December 2020

Fuelled rather than deterred by the disruption and uncertainty of Covid-19, the Advisory Panel conducted its second remote meeting in December.

The disruption caused by the pandemic has produced plenty of talking points and diverse opinions as to where the best opportunities might be.  Central to this was a discussion as to which radical changes the world has undergone have been permanent, and which changes have been temporary.  Permanent changes to an operating environment create the mirage of a value opportunity (or a “value trap”, where a price fall accurately reflects the change in the likely fortunes of a company), whereas temporary changes create genuine value opportunities (where price moves reflect the short term position, and under-value the long term opportunity).  Companies in this second group are likely to experience the “holy grail” of compounding price increases with volume increases as the market recovers.  Identifying these opportunities before the rest of the market remains the challenge facing all investors.

Here are a few ideas that the panel discussed: the UK has had a difficult time through the pandemic, with Brexit adding to the uncertainty, but as one of the least loved major stock markets it looks inexpensive; housebuilders were mentioned as a possible source of opportunity, especially if there continues to be pent up demand and high savings across the population; banks, airlines and pubs (at least those that survive) also look interesting as areas that have suffered, but are likely to remain relevant regardless of how the pandemic is resolved.

This led on to one of the most important issues for global markets: the possible return of inflation.  Most economists have so far thought that a significant rise in inflation is at best a distant possibility, having laid dormant for so long.  Governments’ increased activity – in the markets, in the monetary system, in the size of central banks’ balance sheets, and in directing and guaranteeing lending through the commercial banks – means that times may be changing.  The Barber Boom of the early 1970’s might be an interesting case study for the future.  Most on the Panel agreed that it is certainly worth being prepared – holding some assets that will thrive in an inflationary environment.

Peter Hollis, Russell Napier, Angus Tulloch, Ally McKinnon, Glen Finegan and the Kennox investment team.

May 2020

Due to the lock down, the Advisory Panel met for the first time not in person but over video link, to discuss a changed and turbulent world.

Energy and the fossil fuel economy, the future of global transport, the likely comprehensive change in the world’s perception and understanding of debt, the resilience and/or susceptibility of different emerging economies and their currencies, sources new and old of taxation to finance the enormous economic bill of government intervention, the likelihood of a return of inflation, the timing and shape of any recovery, the possibility of capital controls – all these and more featured in an especially wide-ranging discussion.

A major topic of conversation was the role of government in the global economy and corporate landscape, at present and in the future. The moves of the government have been extraordinary as well as widespread. The Panel felt that the reach of government into the economy was unlikely to retreat at any time soon, even after the ebb of the pandemic, and governments’ changed relationship with the banking system is especially noteworthy. This is an area where governments might find enormous attraction in keeping a finger in the pie (or should we say keeping a major influence on strategy and on lending committees). This is a step change compared to the investment landscape over the last four or more decades and requires a fundamental change in mentality.

On micro-economics, we discussed some of the current conundrums of investing – should a company’s very long term value be affected if it had to shut operations for a year? Which ones will survive and which fail? At least part of this was down to who makes that decision – the markets via emergency financings and rights issues, or government via considerations of national strategic importance. Rights issues and other capital raisings are the current rage and it is worth watching the winners and losers, but also especially the duration and scale of the capital needs of the market. The Panel will continue to monitor developments, which promise to be fascinating even if potentially discomforting.

Peter Hollis, Russell Napier, Angus Tulloch, Ally McKinnon, Glen Finegan and the Kennox investment team.

December 2019

Given elevated levels of global equity markets, the panel expects returns from the equity asset class to be muted compared to recently, and especially in the US where stocks look most expensive. Should one readjust one’s investment style for this? Good growth managers should still look for good growth companies, and value investing will still work where good stock picking avoids the companies that will not recover. Based purely on headline valuations, emerging markets look to be the cheapest, but the panel was sceptical that these would necessarily provide the best returns. There are a preponderance of state owned or directed firms, and without confidence in either property rights or the rule of law, promising returns can evaporate quickly. In addition, higher quality companies in emerging markets are often commanding a significant premium to the market as a whole.

The panel felt that the more focus the industry gives to ESG investing, the less meaningful it is becoming as a tag. It is perhaps more useful to reclassify funds into impact funds (which only buy companies that are focused primarily on having a positive impact), sustainability funds (whose fund managers believe in active engagement), and others (many of which will effectively incorporate ESG into the research in any case). There was an interesting discussion as to whether there was a potential sacrifice of returns for investors in these funds, or whether they might in fact outperform. An increasing demand for ESG funds has driven a differential in valuations of firms that are considered to be ESG positive or ESG negative, and this effect on its own has impacted short term performance. Whether this will have a meaningful positive effect in the longer term, or whether tighter investment restrictions will inhibit returns will only be known with the benefit of hindsight.

