Fund In Focus: US Focus August 2024

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Transcript

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[00:00:00] Nick Peters: Hello, my name's Nick Peters, Investment Advisor at Marlborough, and this week I'm joined by Brad Weafer, who's the Fund Manager of the Marlborough's US Focus Fund, and the fund was previously known as the US Multi Cap Income Fund. Hi there, Brad.

[00:00:16] Brad Weafer: Hi, Nick. Thanks for having me.

[00:00:18] Nick Peters: Absolutely no problem. So, yeah, I highlighted the name change, being other changes with the fund as well.

[00:00:23] Nick Peters: Do you just want to take our listeners through the rationale for those changes?

[00:00:28] Brad Weafer: Sure. First, I actually think it's important to consider what isn't changing. Our investment objectives have always been to deliver a compelling total return to investors by investing in a very select group of highly profitable, competitively advantaged companies that can earn durable economics through a full cycle, specifically the challenging part of the cycle.

[00:00:49] Brad Weafer: And we look for companies that have the ability to grow per share profits over time. This clear discipline on finding high quality companies is the bedrock of our investment loss. That's not changing. The other differentiating component I would add is that we're not only comfortable, but I think it's absolutely necessary to look different than the rest of the herd and construct a portfolio that's dissimilar to the standard passive indexes.

[00:01:12] Brad Weafer: For differentiated results, you really do need a differentiated portfolio, and that's been a consistent part of our approach and the fund since we've been involved. What we are unable to do under our previous income mandate, was benefit from the skills of our management teams and boards at some of the companies we own with respect to capital allocation, is the dividend the correct choice over share repurchases when a stock's undervalued?

[00:01:35] Brad Weafer: If a company can earn a high return on invested capital by investing in growth initiatives, shouldn't we as shareholders applaud that? In today's environment, we think it's a more flexible mandate in this regard makes the most sense. Don't get me wrong, dividends are a great signal of stability, profitability, and quality.

[00:01:52] Brad Weafer: We like the discipline that a quarterly dividend places on management, but we think investors can benefit from uncompounding effect of growth investments made prudently at all of our companies.

[00:02:02] Nick Peters: And just to reinforce that it's sort of business as usual, what do you think the yield of the fund will be going forward? So the ballpark.

[00:02:10] Brad Weafer: So today the portfolio yields somewhere between 1.5 and 2%, reasonably consistent with the S&P 500. We wouldn't expect material changes or material turnover in the fund. At our core, our investment philosophy and process and approach isn't changing at all. We would expect maybe to add a couple of names to the portfolio that we wouldn't be able to add without the income mandate today, so not significant turnover or change in the portfolio or the yield that results from that portfolio.

[00:02:38] Nick Peters: Okay. That's very clear. Thank you very much. Let's move on to recent activity in the portfolio. What's been going on?

[00:02:46] Brad Weafer: Well, we're really excited about the opportunity in one of our latest additions to the portfolio, a company called Equifax. Many of you may know Equifax as one of the three dominant US credit bureaus. They keep data on would be borrowers for mortgages, auto loans, and credit cards. And they're a critical piece of the consumer credit ecosystem. This is a highly competitive advantage business. It's very profitable. It has grown nicely over time through pricing and the expansion of access to consumer credit.

[00:03:16] Brad Weafer: Equally attractive, but probably less known, is their other main business, which is income and employment verification. This is another data set that's crucially important for credit and employment background checks. And Equifax is the dominant provider of this data and it has a similar attractive profitability and growth profile.

[00:03:34] Brad Weafer: The opportunity that we're excited about in Equifax today is that a significant driver of decision volumes happen in the mortgage application process, you know, mortgage rates have gone up significantly as interest rates have risen, and that's significantly depressed mortgage activity. If you were to look at mortgage application volumes, they're down 75% from peak and 50% from what we would see as normalized levels.

