210. Using dividends in the fight against inflation

8 September 2022 (pre-recorded 5 September 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.

[INTRODUCTION] 

James Yardley (JY): Hello, and welcome to the Investing on the go podcast. I’m James Yardley and today I’m joined by Ben Peters, the manager of the TB Evenlode Global Income fund. Thanks for joining us today, Ben.

Ben Peters (BP): Pleasure.

[INTERVIEW]

JY: Now, Ben, your fund is a global equity income fund. How can this help investors to combat inflation?

BP: Yeah, well, I think inflation’s obviously very much in the news at the moment, hitting record levels, – levels not seen since I was a boy. And I think when it comes to investing, in the short term, there really aren’t any perfect hedges for inflation. But over the sort of medium to long term, then equities are not a bad place to be. And particularly equities, companies that can generate dividends sustainably through time, by generating a lot of free cash flow. 

So, the types of companies we look for at Evenlode Investment, they tend to generate a lot of cash flow compared to the amount of assets that are required to run that business. And they can grow that cash flow sustainably through time. And what that means is, if they can do that, and they are producing goods and services that society wants and needs even in inflationary times, that they will be able to grow their revenue in line or ahead of inflation.

They have to invest – reinvest – some of that cash flow that they’ll generate from that revenue back into the business to drive the growth, but not too much. Which means that when the costs of their own inputs go up, it’s not such a big impact on the business. And through time – and you saw this in the last bought of inflation in the 1970s, 1980s – companies actually did manage to price their products appropriately through time and maintain the profitability and cash flows of the companies through time. So ,short term, it’s clearly a difficult picture, both for individuals and companies when it comes to inflation. But income-generating equities are not a bad place to be over the longer term.

JY: So, you think your companies can hold their margins? How are they sort of holding up so far? Are you negative in the short term, but you’re confident in the long term? 

BP: Yeah, absolutely. So, I think the consumer goods sector has been the most sort of immediately impacted on the margin front, their own costs have gone up and it’s really sort of all the input costs for a consumer goods business. So, transportation, packaging, raw materials,,, have all seen reasonably significant increases in terms of the input costs. 

On the flip side, those companies have been raising prices to the end consumer and, really, it’s that pricing power that we are looking for over the medium to long term. Short term, they are managing to maintain margins or at least reduce the impact of input cost inflation by cost cutting measures. They can only do so much of that, and they certainly shouldn’t be cutting the critical costs that they need to run their business, like advertising and promotion – for a consumer goods company that’s very important.

But they do have another mitigating factor also, which is high margins. So, when it comes to passing on costs to consumers, actually to maintain profitability they don’t need to pass on all of those input costs, all of that input cost inflation to maintain profitability. So there are some mitigating factors, but certainly short term, we are seeing some impact to margins for those businesses, but it’s not just consumer goods. Most sectors are seeing some impact even in sort of very knowledge-based sectors like information technology, wage inflation is running a relatively high level as well. But again, these are businesses that generate high margins, which mitigates the impact somewhat. 

JY: And I believe, after many months of virtual meetings, you’ve finally been able to get over to meet some companies on the ground in the US. So, can you tell us about a couple of those meetings and what did you learn?

BP: Yeah, well it was the team found very receptive hosts after a couple of years of Zoom and Teams and virtual meeting. People were very happy to welcome us back. We do like to go and see companies where they are, where at all possible. They tend to be a bit more comfortable in their home environment, but also we get a sense of what the culture and what it’s like to work within that business. These tend to be multinational businesses, so we can only learn so much, but we get a little taste, a little flavour of what that business is about by going and seeing them where they are. So, we saw a lots of businesses across different industries. 

So, a couple I can pick out – a holding in the Evenlode Global Equity fund actually, is MasterCard. The team saw it. They went and learned more detail about their consumer business that would all be familiar with when we’re doing our day-to-day spending on our debit and credit cards. But they also learned about a potential new avenue which could be significant, which is business to business transfers, because currently most business transfers happen by bank transfer which can be expensive. It can take a long time. And so, the card networks are seeing a potential significant new line of business there. 