The panel also discussed a variety of points around building a culture at an investment company. Should employees be able to deal personally, even if they do so within the usual compliance guidelines (no front running, for instance)? Some view it as a dangerous distraction, or even as a conflict of interest if employees start to change their behaviour around stocks they own. Others see it as a vital pragmatic learning opportunity, in that you only really get experience when your money is on the line. Another question is how to get diversity in the investment team? An interesting observation from Rory Sutherland in his book Alchemy was that teams will be more diverse if the company hires in batches – if you hire one a year, you end up with the same mould. If you hire five at once, you can take some risks and might therefore hire some more differentiated candidates. On decision making, there will always be lots of conflicting voices, internally and externally, so part of the investment process is to absorb all the points of view, but still be able to act, even in the face of some opposition.

Peter Hollis, Russell Napier, Angus Tulloch, Ally McKinnon and the Kennox investment team.

May 2019

The Advisory Panel met with the backdrop of markets that have risen 14% in the first 4 months of the year, and a clear return to “risk on”. Information technology once again tops the sector charts (up 25%) and the more “defensive” sectors of Utilities and Health Care are up 7% and 3%. Rising markets imply that investors are feeling relaxed, but should they be? We do not live in ordinary times. There are record levels of debt being held privately and on corporate balance sheets, we have yet to ween markets of quantitative easing fully, interest rates remain at un-realistically low levels, and there are more than $10 trillion of bonds trading at negative yields. What else is on the panel’s collective mind, and what (if any) opportunities does that present.

The ugly face of protectionism: there are increasing tensions between the US and China, and this has potential to be a “trade war” of a size that will not leave any global markets untouched. China has been exporting deflation globally for many years (as the rest of the world benefits from cheap Chinese labour, and seemingly limitless output). A surprising number of people are suggesting that “low inflation” is set to last forever, but should the US impose trade restrictions on China, this will almost certainly result in inflation, and put pressure on interest rates. Japan is the biggest direct competitor for a large number of Chinese exports and could, in the longer term, be a clear beneficiary. Relatively cheap equity markets make this a rich hunting ground for potential ideas. Asset heavy companies (long out of favour with the popularity of the asset light business model) are also likely to benefit from a return inflation as the replacement cost of those business increase with a return of inflation. These are investment ideas for those with a long time horizon though, as if the RMB depreciates in the short term, this trade gets tougher before any tariffs bite.

The rise and rise of the US: Since the bottom of markets in March 2009, the S&P 500 has delivered over 400% returns (416%) in sterling terms. The MSCI World excluding the US has delivered less than half of that amount (196%). The information technology sector has delivered a staggering 555%, whilst energy has delivered less than 100% (94%). These discrepancies in fortunes are remarkable, and inevitably lead value investors to look at those sectors that have underperformed (relatively) to seek havens from what feels like a universal re-rating. The Kennox portfolio already has a significant weighting in energy names. Remember that these are oil and gas companies (no longer just oil companies), that that the world will likely need more energy over the next 20 years and not less, and that we must rid ourselves of coal (which makes up 20% of the world’s energy supply currently) before we reduce our dependence on the other fossil fuels. Remember also that switching to what currently are more expensive alternative energy sources disproportionately hurts the poorest members of society, so is not the political “no-brainer” that it is often portrayed to be. The panel also thinks that the UK market (the weakest of the major regions) may well offer some opportunities. The FTSE 350 trades at around 14x PE (excluding those with negative earnings), compared to over 18x for the S&P500 and over 22x for the Nasdaq. Whilst Brexit is causing uncertainty, it is unlikely (again in the longer term) to quite so detrimental for all of the businesses as the discount implies.

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

VALUATIONS AND LONG TERM RETURNS

2018 saw the passing of a giant in the fund management industry, John Bogle of The Vanguard Group, who was seen as the father of passive investing. He had many interesting insights into the investment industry, one of which was to break down investment returns into constituent parts (back in the June 2013 issue of CFA Institute publication). This idea resonated with us as a useful academic exercise to help investors understand where their returns are generated by different investment strategies. It was also interesting that in the opening paragraph he says: “History shows that the long-term returns of stock markets will reflect intrinsic values – a virtual certainty. But short-term variations in that relationship are equally certain, and they can endure even over decades”. Perhaps this is only the more pertinent nearly 6 years further into the current bull market.