[00:03:57] Brad Weafer: If you think through the very high incremental profits that Equifax earns on each additional score or incremental application, the profitability is very, very high. So any pickup activity would have an outsized impact on their profits. We think this is well under recognized in shares today. We aren't making a prediction that these volumes are going to return soon, but we do think that they'll happen over time, and with the benefit of a longer time horizon, we can really benefit from a coming boom in profits, you know, through the next cycle.

[00:04:27] Nick Peters: I understand the excitement, and it does seem to tick the boxes of what you flagged earlier, competitively advantaged companies, durable economics, ability to grow earnings over time, so I'd be interested to see how that develops over time.

[00:04:41] Brad Weafer: Yeah, we are excited about it. It ticks all the quality boxes that we look for with a really nice growth opportunity in the future.

[00:04:49] Nick Peters: Okay, so we can't get through a podcast with a US fund manager without talking about the election. What's your take on the current picture?

[00:04:57] Brad Weafer: I love this question. I love that we talk about it every six months. Look, just when you think things couldn't get more dramatic in American politics, the last month happens.

[00:05:06] Brad Weafer: I mean, really, just in the last four weeks, we've had a sitting US president have a debate performance so disastrous that it had his own party questioning his physical and mental acuity to serve four more years. Ultimately led President Biden to withdraw from the race in favour of his Vice President Kamala Harris.

[00:05:25] Brad Weafer: There was a subsequent assassination attempt on former President Trump, and a number of public gaps from Trump's choice of running mate, J. D. Vance. It's made things very, very messy. This is, of course, just the last month, and it follows what happened before that, which was former President Trump being convicted of a crime.

[00:05:42] Brad Weafer: I really wish I was making some of these things up. It's a made for TV movie. You know, boiling it down, at the end of the day, it's been like this in the US really for the last 25 years. Current odds highlight that this is a 50 50 electorate, and, you know, if you're trying to predict the outcome of the election, good luck to you, I think it's still highly uncertain.

[00:06:02] Brad Weafer: And I don't think I can even guess what's going to happen over the next three months before we actually go to vote in November.

[00:06:08] Nick Peters: And as you said, it's great to talk about and takes up a lot of column inches, but our findings suggest that actually whoever's in power, it has little impact on the stock market returns.

[00:06:19] Nick Peters: Do you concur?

[00:06:20] Brad Weafer: I do. You know, if you look at the numbers, historically, the broad market implications of which political party sits in the White House has not made a material difference. You know, in our opinion, and I think this is supported by history, the business cycle trumps all others and dictates way more than the difference between Democrats and Republicans.

[00:06:38] Brad Weafer: I would say, you know, I do think it's a little naïve to say that what happens in Washington doesn't matter. When it gets down to it, it's policies that matter much more than politics. So we're keenly interested in the implications of any changes to regulations, rules, laws, and their impact on our individual companies.

[00:06:55] Brad Weafer: You know, really, we try to avoid situations where there's binary risk that a policy change could really hamper a business that we own. But it really does take ongoing effort to stay on top of each and every company we own, and what the policy implications are, but we are doing that each and every day.

[00:07:12] Nick Peters: Okay. Changing the subject completely.

[00:07:15] Nick Peters: We talked in the past about the Magnificent Seven. And how their performance has made life very difficult for some active managers from a relative perspective. But very recently there seem to be signs that the market is broadening out. A relief for you I'm sure, but what are your thoughts?

[00:07:31] Brad Weafer: It's easy to go from genius to dummy to genius again in a short period of time.

[00:07:36] Brad Weafer: What a difference a few weeks make. If we were having this discussion a month ago, it really would be a conversation. You know, performance for the first half of the year was some of the most concentrated in history. With only 24% of the stocks in the S&P 500 outperforming the broad index. And the largest six stocks, that's just 1 % of the companies in the S&P 500 generated over 60% of the returns in the index for the first six months.

[00:08:01] Brad Weafer: That as you say, is a very challenging environment for active managers who even attempt to build a modestly diversified portfolio. Seemingly in a moment, that trend changed, you know, in early July. Since then, we've seen a major difference by size and style and a broadening out of those stock market returns.

