215. Why the UK stock, bond and currency markets hated the mini-budget
Darius McDermott and Juliet Schooling Latter return to discuss the third quarter of 2022. After a...
LF Blue Whale Growth fund has come storming onto the global equity funds scene since its launch in September 2017. It is a truly active fund with a very concentrated portfolio of just 25 to 35 stocks. The fund only invests in the highest quality businesses, although the manager pays close attention to valuations. He also ignores structurally challenged industries or businesses.
1 March 2022 (pre-recorded 28 February 2022)
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.
Staci West (SW): Welcome back to the Investing on the go podcast hosted by FundCalibre. In this episode we’re discussing big names like Amazon and Meta, Facebook’s parent company, but it’s not what you think – these names aren’t top ten holdings. Instead, today’s manager has exited his position in a number of popular names and is here is tell us more about his thoughts for the future.
Ryan Lightfoot-Aminoff (RLA): I’m Ryan Lightfoot-Aminoff and today we have the pleasure of welcoming back Stephen Yiu the Elite Rated manager of the LF Blue Whale Growth fund. Stephen, thank you very much for your time.
Stephen Yiu (SY): Thank you, Ryan.
RLA: Now last time we spoke to you, you told us why you wouldn’t touch the likes of Zoom and Netflix. Those two companies… their share prices have tumbled quite a lot recently. This must have helped performance of your fund in the most recent months?
SY: Yeah, I recall that we have spoken at length about Netflix and Zoom, because I think these two companies were kind of the defacto pandemic winners back in 2020. And I think the one thing that has always been on our mind, based on our research, is that the switching cost for these two companies in terms of services is pretty low. And I think that that is what we probably have seen over the last six to nine months that Netflix has not managed to get as many subscribers as they wanted. And at the same time, I think some of their subscribers have probably gone on to the Disney+ and I think similar with Zoom, that some people probably are now using Teams to do some of the online calls.
I think what happened recently in terms of in the market is, I mean, I think avoiding some of this disaster has been helpful to the performance, but I think we probably would have a bit more conversation in terms of what happened recently, because I think we are not immune to the indiscriminate sell-off in the market, but I think not having the disaster, that when, if, when the market were to recover, then I think we are in a very strong position.
RLA: And maybe another sort of more controversial one, you’ve recently sold Amazon, PayPal and Meta the parent company for Facebook. Does that mean you think that their growth stories are over?
SY: I think I would probably come back to Amazon last. I think for PayPal, there’s a bit of a concern now in terms of the credibility of the management team. So Dan Schulman, which has been one of the highly rated management team in the tech industry, in the US, he’s now close to running the company for about seven to eight years, since 2015. And at the same time, I think if you track the performance of PayPal versus the NASDAQ 100 index for the last seven to eight years, that the PayPal shares has actually underperformed the NASDAQ 100 index, which is a bit concerning if you are, you are the management team, who’s been running it for years. And I’m sure as we’re probably closer to the time that shareholders or maybe the board would demand, that could be a potential change of management team.
So I think if you are looking in terms of the uncertainty who is going to be in charge of this company, then you can argue that the thesis has been broken because whatever PayPal’s manager achieved over the last eight years, I think if you, we were to have a new management team going forward, that growth trajectory could be quite different. And hence, I think from a shareholder perspective like ours, we’d rather sit on a sideline rather than sit with the uncertainty in the shares.
I think for Meta, or Facebook, I’ve probably spoken at length about this, that I think the change of direction for the company when they announced that they’re going to change the name to Meta in October last year, that does constitute to a thesis violation because the way that we assess valuation is we look at free cash flow yield over the next, let’s say three to five years. And if – I’m sure our audience would know this already – that free cash flow is defined as after capital expenditure, and given Facebook or Meta have already spent about $10 billion in building this Metaverse, which I’m sure that in the next probably 5 to 10 years they would need to spend at least $50 – $100 billion to make this successful if it were ever going to be successful, but at the same time that you don’t actually get any profit off this venture. So if you just put this number into our valuation model, that the valuation is no longer attractive and is actually quite expensive on that basis. And so I think we, I’m sure we can touch on this a bit more that we, we are believer of the Metaverse at some point maybe 10 to 20 years from today, but whether Meta/Facebook is going to be the ultimate winner, that is a big question mark.