In a completely different world, the team met with a company called Analog Devices. This is a company that makes semiconductors, but it’s analog semiconductors rather than sort of processing chips that the likes of Intel might make. So, these are components which might measure temperature, that sort of thing, in your smartphone, deal with the wifi signal ,those sorts of things. So, it’s a very interesting business. These tend to be quite low-cost items. They’re very important to the operation of say your mobile phone. The team heard about the challenges of innovating in that space, because you are dealing – when these components deal with the real physical world which is uncontrollable. So, there are challenges in innovating with these devices. But they also have a challenge because there’s a shortage of engineers. So, Analog Devices has a 10-year training program that they take their employees on and train them, so they can have the security of people with know-how to deliver what they’re doing.

This is a company that’s not in our investible universe at the moment. They have just recently announced quite a big capital expenditure program in order to take in-house some of the manufacturing that was previously sort of outsourced to the supply chain. We wanted to understand a bit more about what the steady state capital requirements of that business are before we would add it to our in investible universe. So that was more on the research side. 

Mastercard is a current investment in the Evenlode Global Equity fund as I said. So that’s more of a how’s a current investment [going].

JY: Yeah. Because you typically prefer the capital light businesses, don’t you? So, I guess you want to understand what’s going on there before…

BP: Absolutely. And really.. but one of the things – going back to the inflation question – that we like about asset-light businesses is that inflation protection. You know, if you’ve got a lot of capital that’s required in a business, that capital, the cost of that capital in an inflationary environment will grow, and in absolute terms, the more it is ,the more the absolute increase of capital expenditure would be. So, yeah, it’s something we do look at quite closely in all of the companies that we analyse. 

JY: And what are you hearing on supply chains at the moment? Because we’ve heard sort of different things. I mean, some places, it seems like things are getting much better, other places it’s still, there’s still difficulties. I don’t know what Analog Devices was saying and that sort of thing?

BP: Well, yeah, I mean, in the world of semiconductors, that’s been… there has been a lot of different things. Well-trailed through the pandemic was the difficulty that auto manufacturers were having getting semiconductor components and that did limit their manufacturing. We’re still seeing a lot of disruption. Companies are reporting continued disruption as a result of the pandemic. Really, it’s about kind of logistics and things like ships being in the right place, containers being in the right place around the world. When ships couldn’t dock because of fears that COVID would be imported to the country that they were going to, then what was a well-oiled global supply chain suddenly ground to a holt, and we’re still seeing the effects of that, coming out of the back of the pandemic. 

We’re also seeing, it’s important to remember, you know, in the West and then the UK, it feels like back to normal. And easy to forget this is only about six or seven months ago that we were still in lockdown. But this is still happening, particularly in China where they’re still pursuing a zero-COVID policy. So, it is clearly a global manufacturing hub, very important for global supply chains, and still and so we’re still going to see some of the effects of that policy being enacted in China. All of that disruption has sort of collided with spikes in demand as industries have got back going after the pandemic as well. So, it’s quite,.. there is the supply challenge, but there’s also the demand picture, which has until recently been very strong in fact, as we’ve come out of the pandemic. So, there’s an awful lot going on. 

And on top of that, we also have the spikes in energy prices that we’ve seen and on some commodities as a result of Vladimir Putin’s invasion of Ukraine. So, there is an awful lot going on. What we’re seeing in terms of companies is companies using cash flow to invest in inventories to secure supply. So, they can secure price, they can secure the supply of the components and inputs they are using into their manufacturing processes. That means that has had an inflationary effect. And then, as I said earlier, we are seeing them raise their prices to the end consumer. And it is really important that we see these companies that they are making those investments. So, they continue to invest in the critical functions of their business, you know, research and development for say healthcare technology companies. You know, we really want to see companies continue to invest and companies that generate a lot of cash flow, like the ones that we look for as, Evenlode Investments, are really well placed to do both of those things. So, they can whether the economic shocks but also continue to invest in their businesses.

