105. L’Oréal, Campari and Schindler lifts: quality companies in Europe

12 November 2020 (pre-recorded 10 November 2020)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Darius McDermott (DM): Hello I’m Darius McDermott from FundCalibre and this is the Investing on the go podcast. Today I’m joined by Ben Moore, co-manager on the Elite Rated Threadneedle European Select fund. Ben, hello.

Ben Moore (BM): Hello, thank you for having me.

DM: It’s our absolute pleasure, thank you for taking the time.

[INTERVIEW]

[0:22]

DM: And what a time it has been! Stock markets have had an incredible time as has the broader economy. Tell us a little bit about your portfolio, how it’s done through, you know, the tough calendar year we’ve had in 2020. And what changes did you make in the height of the pandemic and thereafter, if any at all?

BM: Yeah, as you say, it’s been an absolutely incredible year in so many ways. In terms of performance, we’ve outperformed the index for the year as a whole, so far, although as you know it’s never a straight line.

DM: No.

BM: As it stands today, we’re about 10% ahead of the index. In terms of our approach – that really hasn’t changed at all. So, the strategy as you know, has been in place for such a long time, and we continue to do, really, exactly what it says on the tin. I guess I would say, because there’s been so much volatility this year, there have been a few more opportunities in terms of buying and selling just because of the extreme price moves. So there’s been a bit more activity, but we definitely haven’t changed how we think about investing fundamentally.

[1:47]

DM: And look, I’m not surprised to hear that you haven’t changed, but did the volatility in markets give you opportunity for some of your type of stocks? Did some stocks that were overvalued in your opinion become more reasonably valued? Or did you have some things which may have been affected by the pandemic, which with a fair lens you couldn’t have seen as we came into 2020?

BM: Yeah, I think that’s, all interesting points. I guess, to your point on opportunities we’re very specific about what types of companies that we’ll invest in, and we can go into that, but I’m sure, I’m sure you’re familiar with that. So there have been a bunch of companies that we wanted to own for a long time, but they’ve been out of reach in terms of how expensive they were. And there have been some moments where we have got opportunities. And similarly, there’ve been some stocks in the portfolio that are wonderful businesses but have just become so extremely expensive that we’ve considered them less attractive as investments and we’ve trimmed those. So there have been both of those. The only thing I would add to that, is that the movements have been so extreme and so quick that actually we often haven’t been able to build meaningful enough positions in companies we would want to, because the prices has moved against us so quickly.

[3:25]

DM: Yeah. That’s not that uncommon, I guess, in, as you say, extreme and volatile markets. So whist you’ve had a consistent approach there’s not many fund managers – there’s a few, but not many fund managers, I know – who don’t say they invest in quality companies and quality does have different definitions to different managers. Maybe if you tell the listeners about what quality means to you.

BM: I think that’s an extremely good point. I think quality, growth and value are all terms that are slightly overused by investors in general. Because the strategy is so particular about the types of business that we’ll own, we do have a clear definition of quality, as we see it. We see three dimensions basically. The first of those is growth and it doesn’t need to be secular growth – we’re very comfortable owning cyclical businesses – but we really need to have conviction that a company will be bigger in five years’ time. The second attribute is return on invested capital, which is a mouthful, but it’s really about how cash generative the business is and how effectively the management team allocates capital with acquisitions or in organic growth.

[4:51]

DM: Sorry just before we go on, because you rightly say it is a bit of a mouthful. Do you think you could help maybe slightly de-jargonise that? Cause we, I hear that a lot in my job, and I’m sure you do when you’re talking to management of companies. So this is taking capital and doing, or earnings that they make, and doing what with it? What type of thing are we talking about for returns on invested capital?

BM: Let me, let me split that in two parts. Let me talk about organic return on invested capital and inorganic return on invested capital.

DM: Yep.

BM: The example, I think that sums it up most clearly in my mind is a teenage Warren Buffet installing a pinball machine in a barbershop. And, after a month, I believe it was, he took the amount of money that people had spent on the pinball machine, he divided it between himself and the guy who owned the barbershop and ,with that money, with his share, he was able to buy another pinball machine. And with that pinball machine that was then spitting out money and he was then able to go and buy another pinball machine. So soon he had a cluster of pinball machines. Does that make sense?

DM: Yes, absolutely.

BM: So for me, it’s about, you know, if you’ve got a business generating cash, how easily can you invest that money to expand your business? And there are some businesses like Buffet’s pinball machine example, where after a month he was able to double his business in size. But there are other businesses where you may need to invest in lots and lots of heavy equipment, expensive capital, just to eek out a very small amount of growth. So that is organic returns on invested capital.

[6:49]

Inorganic returns on invested capital, is then a question of acquisitions. And this is a little bit more intangible because it takes a lot longer to know if an acquisition was a good one or a bad one. But let me give L’Oreal as an example. L’Oreal bought Kiehls when it was a much smaller business than it is now. Because L’Oreal is a global cosmetics skincare platform they were able to plug Kiehls, an American skincare brand, into their global portfolio and they were able to grow that business very significantly. And it became a very accretive acquisition. Maybe one more example, Campari that we’re invested in, took the money that they were making with Campari and other drinks to buy a little spirits business in Northern Italy called Aperol. And with Aperol, they were able to expand that business into a global brand with tremendous success. The business is still growing, even, even through the current environment.