I think last, but not least, we have also exited our position in Amazon. The fees is really is about that. We are a bit concerning about inflation in terms at least for as far as the retail business is concerned. As you can imagine that with all the trade wars that’s going on between the West and the East, the supply chain issues at the same time wages inflation in the warehouse, logistic delivery, et cetera, that is not going to disappear anytime soon. And I think it is slightly fortunate that Amazon in the recent resales few weeks ago, they decided to raise the prices for the Prime membership in the US, which is about $20 a year increase. But if you really do the calculation in terms of the kind of the monthly increase, we’re only talking about $2 per month in terms of increase. And as we all know, sitting here in the UK, or maybe mostly in London, that you know, that Prime membership, sometimes they get you not only same day delivery, but could be within like the next two hours or three hours. So paying $2 additional a month, probably doesn’t really cover the core increasing cost in terms of what you get as a Prime member. But at least Amazon has managed to offset some of the increasing costs. So it’s not the end of the world, but they would definitely be making less money from here as far as the retail business is concerned. So I think that has not changed. And we’re glad that we have exited the position.
RLA: And just coming back to Facebook, you said you sold it. You said you’re willing to buy back again. It does show that you are quite flexible and pragmatic in your approach, which makes it does help you stand out from your peers.
SY: I think that’s a fair point because I think one thing that we have, sorry, acquired over a number of years, or if you do follow some of our companies, that even though many of our companies are of exceptional quality, or the management team are of exceptional calibre, but things does change over time. And we have spent so much time following some of these companies such as PayPal or Facebook or Amazon and it is always very costly in terms of time that we have spent on this company to then decide to exit the position, because then we have to do repeat this, the level of work that we have accumulated on a new company. And so that we can continue generating performance for our investors.
And I think for Facebook or Meta the challenge now is I think that two things, I think for Zuckerberg to decide to spend tens of billions on to this Metaverse, which is a bit unproven at the moment, as far as Facebook is concerned, that does destroy the thesis, that investment thesis, that we originally had for Facebook. And I think what is going to change from here is I think either if Zuckerberg decides not to pursue this Metaverse interest, then maybe we could look at it again. But obviously given what they have just done recently to change the name of the company to Meta then it’s unlikely it’s going to happen anytime soon. I think the second part then is that at some point, if Meta could then demonstrate that they could actually generate some profit on a back of this Metaverse investment, then maybe we could look at it again, to consider whether that valuation would be attractive at the time. But I think at the moment you just don’t have any of this certainty.
And I think people need to remember that we run a high conviction mandate around 25 to 30 holdings in the fund. At the moment we only have 25 holdings and to put this money to work with the level of conviction that I think the level of scrutiny that we would apply to a company is pretty high. I think in contrast if for a global fund that runs, maybe I don’t know, 75 to 100 holdings, and maybe Meta or Facebook is only 1 of the 100 names you have in your fund with a very small position, then maybe it’s fine. You can just wait it out. You can see what happens in next few years, but when you’re running a high conviction mandate, I think everything counts. And we would rather sit on the sideline that we don’t think we are missing out because we do have other better companies in the fund that we feel that we don’t need to take that level risk or uncertainty to put our investors money to work.
RLA: And you’ve mentioned in a few things that you think a couple of themes for 2022 will be sort of the 5G rollout and the continuation of this digital transformation. Let’s start with 5G, what do you like about this theme and how are you playing it in the portfolio?