[00:08:19] Brad Weafer: That's a very good sign, I think, for the health of the overall market and for the prospects of active managers like us to show our value. We've seen that borne out in our own performance here on the last month, and it's, I think, a very encouraging, you know, forward looking statement on the value we can provide to investors.

[00:08:37] Brad Weafer: Despite the broadening of the last few weeks, though, we still think the bellwether market cap weighted S& P 500 index is way too concentrated. The top 10 largest stocks in the index now make up over 35% of the index. It's not a terribly representative picture of the broad us market. It's a less compelling investment story too, because the largest stocks in the index are trading at significantly higher valuations than the average stock.

[00:09:02] Brad Weafer: On top of that, their growth expectations are very high. And we've even seen this earning season that modest changes in expectation is having big impacts on some of those very large companies.

[00:09:11] Nick Peters: And linked to that point about valuation, we calculated the fund is now trading at the lowest premium to the S&P.

[00:09:19] Nick Peters: Since you started running the fund back in 2016, first explain why you'd expect the fund to trade at a premium to that index? And secondly, what's the premium range you've seen over the life of the fund?

[00:09:32] Brad Weafer: So, you know, I've listed a few of the attributes we look for in individual companies: strong profitability, more certainty on the stability of profits.

[00:09:39] Brad Weafer: Lower financial leverage, better and more profitable growth, and frankly, a greater percentage of accounting earnings transitioning to cash earnings. Those are all obviously attractive attributes and all else equal. You should pay more for those attractive attributes and historically the companies that we own do trade at a premium.

[00:10:01] Brad Weafer: I mean, think about it. Those companies create more value. So, it makes sense to pay an above average multiple for an above average company. The fund's average multiple has traded at a premium to the broad market, you know, on average, it varies year to year, but I would say a 20% premium has been, you know, a reasonable benchmark for us.

[00:10:20] Brad Weafer: Today, in part because the market is expensive and us finding more idiosyncratic opportunities, like in Equifax, the portfolio is trading at a very modest premium to the index. We're really encouraged by the opportunity that we're finding to find value against that concentrated and expensive benchmark.

[00:10:39] Nick Peters: Thank you. And just to finish, any further thoughts on the investment environment at the moment?

[00:10:44] Brad Weafer: We always have opinions. We're firm believers. Stock prices follow the profits of the underlying businesses, right? And in the US and a good part of the global economy, you know, the economy is so growing. It's not gangbusters, but it's healthy levels.

[00:10:57] Brad Weafer: Inflation is falling and policy looks like it's set to get easier in the back half of the year than it is today. That environment is supportive for earnings growth and stocks broadly. Having said that, you know, I don't think it's a scratch to suggest we're closer to the end of the business cycle than the beginning.

[00:11:15] Brad Weafer: We're paying attention to the labour, the consumer markets in the US for signs of stress. But forecasting and timing any turn in the cycle is incredibly difficult. So rather than trying to predict it, we try to prepare for it. We think that the businesses we own are well suited not only to maintain profits, You know, up and through the down cycle, but strong businesses like these also tend to get stronger and down cycles and are able to take advantage of any eventual recovery better and easier than firms that aren't well positioned or are over levered or are forced to make short term decisions because their businesses are suffering.

[00:11:50] Brad Weafer: So, we feel very good. No matter what happens to the economy and the broad market that we're well positioned to take advantage.

[00:11:56] Nick Peters: Okay. Excellent summary. very much for your time, Brad.

[00:11:59] Brad Weafer: Thanks, Nick. Always happy to chat.

[00:12:01] Nick Peters: That was Brad Weafer, fund manager of Marlborough's US Focus Fund, and please visit our website if you'd like to find out more information about the fund.

[00:12:13] Nick Peters: Thank you and goodbye.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of recording and should not be construed as investment advice. The opinions expressed are correct at time of recording and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.