Quality: An evolution of positioning, but not principles

Over time, economies evolve, and markets adapt to a new normal, but principles do not need to change. We have steadfastly applied our purist quality approach for over 17 years, remaining resolutely focused through a variety of market conditions. The inherent adaptability of our approach has enabled us to effectively evolve the portfolio over time as the quality opportunity set and sources of free cash flow (FCF) growth in the market have themselves evolved. Global Franchise’s sector exposure looks very different now to a decade ago, but this is a by-product of bottom-up stock selection, reflecting where we are finding the most attractive individual quality ideas at any given time; importantly, the bottom-up resilient quality attributes we seek have not changed over the years.

Figures 1 and 2 illustrate the sector evolution of Global Franchise and the corresponding Return on Invested Capital (ROIC) for the consumer staples and technology sectors.

Source: Ninety One, FactSet, 30 September 2024. The portfolio may change significantly over a short period of time.

There has been significant disruption in the consumer space in recent years, with the rise of e-commerce distribution and digital advertising reducing barriers to entry, enabling smaller brands to proliferate and reducing the dominance of established consumer brands. Related to this, the trade-off between quality, growth and valuation for many consumer companies has become less attractive relative to other opportunities. As such, we have reduced our exposure to those companies most impacted by disruptive threats, such as food and certain household products, and found more opportunities in select, high quality, attractively valued and cash-generative technology stocks.

Our definition of quality technology businesses

It is important to stress that the technology sector is not homogenous. Technology sits right at the heart of many of the world’s most successful businesses, regardless of their industry classification, and we apply our rigorous bottom-up fundamental research process to identify the most attractive opportunities globally. In particular, we look to invest in high-quality technology businesses with established monopoly-like market positions, secular growth and sustainably high profitability; importantly, at reasonable starting valuations. We typically prefer subscription rather than transaction-based revenue models, as these are more consistent, reliable and resilient. At the beginning of each year, the majority of a company’s revenues are committed or even paid already for those with upfront payment terms, making a subscription model the highest quality revenue stream available.

Given our quality focus and valuation discipline, we do not own high-multiple, non-profitable technology companies with immature financial and business models, that have historically relied on cheap financing to grow. These businesses were particularly hard hit in 2022 as interest rates started to rise and the market, quite rightly in our view, became increasingly concerned about the optimistic valuations attributed to businesses with low (or non-existent) levels of profitability. Subsequently, many of these companies have suffered further in the face of general macro pressures, rising costs and an increase in competition. On the contrary, we believe the quality characteristics we look for should provide more resilient performance and compound steadily over time. In addition, we are mindful of business tail risks such as platform obsolescence, regulatory risks around data privacy, antitrust legislation and taxation.

Technology exposure within Global Franchise is concentrated in the software and cloud computing space, with the likes of Microsoft, Intuit and Autodesk¹ all benefitting from strong underlying secular growth. Each of these companies has very strong competitive positioning within their respective industries. Enterprise software businesses have highly attractive characteristics in the form of recurring revenue streams, often through subscription-based models, strong pricing power, rising margins, exceptional cash flows and very strong balance sheets. The types of software businesses we seek tend to be more reliable and defensive and provide better visibility into future cash flows than, for example, many tech hardware businesses.

Figure 3: Global Franchise technology sector exposure by industry group

Source: Ninety One, FactSet, 30 September 2024. This is not a buy, sell or hold recommendation for any particular security. The portfolio may change significantly over a short period of time. For further information on investment process and specific portfolio names, please see the Important Information section.

Consistent quality profile

Evolving the portfolio on a bottom-up basis has ensured that Global Franchise’s quality profile remains resiliently strong in both absolute and relative terms. Figures 4 and 5 show how a focus on companies with the key quality attributes we seek has delivered sustainably high ROIC, and led to portfolio holdings with faster and more resilient FCF compounding, averaging well over 10% p.a. over time:

Sources: Ninety One and FactSet, 30 September 2024. Re-weighted excluding cash and equivalents showing metrics of the constituent companies, since inception. * MSCI All Country World excludes banks from free cashflow yield calculation, classified in the Banks Industry Group according to GICS. **FCF CAGR means compound annual growth rate of free cashflow. For further information on indices, please see the Important Information section.

Figures 6 and 7 consider the counterfactual case of the Global Franchise portfolio over the last 10 years, assuming no changes were made to the portfolio constituents and weights from June 2014 (47% exposure to Consumer Staples and 12% exposure to both Technology and Financials sectors). The diverging quality characteristics are stark. We believe investment approaches that anchor predominantly or solely to traditional defensive sectors are likely to risk degradation in the quality attributes of their portfolios, lower sustainable FCF growth and, as a consequence, worse investment outcomes over time. We strive to maintain a balance of exposure across defensive, durable and dynamic FCF growth stocks, such that the portfolio maintains exposure to 10%+ FCF growth at the overall portfolio level.

Sources: Ninety One and FactSet, 30 June 2024. Re-weighted excluding cash and equivalents showing metrics of the constituent companies since 2014. *FCF CAGR means compound annual growth rate of free cashflow.

Therefore, while the quality opportunity set has evolved over time, our principles have not. The key quality characteristics we track (FCF generation, balance sheet strength and profitability) are as attractive now as they have been in the 17 years we have been managing the Global Franchise strategy. This should enable quality compounders to continue growing, irrespective of the macro environment.

¹ No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.