122. What hotel choices can tell you about company CEOs

11 March 2020 (pre-recorded 9 February 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 delighted to be joined by Chris St John, who is the manager of the Elite Rated AXA Framlington UK Mid Cap fund. Chris, how are you?

Chris St John (CSJ): I’m very well, thank you Darius.

DM: So Chris, we’re all working from home and I think, as an industry we’ve been pretty successful, but how are you finding working from home? Are there any bits that you miss from being in the office?

CSJ: No, I think on the whole it’s working pretty well, Darius. I’d say if you sort of, if I had to commit myself, I’d say it’s probably, we can get 95% of the job done from home. Unfortunately, the 5% that can’t be done at home, I think is actually quite important. So I’m certainly looking forward to getting back to the office. And it is, it’s just simple things like seeing how chief execs and finance directors, whom you meet all the time, how they behave with people on reception for example, if they’re rude to them, it tells me quite a lot about them as individuals and as characters.

And you know, we have conversations in the lift. Face-to-face we can spend more time just talking around various subjects, whether it’s the economy or the banks and how they’re behaving or what’s happening in the private market, or who in the market is bidding the least on contracts, for example. And that’s all very good and interesting information. You know and we ask silly things as well. So, if we have a chief executive, if they’re based outside of London and they’re staying in a hotel, you know, you’ll ask them, you know, which hotel are you staying in? And it’s very interesting. Those… as a general rule of thumb, I would say those lots of equity [in the business] tend to stay at the Travelodge and those that don’t, tend to stay in the Connaught.

DM: So it’s that soft 5% which I’m sure you will be keen to get back to.

CSJ: Yeah, absolutely. Absolutely.

[INTERVIEW]

[2:03]

DM: So, Chris, you and I have done these a number of times and you know, the one thing as a UK equity manager that’s come up time and time again is Brexit. But now that we have a sort of a deal, I’m interested to hear from you, if you don’t mind, please, what you’re hearing directly from companies on the ground. What’s their thinking and how are companies sort of looking forward to UK listed businesses?

CSJ: Yeah. We’re very fortunate. We spend a lot of time talking to chief execs and finance directors of companies, and we’ve been talking to them about Brexit and the implications since 2016. And I would say on the whole, the companies that I meet have taken a lot of preemptive action ahead of the actual event itself. So, for example, they’ve been building up stocks in anticipation of certain levels of friction cross-border, but they’ve also been taking longer term investment decisions. So, for example, setting up warehousing in Europe, if they feel, or if they felt that it was necessary in the event of a hard Brexit.

From a short-term perspective, I would say most of the conversation is around friction at the borders. I’m hopeful that the friction that we’re seeing will be relatively short-lived, as operators get more efficient really at filling out the additional paperwork. And I would expect over time technology to step in and help reduce friction over time. So, we’re not, in aggregate, we’re not seeing it as a big issue, companies are pretty well-prepared. But the long term effects really will become apparent as time passes by.

[3:53]

DM: And you never know, people may even buy UK equities again, sort of most unloved asset class globally for, well since that referendum, you know, you never know, we might actually get a bit of tailwind for the asset class, which I’m sure you would enjoy.

CSJ: Yeah indeed.

DM: Yeah. Another thing that I know that you look for, sort of part of your process is sort of thematic overview and trying to find structural growth or macroeconomic factors that are giving companies a bit of a push. Have any of the themes changed due to the pandemic, or are there any new sort of thematic bits and pieces in your portfolio that you’re looking at?

CSJ: I’d say there hasn’t been wholesale change, to be honest Darius. A lot of what we’re seeing I would say is an acceleration of what we were seeing before. So, if you look at the high street, for example, and we had a seminal moment recently really with the sort of demise of Debenhams and Arcadia that people would have seen reported in the newspapers, but that was a real seminal moment for me, of just seeing this acceleration to online and away from the high street. And that has been accelerated by the effects of COVID.

You know, there’s been an acceleration on other trends as well: pet ownership. We’ve seen that as a growing market for many years now, but again has accelerated during lockdown as has the, you know, the digitalisation of business – companies really do seem to be hitting the accelerator in terms of investing in their own digital capabilities. So, I would say it’s an acceleration of what we’ve seen before on the whole.

Perhaps a couple of other sort of slightly more subtle things that we’re seeing, which might be new and that revolves around working from home, we’ve seen some companies looking to recruit from much further afield than they would’ve done historically. And I think that’s on the assumption that more of their workforce will be working from home, less need to come into an office, and as a consequence of that it’s just spreading the geographic net that companies can spread in terms of recruitment.

