Global equities: Finding sustainable competitive advantages

Chris Smith, Portfolio Manager, Intermede Investment Partners

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In this episode, Paul is joined by Chris Smith, Portfolio Manager at Intermede Investment Partners, to discuss some of the opportunities and challenges facing global equity markets. With markets being at all-time highs, Paul and Chris address rising inflation concerns, geopolitical risks, emerging markets opportunities, ESG, and the importance of finding companies with a demonstrated sustainable competitive advantage.

 

 

Transcript

Paul O'Connor (POC):

Welcome to the Netwealth Investment Podcast series. My name is Paul O'Connor and I'm the head of investment management and research. Today, we welcome Chris Smith from Intermede Investment Partners Limited, who is a portfolio manager of global consumer for the Intermede Global Equities Fund and is based in New York. Good morning, Chris, and thanks for joining us for today's podcast.

Chris Smith:

Thank you, Paul. Thank you for having me on.

Paul:

Intermede is a boutique London-based asset manager, founded in April, 2014, that specializes in active global equities. The firm is majority owned by the investment team and manages circa U.S. eight billion in funds under management. The global equity strategy aims to outperform global equity markets by identifying well-managed companies with strong market positions in attractive industries and purchasing them at discounts to their intrinsic value. In particular, Intermede looks for companies with a demonstrated sustainable competitive advantage. Intermede define their investment style as growth at reasonable price or gap, and the global equities fund is an active long only global equity product.

The portfolio is relatively concentrated, targeting around 40 stocks across both developed and emerging markets. Chris is a portfolio manager with over 16 years investment experience and covers the consumer sectors. Working alongside Intermede founder, Barry Dargan and Artesian Partners at London, he was a global sector analyst. And prior to this, he worked for investment managers in the U.S. covering drug retail and healthcare distribution, global consumer sectors and consumer finance companies.

Chris holds an MBA from Harvard Business School and a BBA in business administration from the University of Michigan and is a CFA charterholder. The Intermede Global Equities fund is available on Netwealth super and IDPs investment menus. All growth assets, including global equity markets are at all time high valuations. And whilst this is not unusual, the valuation multiples are unusually high, which leads to the question of where markets can sustain this pricing, and particularly if the U.S. Fed commences tapering.

Paul:

The extraordinary QE program that really they've been under for the last 15 years. Rising inflation is further fuelling debate about normalizing monetary policy sooner rather than later. And all of this in the backdrop of rising COVID infections globally with the new Omicron variant. So it looks like the strong returns from global equities over the last decade or so may be harder to achieve in the next 10 years. And the advent of newer technologies such as blockchain will result in some disruptive influences on companies. And I suspect there'll be some big winners and big losers out of that. Perhaps to start with, Chris, you tell us a bit about yourself and your career history and what led you to be a portfolio manager with Intermede.

Chris:

Yeah. I think if you go back to 2010, I was working in New York for Sanford Bernstein on the sale side. That's where I was following drugstore chains and pharma distribution companies. This came after a couple years at a hedge fund called Diamondback covering consumer staples firms. At that time in 2010, I was looking to get back onto the buy side and investment management and was hoping to move to the U.S. West Coast, but ended up moving in the other direction to London, after a few good conversations with Barry Dargan, who was running a fund at a U.S.-based fund manager and is now the lead portfolio manager at Intermede. Since then I have covered consumer staples and consumer discretionary sectors. This has been quite exciting given all of the changes that have taken place in those sectors. At Intermede, I also have broader portfolio management responsibilities, which cut across all sectors.

Paul:

Well, let's say you've certainly had a fairly diverse background there, Chris, and covering, I guess, healthcare and also consumer staples and consumer discretionary. So you must have a little bit of technical knowledge in pharmaceuticals and the broader healthcare sector there. So an interesting combination, your background. Intermede is a relatively new manager to the Australian market, Chris. So can you tell us a bit about the business and what your core investment foundations are?

Chris:

Yeah, sure. So the business is relatively new, though, it's starting to get a bit more mature. We set it up back in 2014, that was Barry Dargan, the lead portfolio manager, me and two other analysts. Three of us had worked together for a few years, managing the global equity fund at a U.S.-based investment manager in London, before we then set up Intermede. As for Barry, he was a portfolio manager at MFS, going back all the way to 2001. We've now been managing client assets for over seven years in Intermede. We have eight people in total on the investment team, and we're all focused on finding high quality, well managed businesses with sustainable competitive advantages. We pay a lot of attention to valuation and aim to put together a portfolio of names with above average growth and returns generated free cashflow yield of 4% plus on a forward basis. Currently with valuations where they are, our portfolio is on a free cash flow yield of 4.0% for 2023, so in line with that currently.

