 40% below the March 2000 high. One could argue that all the magnificent seven suffer from the Halo Effect fallacy. Valuation always matters.
Performance
Turning to the portfolio, we will avoid the fear and greed and believe that value will out. This time it has taken much longer than we would have liked but we are seeing a lot of evidence that the value in the portfolio is slowly being recognised. As a portfolio focused on large cap companies, we do not get many takeovers, but we may get activists or strategic investors. In the last six months we have seen four of the 24 companies in the portfolio receive investments from activists or strategic investors: Carlos Slim at BT; Elliot Partners at Southwest; Warren Buffett at Chubb and, briefly, Trian at Disney.
The fund fell 1.6% in the second quarter of 2024 while the MSCI World Index rose 2.6%. The largest positive contributors to performance were, in order of impact, BT (+28% total return in local currency), Lloyds Bank (+10%) and Henkel (+14%). The largest negative contributors to performance were, in order of impact, Middleby (‑24%), Walt Disney (‑19%), and easyJet (-20%).
BT’s new CEO Allison Kirkby suggested that normalised free cash flow in 2030 would be double the current level. This is mostly driven by falling capital expenditure. The adjusted free cash flow forecast of £3 billion in 2030 compared with a market capitalisation prior to the announcement of just £10bn, highlighting the significant value available in the shares. We see fair value over 200p providing potential upside of over 40% and a dividend that has returned to growth yielding over 5%. Others also clearly recognise the value of BT with three industry operators (Deutsche Telekom, Patrick Drahi and Carlos Slim) holding sizeable investments in BT.
Middleby announced results that showed continued revenue weakness in its residential business, but perhaps more concerning was the weakness of the Food Processing and Commercial Foodservice divisions. The company also guided to a decline in the second quarter, but pointed to increasing orders across all divisions that should lead to improved outcomes towards the end of the year. Despite the topline weakness the company remains highly profitable and cash generative. The shares trade on under 12 times forward earnings, a large discount to the average of 20 times over the last decade.
New Purchases – Whitbread
In the last month we purchased a new position in Whitbread. Whitbread has simplified itself, following the sale of Costa Coffee to Coca Cola in 2018, to being focussed on its ‘premium economy’ hotel brand “Premier Inn”. It also operates several restaurant brands, many of which are located next to their UK hotel sites.
Premier Inn is the largest hotel operator in the UK but also operates in Germany where it is building-out its network of hotels. The UK accounts for 86% of its total rooms and is an attractive market with constrained supply due to real-estate planning constraints. Within the market Premier Inn has some clear competitive advantages. Firstly, it operates a non-franchised model, allowing it to have a simpler operating model and consistency across sites. Secondly, it has scale over independents which create benefits on purchasing and distribution. Most importantly its use of third-party booking platforms, such as Booking.com, is limited to 1% of rooms compared with the industry average of over 30% - something made possible because it has built such a strong brand in the UK. Many of these benefits also apply to the largest ‘pure economy' competitor Travelodge. However, another key difference is that Premier Inn owns the real estate at half their hotels while Travelodge leases all of theirs. Travelodge also have substantial financial leverage over and above the leases.
This creates a long-term advantage for Premier Inn over its largest competitor and has resulted in market share rising from 6% to 12% over the last decade with an average return on invested capital of 13%, excluding the COVID years. The main challenge for the UK business is finding new opportunities to deploy capital but the company believes there is still space to expand the number of rooms by over 30% in the medium-term taking market share to the high teens.
The German business is smaller but an important source of growth. Premier Inn have invested c.£500m into the market and expect to increase this to c.£1bn in the next few years. The segment is expected to turn profitable in the next twelve months. There are few scale operators in the German market and Premier Inn believe there is an opportunity to repeat their success in the UK. The company is targeting a return on capital in the low double digits. We don’t think the possibility of success is factored into the current valuation. Investors appear focussed on the near-term declines in revenue per room year-on-year after a post-COVID bounce in travel last year, as well as the likely downturn in revenue and profits caused by the conversion of their weakest restaurant locations into additional hotel rooms.
The shares trade at under 14 times price to earnings compared with an average over the last decade of closer to 20 times. Alternatively, the market capitalisation is just over £5bn, around the same valuation as Premier Inn’s property assets. This implies the operating company has no value.
Commentary
Summary
The fund fell 1.6% in the second quarter of 2024 while the MSCI World Index rose 2.6%. The largest positive contributors to performance were BT Group, Lloyds Bank and Henkel. The largest negative contributors to performance were Middleby, Walt Disney, and easyJet. We made a new investment in Whitbread, the UK based hotel operator during the quarter.
Despite the indices being driven by higher and higher valuations we remain committed to our approach of investing in companies that are attractively valued and we believe this is being recognised with four of the holdings in the portfolio over the last 6 months receiving investments from activist or strategic investors.
The weighted average upside of 54% is well above the long run average. We are even more excited on a relative basis. The broader market is trading on a price-to-earnings multiple of 19 times; this is nearly a 100% premium to the portfolio.
Overview
Warren Buffett’s advice for investors is to be fearful when others are greedy and greedy when others are fearful. Greed is often associated with markets that are trading at all-time highs but today we believe it is fear, the fear of missing out, that is driving markets to all time highs. The posterchild of this fear is Nvidia, a company that has risen over 30 times in the last five years to briefly become the world’s largest company, as measured by market capitalisation (but little else).