JY: I believe you’ve cut the number of holdings in the portfolio to close to the lowest it’s ever been. I think we’ve got it 33 in June. I don’t know where it is now, but I mean, is that a reflection of, you know, the difficult times we’re in and are you really sort of homing in on those businesses you like, or is it something else?

BP: Well, it’s really a reflection of the overall market level, which despite the downturn earlier in this year, you know, we’re still we’ve still overall experienced quite a strong bull market since the start of the pandemic. So, it’s partly of a reflection of the market level. We have added like a couple of new holdings as some share prices have fallen. There has been quite a large dispersion of returns in the market as well. So, where we have seen more value – to generalise – has been in sort of larger, more diversified, globally diversified businesses, which, all other things being equal, we’re happy to have larger position sizes in simply because they’re more diversified. 

JY: Are you saying you still think valuations are a bit high and maybe have a bit further to sort of fall or multiples have further to compress perhaps? 

BP: I think overall the valuation environment is looking a bit better than it was at the end of last year. But overall, the market does look a bit expensive to us. But we are very, very able to construct a sensible portfolio of sensible businesses, trading and sensible prices in the market at the current time. What is interesting is that there have selectively been valuation opportunities to be taken in the market. I think what we were saying through the course of the pandemic and as the market level rose was, we were, the changes we were making in the portfolio were more about managing valuation risk. I think that might be turning towards more valuation opportunity. But we’ll see how it goes. I mean there was quite a big rally in the market and over the last couple of months, and we may start, we may see a downturn, but we don’t predict market movements, but we certainly react to them when they happen.

JY: And I noticed as well, you seem to have quite a high weight to Europe for a global fund. You’ve, at least on your last fact sheet, I saw you had more of a weight to Europe than North America, which is quite unusual. Is that again a factor of just valuations being cheaper in Europe? 

BP: Yeah, so that’s in terms of where the companies are listed, yes And I think that that’s fair to say there have been more valuation opportunities on this side of the pond than the other. I mean, we don’t particularly target a particular weighting in European-listed companies versus UK listed. What’s more important to us is where those companies do business.

JY: Of course, a lot of your businesses are multinationals who do business all the world, so it doesn’t really matter where they’re listed. 

BP: Yeah. I mean, it does matter in the sense that we want to make sure that they’re listed in regimes where there is good governance, where we have good access to the management teams if we want to ask them questions, that they have the right kind of board structures and so on. But in terms of where they do business, so that’s about a fifth of the underlying revenues of the portfolio come from Europe. It’s about 45% comes from North America, which is still a slight under [weight the] index compared to global GDP but is probably more representative of the actual exposure of the portfolio.

JY: And I understand you’ve just had your net zero targets approved. Could you detail your approach a bit more for us on that?

BP: Yeah, absolutely. We signed up to the Net Zero Asset Managers Initiative. We’ve had our targets approved by them. And now we’re in the process of putting them into practice and with all long-term issues, whether it’s about corporate strategy, whether it’s about governance of the company or this very important one of decarbonisation, our approaches to engage with companies first. We believe that our best chance of influencing things for the better is to have a positive relationship with companies. We don’t invest in oil producers, sort of basic materials producers and that sort of thing. First, because they don’t fit our investment criteria. There are clearly decarbonisation risks there as well. But nonetheless you know, there are emissions from the portfolio, but those emissions come largely from the supply chains of these businesses, rather than being directly emitted by the businesses.

