278. Competitive advantage and the power of a strong brand

28 September 2023 (pre-recorded 12 September 2023)

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]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. Today we’re focusing on company-specific factors such as competitive advantages and long-term growth potential, highlighting a few household names such as Apple and Pepsi.

I’m Staci West, and today I am joined by David Dudding and Alex Lee, co-managers of the CT Global Focus fund. David, Alex, thanks for very much for joining me this morning.

David Dudding (DD): Thanks for having us.

Alex Lee (AL): Thank you

[INTERVIEW]

SW: So, I want to start with the bigger picture. Is there a growing optimism in the global economy? What are companies kind of saying to you guys on the ground for the outlook for the next 1-2 years maybe?

DD: I think it really varies region by region. So, I think we’ve all been surprised a little bit by how strong the US economy has been in the face of, you know, some very significant interest rate increases over the past year -18 months. And so, the US economy’s been going absolutely gangbusters, so I don’t think the economy there is probably improving. You know, it has to start slowing down at some point, but I think at least people are optimistic that there’s not going to be a recession. And that the mythical … well, hopefully not mythical soft landing is going to be reached. So, you know, that’s a fantastic scenario, but I wouldn’t say it necessarily means that things are improving. It means that’re likely to not be as bad as once been feared.

If we turn to other parts of the world, I mean, China obviously economic growth has been slowing fairly quickly. And I think there are more concerns there about what the economy’s doing and whether the government is going to stimulate or stimulate enough, and indeed what it can do.

And similarly, Europe [is] pretty lacklustre. I think some economies are probably in recession right now. So, yes, it may get a little bit better, but again, a lot depends on sort of oil and gas prices. It looks like we’re heading into another winter of war in the Ukraine. And so, I’d say the outlook has quite possibly bottomed, but it’s fairly muted, nonetheless.

AL: I guess as you mentioned, trends are different region by region. And then if we’re speaking to companies as well, trends are different, sector by sector. And even within sectors, trends are different.

So, I guess if we take industrials, for example, if we look at areas like construction machinery, the environment’s been very strong, maybe stronger than many people had expected for longer. And earnings of these companies continue to be pretty good. And we’ve spoken to some companies recently and they remain optimistic on the outlook. But if we speak to factory automation companies within the industrial sector, there are definitely clear signs that the environment has been slowing. I guess again, related to China, the Chinese economy has been quite weak. But the Chinese, there was a huge amount of investment in EVs, for example, in China over the last couple of years. And suddenly investment there has definitely taken a tumble and that’s hurt some of the automation companies.

Other areas like semiconductors, semiconductor kind of earnings in that sector have been weak for the last year or so. And that’s having a knock-on impact to the automation companies. So yeah, within sectors, I think there are … sometimes people would look at the industrial sector and often many kind of sub-sectors would be quite correlated, and we have seen some of those correlations break down, so, it’s really important to look at the world, not just from a top down view, but really understand what’s going on from a kind of a sub-sector level and a company-specific level.

SW: Is that how you approach this fund then? More on a sector / sub-sector level than perhaps a regional outlook?

DD: I’d say we’re very bottom up. And there are a couple of things worth highlighting around that.

So, basically, we obviously pay a little bit of attention to the macro, particularly if you’re investing in something like a bank then, you know, that is obviously very tied up with a local economy. So, it’s false to say that we don’t spend any time looking at the macro. But basically we try and spend as little time as possible, and that may sound a bit sort of flip, but basically we’d rather know … we’d rather be owning companies that, if not in control of their own destinies, at least are beneficiaries of long-term trends. And as long as the long-term trends are okay, then we’re prepared to weather some short-term turbulence if economies slow, etc. etc.

So, we’re not sort of constantly changing ideas depending on our view of local or regional economies because our information is no better than anyone else’s when it comes to predicting what’s going to happen in economies. And even if we did know, quite often we get the results of those predictions wrong. So, the best example of that came in 2016 where we didn’t think Brexit would happen. The fund owned quite a few UK stocks and they all went up after Brexit. So, we did well out of Brexit despite not thinking it was going to happen.

And then we didn’t think in Q4 of 2016 that you had the US presidential elections, and we basically thought that Hillary Clinton would win. So, we got that completely wrong. But if you had told us that Donald Trump was going to win the elections, we would’ve said, oh, well we’ve got a really well-positioned portfolio for that because it’s sort of lots of good long-term stories and basically the market’s going to sell off very dramatically because it’s not going to welcome the prospect of a Trump presidency. And exactly the opposite happened. So basically, US banks, construction companies, companies that would benefit from a much stronger US economy did very, very well. And that was basically ahead of Donald Trump actually becoming President in the January of the following year. So, Q4 2016, we didn’t know who was going to win the election. We got that wrong, and then we got the impact wrong as well, and so that basically proved to us that there’s not much point us doing that sort of thing. And, actually, we’re much better off trying to focus on long-term fundamentals of the businesses that we’re investing in.