Nvidia is valued at 40 times trailing sales and 70 times trailing earnings. People may well point to the growth and suggest the 45 times forward earnings is more acceptable, but this is based on 54% net profit margin, which is unlikely to be sustainable. Microsoft is valued at 13 times forward sales and 38 times earnings with a record 35% net margin. Apple is valued at eight times forward sales and 32 times earnings also on a record 26% net margin. The three largest companies in the world are larger than the entire S&P500 was just over a decade ago and they are trading at record valuations on record margins. The operational performance of these companies is obviously exceptional, however, their beatification may be premature.
The Halo Effect, a book written by Phil Rosenzweig, perfectly highlights this risk. The star of that book was Cisco whose story looks remarkably like Nvidia’s. In 1999, Cisco was a leading networking company which was going to play a dominant role in the prevalent technology of the next decade or two. Cisco had a margin of 16%, a net cash balance sheet and had doubled revenues over the previous two years. Over the next 25 years revenue rose five times and earnings seven times. Today the share price is still nearly 40% below the March 2000 high. One could argue that all the magnificent seven suffer from the Halo Effect fallacy. Valuation always matters.
Performance
Turning to the portfolio, we will avoid the fear and greed and believe that value will out. This time it has taken much longer than we would have liked but we are seeing a lot of evidence that the value in the portfolio is slowly being recognised. As a portfolio focused on large cap companies, we do not get many takeovers, but we may get activists or strategic investors. In the last six months we have seen four of the 24 companies in the portfolio receive investments from activists or strategic investors: Carlos Slim at BT; Elliot Partners at Southwest; Warren Buffett at Chubb and, briefly, Trian at Disney.
The fund fell 1.6% in the second quarter of 2024 while the MSCI World Index rose 2.6%. The largest positive contributors to performance were, in order of impact, BT (+28% total return in local currency), Lloyds Bank (+10%) and Henkel (+14%). The largest negative contributors to performance were, in order of impact, Middleby (‑24%), Walt Disney (‑19%), and easyJet (-20%).
BT’s new CEO Allison Kirkby suggested that normalised free cash flow in 2030 would be double the current level. This is mostly driven by falling capital expenditure. The adjusted free cash flow forecast of £3 billion in 2030 compared with a market capitalisation prior to the announcement of just £10bn, highlighting the significant value available in the shares. We see fair value over 200p providing potential upside of over 40% and a dividend that has returned to growth yielding over 5%. Others also clearly recognise the value of BT with three industry operators (Deutsche Telekom, Patrick Drahi and Carlos Slim) holding sizeable investments in BT.
Middleby announced results that showed continued revenue weakness in its residential business, but perhaps more concerning was the weakness of the Food Processing and Commercial Foodservice divisions. The company also guided to a decline in the second quarter, but pointed to increasing orders across all divisions that should lead to improved outcomes towards the end of the year. Despite the topline weakness the company remains highly profitable and cash generative. The shares trade on under 12 times forward earnings, a large discount to the average of 20 times over the last decade.
New Purchases – Whitbread
In the last month we purchased a new position in Whitbread. Whitbread has simplified itself, following the sale of Costa Coffee to Coca Cola in 2018, to being focussed on its ‘premium economy’ hotel brand “Premier Inn”. It also operates several restaurant brands, many of which are located next to their UK hotel sites.
Premier Inn is the largest hotel operator in the UK but also operates in Germany where it is building-out its network of hotels. The UK accounts for 86% of its total rooms and is an attractive market with constrained supply due to real-estate planning constraints. Within the market Premier Inn has some clear competitive advantages. Firstly, it operates a non-franchised model, allowing it to have a simpler operating model and consistency across sites. Secondly, it has scale over independents which create benefits on purchasing and distribution. Most importantly its use of third-party booking platforms, such as Booking.com, is limited to 1% of rooms compared with the industry average of over 30% - something made possible because it has built such a strong brand in the UK. Many of these benefits also apply to the largest ‘pure economy' competitor Travelodge. However, another key difference is that Premier Inn owns the real estate at half their hotels while Travelodge leases all of theirs. Travelodge also have substantial financial leverage over and above the leases.
This creates a long-term advantage for Premier Inn over its largest competitor and has resulted in market share rising from 6% to 12% over the last decade with an average return on invested capital of 13%, excluding the COVID years. The main challenge for the UK business is finding new opportunities to deploy capital but the company believes there is still space to expand the number of rooms by over 30% in the medium-term taking market share to the high teens.
The German business is smaller but an important source of growth. Premier Inn have invested c.£500m into the market and expect to increase this to c.£1bn in the next few years. The segment is expected to turn profitable in the next twelve months. There are few scale operators in the German market and Premier Inn believe there is an opportunity to repeat their success in the UK. The company is targeting a return on capital in the low double digits. We don’t think the possibility of success is factored into the current valuation. Investors appear focussed on the near-term declines in revenue per room year-on-year after a post-COVID bounce in travel last year, as well as the likely downturn in revenue and profits caused by the conversion of their weakest restaurant locations into additional hotel rooms.
The shares trade at under 14 times price to earnings compared with an average over the last decade of closer to 20 times. Alternatively, the market capitalisation is just over £5bn, around the same valuation as Premier Inn’s property assets. This implies the operating company has no value.