Paul:

I read your November monthly report and was interested in how you expressed your primary mission, which is to identify and understand high quality growth businesses in possession of defensible competitive moats. Most managers talk about quality and economic moats in their investment philosophies, but all have different views, I guess, on what these mean. So can you make a few comments around how Intermede view quality and defensible moats, and how does this guide your focus as we enter 2022?

Chris:

Yeah. I guess so for us, a quality business is one that can grow its revenues consistently over time. So we have a minimum that we require companies in our portfolios to meet on that metric, and that's at least 5% revenue growth per year. At that level, that is a company that's growing nicely above global GDP growth. We also like companies that have high margins and that can improve their margins over time, as we mentioned before, and also companies that are light users of capital and are able to give a lot of cash back to shareholders as well, which that combination for us should result in a company that can grow its earnings per share by at least 10% a year. Those are the sort of businesses that we look for.

And again, those type of companies to be defined as quality for us need to have a sustainable competitive advantage, which could come from the factors that I mentioned before in tangible assets scale, also network effects are very important and certainly play a big part of the advantage of a lot of the technology companies that we have in the portfolio, to name just a few.

Paul:

So Chris, given the market is around all time highs, can you find these types of businesses that can be board at attractive valuations today, or is everything expensive?

Chris:

Yeah. It's an interesting question. I would say, I mean, markets are at all time highs, but so are operating margins and earnings, and businesses are thriving currently. For us, I think there's a real advantage to be able to look globally for investments. And in my experience, you always see some pockets where stocks are at attractively priced. Currently, the U.S. market in particular looks expensive on a lot of metrics, but even there, if you were to look at the NASDAQ, for example, it's up by around 20% this year and only six stocks account for all of that gain plus some. So if you look beyond those six stocks, there are a lot of stocks that are down for the year, and there are quite a lot that are actually down 30% or more from their high.

This provides a good opportunity for those looking at stocks individually to add value. Another area that has been a significant lagger this year is emerging markets generally. I mean, as a group, they're actually down year to date, so that another source of potential opportunity. So I think if your investment universe is broad enough, you can always come up with a good set of companies and we're able to construct a portfolio that we're quite happy with from those opportunities.

Paul:

Yeah. Well, I guess that makes sense. So Chris given how large that investment universe is, I'm not sure how many thousands of stocks would be in the MSCI all country, but it's certainly a large fishing pond for yourself and Intermede there. Geopolitical risk appears to have risen significantly over the last months with China's tensions, and now news that Iran is closer to nuclear enrichment. China has been difficult for investors and China's increasingly appears to be using their dominance in global trading to punish countries, mainly via tariffs and countries, this is on countries that hold different views on issues such as Taiwan, the South China sea and China's ethnic minorities. What's Intermede view on geopolitical risk? And can you discuss how you were positioned in China or exposed to the China's market and how you're thinking about this market moving forward?

Chris:

Yeah. I would say China, it's one of the top two economies globally, it is the source of a lot of global growth and it does have an array of very interesting listed companies, so it's definitely a market that we pay a lot of attention to. We have investments in companies with significant business from China, such as the luxury goods firm, LVMH, and also we own Chinese domestic names. In that bucket, at the start of this year, we had two names in the portfolio, Mate One and Alibaba. Mate One is in food delivery and also hotel bookings and Alibaba is the leader in e-commerce. We sold out of Mate One due to concerns around the regulatory environment and also the valuation on the shares back in January and have kept Alibaba, which has been in the portfolio since 2015, given its dominant position in e-commerce, which is the world's largest e-commerce market. That is a 2% position for us.

If you think about the Chinese market over the last couple of years, 2020 was a reasonably good year. China had COVID pretty well under control, life went on as normal for the most part, and the market performed fairly well. 2021's been much more difficult. Fiscal and monetary policy have been tighter than other places in the world. Also, there has been a continued effort to fully suppress COVID, which has held down economic activity. It's seen, especially in the consumer space that I follow. And then of course the regulatory environment has become much less favourable for firms in many areas, but especially in education, in gaming, both online gaming and also gambling gaming as well, and then in e-commerce. Going into 2022, we do see things, maybe looking a little bit better.