[6:10]

DM: And any sort of thoughts on things like renewables or infrastructure, that appear to be topical with respect, not just the recent budget, but, you know, areas that you know, government have support into.

CSJ: Yeah, they’re both interesting areas, I suppose, for different reasons. I think if I looked through the FTSE 250 index and, just as a reminder, this fund, I need to invest a minimum of 70% in the mid 250 index. There’s not actually that many renewables companies within it, to be honest. There’s a number of companies that would give you exposure on the AIM market. But on the whole, the types of the businesses I look at in the mid cap space, there are very few pure renewable players. I mean, I do have slight reservations, although I’m very supportive and understanding of the green agenda, I, as a fund manager, I much prefer to invest in businesses that can stand on their own two feet and are profitable and cash generative and can grow without the needs of government subsidies. So, I’m always slightly wary of businesses that require subsidy to be profitable. So, I sort of throw that general caveat out there.

I mean, from an infrastructure perspective, more generally, the government seem pretty vocal in terms of supporting infrastructure spend, I think making something like £600 billion available to address historic infrastructure under investment as part of the ‘building back better’. And we can certainty get exposure to that through the mid cap space. Typically, it’s a sort of picks and shovels, it’s the suppliers into that infrastructure investment. So, companies like Hill & Smith, Polypipe, Marshalls and you’re also seeing big capital investment and infrastructure spend internationally as well. So, a company like Ashtead is certainly benefiting and will benefit from infrastructure spend over in the US for example.

[8:21]

DM: Now you touched on the AIM market, and you’ve also reminded us that the fund needs to be 70% or more in the mid cap, but you do currently have around 10% in the AIM market and that as a market, it’s done pretty well in the last year or so. What’s the story behind the stocks that you hold that are listed on the AIM market?

CSJ: Yeah, the AIM market is always, it’s always an area of the stock market I’ve found very interesting. There’s a pretty eclectic mix of businesses on there, and it’s certainly ebbed and flowed in terms of its reputation. Now, as I said, 70% minimum FTSE 250, I can invest up to 15% in the FTSE 100 which is there really is a mechanism by which I don’t need to sell FTSE 250 stocks if they get promoted. However, that does leave a certain percentage of the fund I can invest elsewhere. And yes, around 10% of the fund currently is invested in the AIM space.

It did, as an index, perform well last year. Interestingly, in terms of what drove that, we talked about renewables earlier, that ITM Power, Ceres – two hydrogen energy stocks, relatively early stage from a profitability perspective, but good performers. They’ve [AIM] also benefited from some great performers in computer software and gaming companies, as well as online retailers like ASOS and Boohoo. When I look at the AIM exposure we have, the vast majority of it, if it is cerca 10% of the fund, 9% of that 10% would qualify for the FTSE 250 by market capitalisation.

DM: Now that’s interesting because it’s often thought that AIM are very, very small companies, but, you know, and I do as well, that actually some of those companies, if they were listed on the full London Stock Exchange, would be in the mid cap index.

CSJ: Yeah, absolutely. So, companies like FeverTree, the premium drinks mixers is valued at 2.8 billion, Breeden in construction materials, which we hold one-and-a-half billion. We have a holding in Boohoo that’s around 4 billion and healthcare companies like Clinogen is around a billion. So, you know, these are profitable businesses that would sit very well inside the FTSE 250.

[10:48]

DM: Now, when we do our podcasts, we like to talk about one or two stock names that people may have heard of who listen to the podcast. So, we’ve drawn out a couple, you’ve touched briefly on pets, so one is Pets at Home, so maybe a moment or two on that, and then maybe a moment or two on Dunelm?

CSJ: Ah, right, yes Dunham and pets, yes two companies I like very much, both market leaders, both exposed to the consumer, both with a multi-channel offering and both with increasing or benefiting increasingly from technology investment, which is helping to increase customer service and should increase the customer lifetime value as well.

Both have benefited actually to some degree from COVID. Dunham, interestingly, less than you might think. It was actually deemed to be essential for the first two lockdowns and non-essential for the third. So, they’ve had their shops closed for a while now. However, they’ve carried on trading well, and that has come around principally because of their online sales. And this is a part of the business that has really developed over the last few years. In the second half of 2020, the digital revenues, for example – this is home delivered and click and collect – were up 110% and now represent 35% of revenue of that business. And if you go back not that long for five, seven years, that would have been close to zero. So, it really shows the impact, really the necessity of having a multi-channel offering now.