SW: Well, let’s talk about some of those businesses then. You have taken some new positions recently in the fund in Apple [Inc.], PepsiCo [Inc.] and CRH [plc]. What is it about these companies – maybe if we can take them each in turn – what is it about them that you like? Is it the company fundamentals? Is it these long-term trends that you’re seeing? Give us a little bit more information.

DD: Yeah, well if I go through Apple and then … I mean basically what we like about Apple is, well, it’s probably the world’s greatest brand at the moment. And, you know, brand strength is one of the key things that we look for. We try and look at everything through a lens of competitive advantage. And, you know, we think that there are five sources of sustainable competitive advantage. One would be intangible assets, which includes sort of brands, patents, that sort of thing. And then you’ve got cost, scale, switching costs, and the network effect. And Apple you know, certainly it has an incredibly strong brand, but increasingly I think as well, and it is becoming the … surprisingly, I mean, it surprises a lot of people, but Apple is not the biggest handset company in the world in terms of volumes. I mean, it’s about to become the number one we think. It is by value, because their phones sell [at] a massive premium compared to everyone else’s.

What Apple’s been incredibly successful at is really developing a whole ecosystem around phones, effectively. So, as most people who have an Apple phone realise, it’s quite hard to leave once you’re sort of tied in. And there’s still room for them to grow in markets like India, but increasingly new products as well. But a lot of the growth now is being driven by services, so consumption of products based around the handset or the wearable or whatever device it is. And that is a very sticky revenue stream where the company has a lot of pricing power and people tend not to switch out of the Apple ecosystem into that of someone else. And that means that it’s relatively quite a slow-growing company, but it’s very visible and sort of very sustainable growth.

And then, you know, this is a company that doesn’t make too many acquisitions, certainly not very, very big ones, and so they basically return a lot of the profits back to shareholders in the form of buybacks in particular. So, what we call the capital allocation, what they do with all the profitability, is very much in investors’ favour.

SW: I love that description of an ecosystem of Apple products and how difficult it is to get out once you are in <laugh>. That is very accurate. Alex, maybe if you can tell us a bit more about CRH and the appeal for that company.

AL: Sure thing. Yeah. As Dave mentioned, we look for companies with competitive advantage. We tend to be a, well, we’re known for being a quality fund. And often quality funds will look for simply companies with very high sustainable returns. But kind of we look at quality more through a lens of competitive advantage. And we’re happy to buy companies with maybe lower, but rising returns on capital. And I think CRH ticks this box. CRH has got very high barriers to entry in its industry. It’s very difficult – or it’s going to be very difficult – to build out new supply for cement going forward. And so CRH operates in an oligopoly. And so, we think that the sustainability of its returns are very visible going forward. The demand environment is being helped, especially in the US, by localisation of supply chains. And again, we think that the demand growth could accelerate or could be stronger over the next decade than it has been over the last decade.

And another area where CRH has got an advantage is in its ability or its  technology around recycling. So, increasingly there are mandates for production to be done or construction to be completed using recycled materials. And CRH is ahead of the game here, so I think that helps to set it apart from perhaps some of the smaller players that can’t afford to invest in these areas. So, all in all, yeah, we do see CRH as a company where the returns can rise over time. These returns can be very stable and sustainable. And we’re also very focused on valuations. So, we saw a lot of upside in the company when we started that position. And yeah, it’s done quite well so far, but yeah, we still expect upside from here.

DD: And Pepsi. [SW: And I was going to say, and Pepsi, what is it about Pepsi?] Again, it’s the strength of the brands. So, Pepsi has a drinks business, you know, and a good business, so many more brands other than just the original Pepsi – things like Gatorade – but it also has an incredible snacks business, particularly in the US, but also Mexico. So, it’s making basically … so, that business is Frito-Lay effectively. And these are incredibly strong brands and that shows itself by tremendous amount of pricing power. So, basically, just recently when there’s been a lot of inflation in the US and indeed worldwide, and input costs have gone up, packaging costs, fuel costs, etc. etc., they’ve been able to raise their prices on their products without really seeing much in the way of a deterioration of volumes because the brand strength enables them to do that. So, its snacks business is a particular highlight, at least for us when it comes to Pepsi. And it just sort of shows the resilience of companies if they have very, very strong brand equity.

SW: And this fund also has a few positions in Japanese companies in an area that legendary investor Warren Buffett has topped up recently, and it was kind of in headlines again. So, do you see the weighting increasing in the future? What is it about Japanese companies more in particular that you like?