Monetary policy in China is loosening a bit while the rest of the world is going in the other direction. And also the rest of the world is now dealing with rising COVID cases again, putting the countries a little bit more on par, at least China versus the rest of the world. And maybe the markets can do a little bit better for the year.

When we look at our portfolio, we have only a 2% weight to China that compares to 60% for the U.S. So a huge gap there. We have definitely been spending a lot more time looking at names in China, and we did add a team member during the year to help us with that effort. So for us, it remains an area where there are attractive investment opportunities, but there are certainly a large number of risk and rising risk, and the investment environment for an international manager has certainly gotten not as favourable as it was in the past, to say the least.

Paul:

Looking towards 2022, what are some of the opportunities and concerns that you and the Intermede team are focusing on?

Chris:

Yeah. So there has been a lot of volatility in the market, especially in the last few months, which has opened up some potential opportunities. Some of the names in the software space are looking more attractive, for example. If you look at a company like Adobe, which we have a position in, it's a leader in digital content creation, it's down more than 20% in just a month. In the payment space, you've seen valuations come in, quite a lot. Visa, MasterCard, have seen their PEs fall from 40 to 50 times to 30 to 35 times during the year, while PayPal, that stock is down 40% from its high, just set back in July. Then in some areas like e-commerce, which did well during the initial phases of the pandemic, you've seen significant selloffs. Chewy, which is the leading online pet goods retailer in the U.S., it's down 40% this year, MecardoLibre is the Latin American e-commerce leader, it's down 30%. Farfetch is the leading online luxury goods seller, and that's down actually more than 50% year to date.

So there are definitely some significant pockets of opportunity out there we think, and we're quite excited by that. I wouldn't say that was the case maybe at the start of the year, where valuations across the board were a bit more uniformly high. So that's quite interesting and exciting for an analyst like myself. As far as concerns as we go into 2022, monetary policy has been incredibly loose across most of the developed markets, and this is going to be tightened at least in the earliest part of the year. And this is in the context of a global pandemic that will unfortunately still be with us in high levels inflation that may or may not come back down. So we think it's going to require great skill and some luck to not tighten too much, harm and growth, or to not tighten quickly enough, necessitating more aggressive tightening later on. So I think that's what we're most worried about.

Paul:

Yeah. It's certainly a fine line that the Central Banks need to walk over the next few years there. And which leads me into the next question around, there has been that much talk and debate around inflation and really whether the recent spike in inflation is structural or whether it's transitory and built on by perhaps COVID induced supply chain shortages. If rising inflation does have a structural element, this should lead to Central Banks increasing their tapering of QE policies, which has the potential to significantly impact on global equities and all growth assets, I guess. Does Intermede have a view on this and how does a play in portfolio construction? Are there any sectors of the market industry, specific companies that can really provide inflation protection?

Chris:

Yeah. Inflation has certainly become a much larger topic as the year has gone on. And certainly, in our daily lives, we're seeing it. Prices are up, there's also stockouts across a wide range of products, including things like just trying to buy a car in this country's quite difficult. And inflation overall is at a level not seen since the '80s in the U.S. at the moment. We think that if you focus on companies that have pricing power, they will be able to manage much better than companies that don't through a period of high inflation. The companies that don't have the pricing power are going to be the ones that suffer the most impact on their profit margins.

If higher inflation does lead to higher interest rates, then share prices could be hurt with the greatest risk for the most highly rated shares. And we've already seen how large drops in some of the most speculative names in the markets. For Intermede, we have a portfolio of businesses with strong pricing power, and we pay close attention to valuation. We hope that this will help the portfolio hold up well with what comes next. And I would say we do have a position which we talked about before Schwab, which is our largest actually in the portfolio that would benefit from higher rates. It's a company that earns a spread on client cash, and that spread becomes quite narrow and rates are at low levels, which they've been pretty much zero for a while, so earnings would rise significantly for that company. So that's an example of one of the types of companies that might do well.

Paul:

Is the growth of ESG Investing having an impact on listed company valuations? And I guess we hear about it so often now, and not a day goes past with myself without ESG coming up, and what have you. And I guess what I mean by that are companies that are well regarded from an ESG perspective trade starting to tick up to high valuation multiples versus companies that I guess don't meet the standard of ESG.

Chris:

I think it's interesting. It would seem like that would be the case. And my sense would be that would be happening given all of the assets flowing into sustainable strategies. I haven't, I would say seen strong evidence of that. I mean, maybe you could argue that some of the reason some of the large technology companies have ever higher market caps in the trillions these days is partly down to ESG Investing, given those companies typically rate pretty well.