DM: And that’s buying it and using their own platform of marketing and distribution to really grow the acquired asset.

BM: That’s exactly right. So again, it comes back to what does a company do with the cash that they’re generating?

DM: Okay, so that was the return on invested capital before I interrupted you. And then the third point, or the third thing that you might look for?

BM: The third thing in a way is the most intangible, but the most valuable, which is sustainability. Which really is about how long can a business sustain its current attractive economics? Is this business going to be competed away to a commodity type of business? Or is this a business that in, in the same way that Campari is now 150 years old and continues to be an absolutely vital ingredient for most bartenders, is this, is this going to continue to defend its competitive advantage? And so those are the three criteria that we see as absolutely critical in our definition of quality.

[9:10]

DM: That’s really interesting, thank you very much Ben. Looking through your recent factsheets and presentations, I see the fund’s largest overweight is industrials. Can you explain to our listeners what type of a company an industrial company is – I think they sometimes have very wide definitions.

BM: Very happily and I’m glad you asked that question because it’s one we get a lot. I think when you think of industrials you might think of some earnest metal-bashing factory with lots of sparks flying around and lots of capital equipment and stuff like that. And in a way that would be quite unlike the type of business that we would want to own. The industrial businesses that we own are actually much more asset-light. I’ll give two examples to illustrate that, the first would be we’re invested in both Schindler and Cooner, which are…

DM: Lifts.

BM: Two of the global lift companies. And most of their profits actually come from maintenance contracts. So this is contractual service revenues, and there’s no factory at all. It’s guys driving around in vans making sure that lifts comply with safety regulations and are functioning properly, et cetera. So it’s an industrial in technical terms, but the economics of the business are really very far removed from that metal-bashing example. Maybe the second example I’d give would be something like Brentag, which is a chemicals distribution business. They don’t actually make any chemicals. It’s a logistics business, they store chemicals and they distribute them from A to B as quickly and as cheaply as possible. But again, it’s relatively asset light.

[11:02]

DM: So another area which I find interesting is payments, and I believe there’s a stock called Worldline, which is in your top 10. Tell us a little bit about that and which role in the payment chain that has, because that’s also been a fast growing industry as we’ve moved from a cash to a cashless society – not just because of the recent pandemic, but that’s a long standing trend, tell us a little bit about it.

BM: Yeah, that’s absolutely right. So I think Worldline is really interesting for, on an organic basis and on an inorganic basis, going back to our conversation about capital allocation. As you said, there is an increasing shift to paying less and less with cash and more and more digitally. And Worldline is a payment processing business. So there is an organic trend that will benefit it. But the other element that’s really interesting about Worldline, is that payment processing is, in a way, a scale game. And it’s an, it’s a market that we think still needs to consolidate significantly in Europe. And what I mean by that is that there are still lots of banks that process the payments for their customers in-house. And they’ve got all of the payment infrastructure that you need to do that. What Worldline is able to do, and is looking to do, is to consolidate and drive an outsourcing trend away from the banks to a central platform that it manages, so that it can enjoy the cost synergies from that. And we see that as a very clear growth driver on top of the trend that you talked about of payments becoming more and more cashless.

[13:08]

DM: Well, that’s a couple of really good examples. And then maybe just a final one, which has come from a female colleague and may interest our female and maybe our male listeners as well, but it’s about Loreal and you’ve already touched on them being a skincare business. In a working from home environment and an environment now where we, certainly for the foreseeable future, have to wear masks. How’s L’Oreal holding up in the current climate?

BM: Yeah. So I think there are two elements to the challenge that L’Oreal has faced this year. The first has been, as you said, a demand challenge which is in terms of whether or not people wear as much makeup or look after their skin as much as they did. And the second is a supply issue of hairdressing salons being closed, physical retail stores where you can go and try stuff being closed. On the demand side, we’ve been surprised by how resilient that has been. And that’s partly a continuation of trends that we’ve seen for the last 5 to 10 years of people basically looking after themselves better.

DM: Yep.

BM: And so in terms of skincare, that means more elaborate routines and more products. From a supply perspective where L’Oreal has executed phenomenally well, is that they have a very, very strong online business. So I think online could be around 25% of the company’s turnover this year. And so in a way they’d been able to leapfrog a lot of the physical retail limitations this year in order to meet customer demand.

DM: Ben thank you very much for that roundup. I think we’ve covered quite a lot from growth and return on invested capital. I think that’s been one of the best explanations maybe I’ve heard and hopefully our listeners. We’ve have talked about industrials and lifts and payments and skincare. So I think that’s been really interesting. And, of course, all these types of investment opportunities are available on listed equities to you in Europe. So Ben, let me thank you very much. That’s Ben Moore, co-manager of the Elite Rated Threadneedle European Select fund.

BM: Thank you. Thank you, Darius.

DM: If you’d like to get further information on the fund please visit FundCalibre.com or please do subscribe to the Investing on the go podcast at your usual podcast supplier.