SY: We yeah, we do like the 5G. I think one thing that 5G does, or similar to a bit similar to fibre is we would ever be consuming a lot more content like on a mobile phone, like anywhere that we are, we could be working remotely, sitting on a beach and still able to do some conference calls, et cetera, et cetera. And I think one thing on the back of that is not only that this is going to power or enhance a lot of digital transformation in terms of how we conduct businesses, or how we conduct our day-to-day life. But at the same time, there’s a lot of data that we generate on the back of this 5G. The kind of the penetration of 5G or the fibre onto the cloud, let’s say onto the cloud data centre. And one thing that we know already, that all this data that has been generated from us are quite valuable to a lot of businesses in terms of the analytics they can perform in terms of our shopping habits, in terms of the recommendation they want to make to us on a real time basis, et cetera.
So one company that we have been a big fan of since last year, that it was a new addition to the fund, to our top 10 last year, was Nvidia and Nvidia I’m sure some of our audience would have followed the company that back in the old days, that Nvidia was all about gaming and crypto mining, but what’s happening now or going forward in the next three to five years at least, it’s all about utilsing Nvidia’s GPU, which is a very powerful processing unit on, in the hyperscale cloud data centre. So that when we, let’s say when we are going onto the YouTube, we watch a certain program and then suddenly you get recommended some similar video that you may want to see. And then obviously if you go to an Amazon website, you bought something and suddenly some recommendation come to you quite quickly.
So historically before we have the 5G or the fibre, like by the time they make the recommendation to us, it could be based later, like by the time that they make recommendation, we would no longer be interested, but now with all our data on the cloud and also with the very powerful GPU that Nvidia produced, that they could make recommendation to us on a real time basis. And you are talking about like, I think globally that probably around maybe 2 billion kind of smartphone users or people who have some access to the internet. So you’ll talk about 2 billion of individual recommendation systems, which is very powerful. And obviously that’s only possible with the 5G and the fibre.
RLA: And moving on the digital transformation, the digital infrastructure story, do you have an example of that theme in the portfolio and what’s the appeal behind it? Other than we talked about software, so what about the hardware and things?
SY: We probably are not probably less of a fan on hardware. So I think one feature, sorry one of the more prominent features in the fund under this digital transformation theme is that we do like software businesses. And I think Microsoft is one of, has been one of the top holdings in the fund since we started. And I think recently we have actually made the holding even a bit bigger compared to before. And I think one thing that you come across about software business is not only that they’re not constrained by supply chain, because at the moment, if you are talking about any sort of like hardware capability, that a lot of that will be constrained by supply chain. And then secondly, that if you are purely a software provider, that you will be able to roll out new software to your customer base quite quickly. And I think Teams has been a good example for Microsoft that you don’t actually need to download manually this Teams onto your PC. I think one day we just woke up switched on our PC and then you see this window that says, pop up to say, oh, it’s Teams, maybe you want to sign up here and suddenly all of your colleagues have started using it. And then you’re part of this ecosystem.
And then the other thing about software is last year for Microsoft, they announced that they’re going to increase their prices for the Office 365 subscription by 15% to 20% this year. So this 15% to 20% increase in prices is going to kick in from next quarter. And given that the switching cost is very high, that you are, you’re not only using Teams, you’re using Outlook, you’re using the Windows, et cetera, that we are going to pay for the price increase. So that is only possible when you have some sort of software or subscription model.
I think hardware, I think some hardware companies could do well, but then you do get the other side of the fence that may be when the world is a bit uncertain, then maybe capital expenditure in terms of buying new hardware could be reduced, et cetera.
RLA: And then moving on sort of the, some of the bigger themes in the world, inflation is a massive buzz word of moment. Seeing a lot of it, you’ve talked a lot about the pricing power of your companies and being able to get those through. But what about those that can’t, what else do you feel that they need in order to succeed and what sort of impact’s inflation going to have on your investing choices going forwards?
SY: Yes, I think that the two things that we could talk about here, I think the first part of the conversation is definitely related to the companies – how they operate in the inflationary environment and there are two parts of the equation to make a company to be quite inflation proof. The first part is pricing power. I think a lot of people talk about pricing power, but still, I think you need to differentiate the magnitude of the pricing power because that you, on one side, you have Microsoft, which could increase prices by 15% to 20% with no customers going, without losing any customers. On the other hand, you could have, let’s say maybe Unilever that could raise prices by 3% to 4%. So the magnitude is different, but then the other part of the equation, which is equally important, I don’t think many people talk about this, is the gross margin. So gross margin is the difference between the revenue line and how much you pay to the external suppliers before it comes back to how much money you have to pay the internal staff or your offices, et cetera.