For us, ESG analysis, it's part of analysis we do on any investment opportunity. We assess what risk a particular company is exposed to from an ESG perspective and also assess what the biggest ESG related issues are for that business. If we're comfortable with the risk and the company's efforts to address any of the substantial issues that it faces, we are willing to qualify a name for purchase. We then track the company's progress on its ESG initiatives and engage with management along the way. So for us, it's embedded in what we do. And I would say given the types of companies that we're investing in, the portfolio tends to score pretty well on ESG related matters.

Paul:

And that, Chris, sounds like a common sense approach to me in terms of dealing with ESG and the growth of ESG, the ability to, I guess, have dialogue and influence companies is really what capital markets are all about. So, yeah, yeah, it certainly sounds like a sound approach there. Just back, maybe on the emerging markets that we touched on China earlier, but what's your thoughts on the broader emerging market universe, maybe just parking China to one side and certainly given that Intermede can invest up to 30% of your portfolio in emerging markets. So can you talk about your exposures and whether that's been rising or whether you've been trimming?

Chris:

Yeah. So when we set up, we did have a decision to make regarding emerging markets, whether we wanted to have an emerging markets included in our investment universe or not. We chose, as you mentioned, to have a limit set up to 30%, because we do see a lot of the growth going forward and the world coming from emerging markets. So therefore we thought it is definitely an area we wanted to have the opportunity to invest in. We do invest in developed market companies that have substantial sales and profits from emerging markets, and we also invest directly in emerging market names. In the first category, you'd have companies like an LVMH that I mentioned before, it has over 40% of earnings coming from emerging markets. In that case, it is largely China, but we also have Heineken in the portfolio that has 65% or more of its earnings coming from emerging markets, that's countries like Vietnam, Brazil, and Mexico.

Over time, we have had between 10 and 15% of the portfolio in companies listed in emerging markets. And that set of companies does include some of the global leaders like Taiwan Semiconductor or Samsung. These are companies that, I mean, they could be listed anywhere really, including in a developed market. And then we also have companies that are local champions, such as HDFC, which is a leading mortgage firm in India, or as I mentioned before, Alibaba in China. So for us, it's a bit of a mix. It's some developed market company exposed, and then it's global leaders in developing markets and also local champions in some of those emerging markets.

Paul:

Yeah. It's sort of interesting there, the growth of the large and almost mega cap companies in the emerging market universe. And really, I guess that the geographic location to a degree becomes irrelevant with a company like Samsung, as you mentioned there, Chris. So yeah, I think it certainly makes sense to keep the lens as broad as possible when you're an active manager and considering your investment universe. And I guess for the last few years, I've thought to myself, it doesn't make a lot of sense not to include emerging markets in your universe there.

Paul:

It seems to be a bit of a historical just binary decision that was made at years ago to only invest a lot of your competitors to invest only into the MSCI world. So, yeah, it certainly makes sense there. Maybe to finish with, Chris, the global growth fund manager universe is very large and I guess on the reverse, the value universe has shrunken considerably over the last maybe decade. We have so many managers that sound similar to you on this podcast. So in your words, can you sum up what really differentiates Intermede and sets you apart from the other growth managers?

Chris:

Yes. So I would be happy to. I would say that if you think about our business, we set it up to ensure that we could be focused on finding quality companies. They grow revenue by 5% a year, earnings by 10% a year. We have eight people on the investment team, 15 people in total, and we have one strategy. There isn't much management required of this business. We're willing to be patient, we're happy to identify great companies to track them and potentially to not make an investment for several years, if we don't feel the price is right. In the past, we've been able to mean downside protection in falling markets, and we don't believe that many managers do growth investing with evaluation discipline the way that we do.

Paul:

Yes. I tend to agree with you. When you look at the average PE on some of the portfolios in the competitors, it can be quite eye watering. But just to conclude there, Chris, thank you very much for joining us on the Netwealth Investment Podcast series this morning. It's certainly been interesting to understand a bit more about Intermede. I'll be honest, I didn't know a lot about Intermede as a manager, but as a boutique manager, and I guess it certainly makes sense that when you have a business and you are just focused on one product, I think it can really differentiate a manager from a manager trying to offer different strategies across all types of asset classes. So thanks for joining us there, Chris. We do appreciate your time and your insights that you've provided this morning and all the best to the business for the year ahead in 2022.

Chris:

Best year as well. Thank you for having me on, Paul.

Paul:

And to the listeners, thank you very much for joining us again on another instalment of the Netwealth Investment Podcast Series.

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