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23 May 2016

Making money out of used cars

We chat with Hutch Vernon, co-manager of Brown Advisory US Flexible Equity

When we talk about the US stock market, it's usually in terms of entrepreneurial businesses, new technologies and exciting things like FANGs (the name given to Facebook, Amazon, Netflix and Google). So it's perhaps surprising that used car companies can make a good investment too. But that's exactly the type of company Hutch Vernon and Mike Foss, managers of Elite Rated Brown Advisory US Flexible Equity fund, look for when researching the market.

Hutch and Mike are 'market agnostic', meaning they don't really care what is going on in the economy as they look for non-cyclical businesses – those that have the ability to do well in any kind of environment. This is, perhaps, reassuring, at a time when the eyes of the world are on the US, wondering if it is strong enough to withstand a further interest rate rise, and who exactly will be in charge come November and the election.

We caught up with Hutch last month, when he visited the UK. He's not really worried about the politics dominating the headlines at the moment. “US business will do fine regardless,” he said. “They will adapt to whatever comes along in the elections. Even if the presidency is unconventional, the two houses are likely to have split representation anyway. So the thing will be a case of evolution rather then dramatic revolution.”

Despite all the noise around the election candidates and question marks over economic growth, Hutch believes there are good investment stories out there – companies that will continue to grow and do well. “The rate of achievement in technology and healthcare is exponentially growing right now and living standards are increasing along with it.”

That said, US market valuations generally are high at the moment, which is limiting the upside potential of investing in any new names. So Hutch and Mike are sticking to the investments they own and adding to existing holdings here and there. The cash weighting of the fund is slightly higher than usual right now at around 4.5%, as they wait for the right opportunity.

How should you invest in the US this year?

Teva Pharmaceutical is an example of a position they have 'topped up'. It is a generic drug producer, benefiting from the growing healthcare trend.

Healthcare's lost decade has come to an end

Carmax is another. This is a superstore for used cars. They have a good business model built on identifying and addressing the distrust in the market, they say. Hutch and Mike made their first investment in this company in 2002 and continue to have faith in it today.

“We like companies who will reinvest their earnings to generate growth, or have good free cash flow to distribute to investors. We also like up-and-coming businesses that haven't reached full potential yet.”

They will often find a catalyst to show this, such as a management change, indicating that the future will be better than the past, or a previous government-held company moving to more public ownership.

They also like financials – in no small part due to their recurring revenue streams. At the moment these companies are oppressed in their profitability due to low interest rates and regulatory capital constraints. However, their rate of expense to cover new regulations will be slowing and this profitability should start to be returned to investors.

In Hutch's view, there is now no glaring risk to the US financial system, unless it's a severe Lehmans style moment. Student debt is high and is a headwind to spending, but that is centrally a government issue rather than a banking issue.

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Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Hutch's views are his own and do not constitute financial advice.