And so there is an engagement job to be done. If you look at the analysis of the Evenlode portfolios as a whole, we’ve got about quarter of the assets that come from materially emitting sectors that are aligned with net zero by 2050, which is commonly taken to be in line with a one and a half degree Celsius, increasing global average temperatures. About half of the companies have set some targets for the long term, but haven’t yet set sufficient, short-term targets for us to assess whether they’re aligned or not. And then about a third of the companies by weight have targets, but they’re not aligned with one and a half degrees Celsius. So, in terms of the engagement strategy, those companies are getting the most immediate engagement to ask them to set targets that are in line with one and half degrees. And then to go about setting shorter term targets and then measuring against those targets. 

So, our aim is to have 100% of the invested portfolios either aligning with net zero by 2050, or under active engagement by the end of this year, we’ve done that. And then we are looking for, we have interim targets up to 2025, 2030 and 2040, based on both the alignment with net zero, and then also actual progress towards decarbonisation in absolute terms as well. As we move through time, we will ramp up our engagement and then escalate our involvement if companies are not making sufficient progress up towards particularly 2030 targets that we have, and that will include potentially using our vote at general meetings, collectively engaging alongside other investors. And ultimately, if we don’t see any progress, then disinvestment is an option, but very much a last resort. As I say, I think engagement is certainly our first port call.

JY: Yeah, no, that makes a lot of sense. And I guess in many ways you can do a lot more if you’re engaging with the company than if you just sell the shares.

BP: I certainly think so. Yeah. 

JY: And are there any new challenges arising given the short-term effect of the war in Ukraine and obviously the crazy spike in energy prices we’ve been seeing in Europe?

BP: Yeah, I mean, thinking about decarbonization – that the long-term challenge remains, of course, despite what’s going on with markets. But nearer term there are clear challenges of securing supply of hydrocarbons, not forgetting that the world today does need to continue to operate. It does need to use hydrocarbons to do that. And there’s a big challenge of making sure those are available so that both business, industry and also consumers can go about doing what they do. So, that really is a near term challenge for policy, near term challenge for companies – some companies not so much, the businesses that Evenlode invests in actually, but some companies. Overall, you know, what should happen, I think is that the case for energy independence means that renewable energies should become more of a focus from a policy point of view. But there is a lot of infrastructure that still needs to be built. So, the near-term challenge really is one of ensuring operation, longer term challenge remains the same. There’s a lot of infrastructure that needs to be built. Companies need to be demanding cleaner sources of energy. They need to be dealing with all the other things in their supply chains, like the circular economy, recycling and all these other things as well. And those aren’t changed as a result of the war in the Ukraine.

JY: And how have you found it with… so oil companies coming massively back into favour and being one of the places of outperformance this year, they are obviously not much of a feature in your fund? 

BP: Yeah. 

JY: How have you found this period? You seem to have held up reasonably well, despite sort of the big rally we’ve seen in oil and gas and commodities.

BP: Yeah. Reasonably well, the fund has underperformed the global equity income sector, it should be said. And the main cause of that underperformance is because the oil and gas sector oil or energy more generally is a reasonably big component of global income funds generally. It’s not for us, so that has held back relative performance. But as you say, in absolute terms, the fund has held up pretty well. We accept at Evenlode that we run a strategy which is different to the market and different to other funds, and when something like this happens, which is very specific to a certain sector that we don’t have exposure to, then that’s going to, that’s going affect relative performance. 

But you know, our focus is on the companies that we do look for, how are they getting on? How are they operating? Are they managing to cope with this volatile economic environment that we’re certainly in and engaging with them on long term matters. And we’re very satisfied across all of those dimensions that the Evenlode funds and the companies within them are still ticking the boxes. But yeah, it has been, but lack of exposure to oil and gas particularly has been a drag on relative performance this year.

JY: Well, thank you very much, Ben. That’s been really interesting and some really good insights there. So thank you very much.

BP: Absolute pleasure.

JY: And if you’d like to learn more about the TB Evenlode Global Income fund, please visit fundcalibre.com. And please also remember to subscribe to the Investing on the go podcast.

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.