DM: And by multi-channel you mean an online and offline presence?

CSJ: Yeah, that’s right. Stores and an online presence. Yeah. And being able to give customers great flexibility in how they shop, how they pay, whether they go in and collect the goods from in store, or they have them delivered at home, or whether they just go in and look around stores and buy when they’re there. We’ve seen the demise of the high street, or ongoing issues in the high street, I should say, and so where these companies have their stores is very important. And part of the due diligence as a fund manager is to have a look at that. And you, I have to say Dunelm has been a long-term holding and if you speak to landlords – and I’m not talking about recently, but over the last sort of 10, 15 years – there’s always been a very consistent story that they’ve been very judicious with the leases that they take on, and the locations they take on, and that now stands them in very good stand, relative to those who are just sort of happy to open their stores anywhere from what I could see anyway.

[13:41]

DM: And Pets at Home and multi-channel, what are they doing, right?

CSJ: Yeah. Pets at Home again, offering a great multi-channel flexibility. They have stores, you can buy online as well. Again, a company that I think most of the benefits will be ahead of it actually, in terms of the investment it’s made from a technological perspective. And this business model I think is very interesting for a number of reasons, but one in particular, and that is the ability of a retailer to generate some annuity income. By that I mean, as a repeatable income stream from its consumers. If you think about the sort of the process of pet ownership, and we have dogs at home, you know, there are monthly, there are annual, there are quarterly, and in fact daily pills that you have, you know worming, flea, food, health care plans, these are all products that consumers buy on a regular basis. And what Pets at Home is starting to do very well is to increase things like people who are a part of their VIP membership for example, they’ve got 5.7 million active customers currently, and over time it’s hoped that number will grow, and that the customer base itself will buy more products and services on a repeat basis. And that really offers something that retailers couldn’t give investors access to even as a little ago as 10 years.

[15:22]

DM: Yeah, good recurring income always helps. So maybe then just to finish, and we’ve probably come full circle talking about the UK market as a market and how, you know, overseas investors look at the UK stock market. One option that obviously foreign companies have, is to buy British companies. What do you think about mergers and acquisition or M&A? Do you suspect that will pick up as we go through the year or not?

CSJ: Yeah, it’s been, UK equity ownership has been yeah, since 2016 has been a pretty clear and consistent flow of capital away from UK equities. As a consequence of that, on a relative basis, UK equities look cheap, certainty when you compare them to international equities, if you look at the mid cap space and compare the cost of debt and the income you can get from these businesses, they also look cheap on an absolute basis.

And it’s been quite frustrating sitting here as a mid-cap investor, when I look at the returns you’ve been able to get in this space. You know, we talk about, you know, annualised returns and over 10 years, the mid-cap space returned 8.7% a year. That was up to the, to the end of December 2020. But if you look over a longer time period, the numbers are very similar and indeed the annualised return over 30 years is just a little short of 11%. So, you can see, and that really has come about because this is an area rich in businesses that have the ability to change and adapt and grow and increase their economic output. And that hasn’t changed. So, from where I sit, it can be quite frustrating seeing these great businesses and the lack of interest international investors have.

Now, what I find interesting from an M&A perspective, yeah, we have seen M&A pickup, and it really started to pick up in the middle of last year. And that said to me that there were people out there who were prepared to take a long term view, that saw this area as cheap and saw this area as having interesting value.

And what I’ve also found interesting is that the M&A that we’ve seen, the buyers have been not only private equity buyers and financial buyers, but corporate buyers as well. And they’ve been domestic UK buyers, and they’ve been international buyers, and we’ve also seen from an M&A perspective, a very broad spread in terms of the end, the end markets, these customers are exposed to – companies like McCarthy & Stone on the housing side, Urban & Civic property as well, Codemasters which is a gaming company, Applegreen, which some people may have seen around those petrol forecourts, RSA in the FTSE 100. So, a really broad, diverse spread of businesses and, given the spread between the cost of debt and the income that you can earn from these businesses, I suspect it’s going to be something that we see more of going forward.

DM: Well, given we’re just approaching five years to the Brexit referendum, maybe there will be some genuine interest in UK equities and the richness that the mid-cap index and active stock pickers like yourself can find plenty of opportunity in that area, which may get some support at last. So, Chris, thank you very much for your time.

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