And typically, for the FTSE 100 index, if you use FTSE 100 companies as a collective, the gross margin is only about 30%. So 70% of the revenue that FTSE 100 companies make are paid to external suppliers, which means that you can’t actually control those costs. And if you look at the world stock market, it’s about 40%, which is a bit better than the FTSE 100 index. If you look at Unilever, it’s about 40%, look at Amazon on a combined basis, including the AWS, it’s about 40%. But if you look at software businesses for Microsoft, the gross margin is about 70%. So when you have a company with very high gross margin, 70%, so only 30% of the revenue lines are paying to some external suppliers. Then at the same time, you are increasing prices by 15% to 20%, you could actually be making more money on the back of the inflation narrative in contrast to the lower gross margining businesses. Even though that you can raise prices, but because like you have to pay a lot to external suppliers then at best you’ll be able to protect your operating margin, which is not making more money, but at least you’re not making less money.
And if you look at our fund, the LF Blue Whale Growth strategy, the weighted gross margin for our fund is 70%. Because I think I already talked about earlier that we do have quite a lot of exposure to software businesses, so not hardware companies, and for software businesses high growth margin is what you get.
RLA: Well, thank you. And I know we’ve talked about a few companies already and a couple that you’ve sold, but just to end, can you maybe talk to us about sort of a recent addition to the portfolio, especially in the light of volatility that has been in the market
SY: So late last year that we have added a new company called Charles Schwab into the fund. So I think if people are familiar with the investment market in the US, that Charles Schwab is the largest investment platform. So similar to in the UK will be similar to the likes of Hargreaves Lansdown, or AJ Bell, or interactive investors, and what we like about a company is not so much that it’s going to benefit from an increasing interest rate. So basically for the US customers that they have, that typically the customer would maintain about maybe 10% of the portfolio in cash. And obviously if you are holding cash with the investment platform that you don’t actually receive much interest, even though that interest rate is going to go up. And what Charles Schwab is trying to do is to pay you a bit of interest, but at the same time, they will use the money to invest into high yielding asset, which is how they make the money.
But at the same time on top of the, that recently they have acquired a very close competitor called TD Ameritrade in the US. So that acquisition actually strengthened the competitive positioning of Charles Schwab at the same time that there’s a lot of synergies that go behind the scene that they could probably consolidate some of the back office or the technology platform, et cetera.
And I think last but not least, if you, you follow Charles Schwab in terms of the company, that the customer base are pretty sticky because the average customer base would be over the age of 50, at the same time, the portfolio that they have on average would be over 200K US dollar. So if you, do you equally follow Robinhood as part of your research that you would know Robinhood’s the average portfolio size will be a few thousand dollars, which is quite small sum and then, over time, I think in terms of structural growth story is like, if you do believe that the American household in general are pretty robust in terms of the economy, in terms of people getting a bit wealthier, then they have this natural tailwind in terms of the asset that they manage over time.
But obviously what has drawn us into investing into Charles Schwab now, rather than let’s say three years ago, was to do with the fact that they are quite the closest competitor at the same time interest rate is going to be a tailwind for them in terms of profit. So then you put all these together into our valuation framework that then the valuation is looking pretty attractive at the moment.
RLA: Brilliant. Well as ever thank you very much for your time Stephen, it’s been really interesting. And hopefully we can, that 5G story does play out and I can be on the beach when we do this podcast next time.
SW: Launched in 2017, the LF Blue Whale Growth fund, has come storming onto the global equity funds scene. As Stephen alluded to in today’s episode, it’s a truly active fund and a very concentrated portfolio. The manager only invests in the very highest quality businesses and, although the fund may not have been around for long, its strong performance has certainly drawn attention. To learn more about the LF Blue Whale Growth fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts. Stephen’s previous comments on Zoom are part of past episode 92.
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 the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.
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