AL: When it comes to Japan, as we explained earlier, we don’t really look at the world based on regions. So, we look at the world based on kind of companies and where the great companies are, and we’re very lucky working at Columbia Threadneedle, where we have a huge amount of resource. So, we have teams of people looking at every region. So, you know, we have a very large team, including analysts looking at the US, we have teams looking at Europe, UK, Asia, and we also have a team looking at Japan. So, sitting on the global desk, we’re very lucky whereby we’re constantly being given great ideas from around the globe. So, we’ve always been looking in Japan and we’ve always felt that Japan has some very, very good companies. Perhaps where Japan’s been lacking over the years has been the companies have not always prioritised return on capital or had a particular focus on return on capital. And, as we mentioned, we do look for companies with high or rising returns on capital. Over recent years, I think the – supported by better corporate governance – or actually over the last decade or so, there’s been much more focus in Japan on return on capital and improving return on capital. And I think we’re really starting to see that today in the market where you look at some of the action that’s been happening in the market recently.

But as we mentioned, we’ve been looking at Japan for a long time. We’ve held positions in companies like Keyence [Corporation] for a great many years. But we do think that perhaps there are companies now that might enter our universe or perhaps the investment opportunities will increase because of this increased focus on return on capital, better governance, more focus on or rising quality of some of the companies in the region.

But yeah, you mentioned Warren Buffett. So, I think Warren Buffett invested in a number of large trading companies. We don’t actually own the trading companies in the [CT] Global Focus fund; the regional fund does own some of the trading companies and I think his investment was seen as endorsement in that specific area, and those companies have performed very well since. He’s mentioned there might be other companies he’s interested in in Japan. But we’re not going to, I guess, try and second guess what he’s going to do. We’re just going to look at where we see the opportunities are and, yeah, I mean, I guess it’s a good boost for the region to see a famous investor like Warren Buffet coming in. But we’ve always looked at Japan and we do see a lot of opportunities there.

SW: And you can also venture into emerging markets when you see opportunities. So, are you seeing opportunity? Or you invested in any emerging market companies today in the fund?

DD: Well, we’ve always been able to invest in emerging markets and we do. So, we have positions in Indian and Indonesian banks in particular, and those are both economies that we’re very positive on over the next four or five years. I think what makes them stand out is that they’ve got very young populations so, as Japan has led the way in terms of the ageing of the world’s population, and now China is following on, India and Indonesia are basically, you know, very big countries, very big populations, but very young populations. And that means there’s a lot of demand for things like the products that banks sell, et cetera, et cetera. But it means they’re pretty dynamic economies and we think well-placed of the medium term. So, we’ve always had some emerging market exposure.

But another thing we do is get emerging market exposure via developed market companies that have significant exposures there. So, you know, that’s where a lot of European consumer staples companies, for example, have very big presences in India or China. So, luxury goods companies obviously depend a lot on the Chinese consumers, so, that’s been something else that we’ve been looking at for the past few years. So, we have a lot of exposure to emerging markets, but it’s not all via direct investment in emerging market companies.

SW: Moving on then lastly to something that you had in a recent update, which was that investments in companies that tackle issues such as decarbonisation and energy efficiency are creating a broad opportunity set. So, can you give us an idea of what these opportunities are, what type of companies they are, and then if you’re investing in any of them?

DD: Well, I think this summer has sort of really highlighted the impact of climate change. We’ve seen sort of significant fires in Europe and natural disasters around the world. So, climate change is a theme that’s not going away. So, it’s inevitable that decarbonisation is going to throw up lots of opportunities. So, you know, we are very much taking advantage of those and invest in companies that either improve energy efficiency or actually can lower carbon emissions. And that can take many shapes or forms, really. I mean, it could be sort of automation – just simply making things more efficient. Or it could be companies that make products that actually, you know, make a more efficient building, for example, like Schneider [Electric SE], it’s a French company. But basically, a lot of what they do is around making factories more efficient or buildings – particularly non-residential buildings – be more fuel efficient. So, there are sort of myriad of ways in which we can tackle those themes.

Another big holding of ours would be an industrial gases company called Linde [plc]. They’re going to play quite a big role, we think, in terms of sort of things like carbon capture and storage, or green hydrogen. They’re a gases company, and so they have to be part of that equation as we try and decarbonise the global economy.

AL: Yeah, I guess the opportunity set is very broad and, as Dave mentioned, we do expect a lot of money to be put into this area and towards solving what is inevitably going to become an increasing problem facing the world over the next decades. But when we come back to it, ultimately, we’re going to look for the companies where they can make good return on capital and where they can differentiate themselves, and where they have strong barriers to entry to find the winners in terms of investing in this space.

DD: We don’t want to invest in something because of a theme. You know, it’s just we’re looking at how each and every company’s valued and what sort of returns we might be able to make out of it. But there are obviously probably some underlying themes within the portfolio, which decarbonisation and energy efficiency is certainly right up there.

SW: Well, David, Alex, thank you so much for joining me and talking through a number of different areas and companies as well within the funds. It’s all very interesting to hear your views on them and really appreciate you taking the time to talk to us.

AL: Thank you very much Staci.

DD: Thank you.

SW: The CT Global Focus fund is a concentrated, high conviction portfolio of best ideas with a clear quality growth bias. To learn more about the CT Global Focus fund, visit FundCalibre.com – and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.