The theory is this; Investment returns can be broken down into capital return (an increase in the share price) and dividend yield. The capital return can in turn be broken down into two parts: a growth in earnings (i.e. assuming the PE multiple stays the same, the share price will increase to reflect the increased earnings); and an expansion of the PE multiple (i.e. even if the earnings remain the same, the share price will increase in line with the change in the PE multiple). Bogle shares a study of US stock market returns by decade from 1900 to 2010, and a few points are interesting to note. The first is that nearly half of all returns over the 110-year period come from the dividend yield (4.5% of 9.2%) with almost all the rest coming from growth in earnings. The impact of the changing PE multiple (what Bogle calls the “speculative return”) is essentially 0%. This is, of course, what you would expect over such a long study. PE multiples fluctuate over time but cannot move in the same direction forever. Note, however, that in each individual decade, the impact of the speculative return is significant, and often larger than either of the other two return elements.

The speculative return reflects a change in sentiment over the period and is inherently difficult to predict. That said, in all but two of the eleven decades, low starting valuations resulted in a positive speculative return (i.e. in years when the starting PE was lower than 15x and the dividend yield was larger than 3.5%, then a positive speculative return ensued). The two decades in which this wasn’t the case were the 1990s (where starting valuations of 15.2x and 3.2% would predict a slightly negative speculative return, but the tech bubble at the end of the period resulted in rapid multiple expansion); and the 1910s (where starting valuations of 13.6x and 4.3% would predict a positive speculative return, but WWI resulted in falling share prices).

Active investors aren’t constrained by overall market valuations and can manipulate their portfolio to take advantage of Bogle’s observations. Companies’ earnings multiples and dividend yields are known – investment decisions can be made on the basis of valuation. Looking at the empirical evidence, these same valuation metrics also provide an investor with the best possible chance of benefitting from a positive speculative return. What’s more, by manipulating the portfolio over time (by selling companies where valuation metrics deteriorate, and buying companies with favourable metrics), it is possible to maintain a portfolio with advantageous valuation characteristics, so positive speculative returns can persist over time.

Managers should also look to increase the probability of benefitting from earnings growth. There are two ways of doing this. Either by buying companies with depressed earnings (where “growth” is effectively a reversion to mean) or by buying companies that look set to benefit from strong market positions and attractive product offerings. Kennox follows the first of these approaches as depressed earnings are usually coupled with low valuation metrics (i.e. we can have our cake and eat it), whereas the second approach is usually associated with higher valuation metrics. As such, growth-based stock selectors must realise strong profit increases to avoid being diluted by a lower dividend yield, and over time, a lower speculative return.

We are writing this at a time when, for the best part of a decade, value-based approaches have underperformed, and speculative returns have favoured more expensive stocks rather than those with lower valuation metrics. This brings us back to Bogle’s opening remark, that it is not impossible for short-term variations to endure for a decade or more, but that long-term returns reflect intrinsic value is a virtual certainty. We most heartedly agree.

November 2018

Max Ward (former head of UK equities at Baillie Gifford and current manager of the Independent Investment Trust – the best performing Investment Trust in the UK in 2017) joined the Advisory Panel for our November meeting. As a self-confessed perma-bull (“because it’s just more fun”), even Max was interested to explore whether or not there were any “safe havens” remaining after nearly a decade of quantitative easing has inflated global markets to a series of record highs. Rumours of a reversal of this long-standing policy, or “quantitative tightening” have left market participants feeling jittery in the 4th quarter of 2018. Below are a number of areas that the panel felt might offer some safety should jitters turn into anything more serious:

The Kennox house view: companies that have solid balance sheets (i.e. those that have benefitted least from QE and the abundance of cheap credit) for the most part have underperformed recent bull markets, and remain on reasonable earnings multiples. As such, these businesses should be well placed to outperform global markets for two reasons. First, their earnings should be less impacted by rising interest rates (as this benefits cash savings and penalises leverage) and second, they should be less susceptible to a reversal of inflated earnings multiples (as their starting multiples are already more palatable).

UK Businesses: The UK market has its own set of concerns currently. Over the last 5 years, it is flat in USD terms (against global markets that are up over 40%) as the market considers the risks of Brexit. Whether or not it will be a “hard Brexit” remains to be seen, but that it will be poorly managed now seems a racing certainty. These concerns have weighed on company valuations, but for an investor with a long enough timeframe to look through the inevitably volatile transition, this may well be an excellent opportunity to invest in world-class companies that are sure to survive.

Challengers to lazy incumbents: Many markets are dominated by one or two giants. In some cases, size and longevity of success leaves these giants as “lazy incumbents” ripe to be toppled. Max Ward has had notable success in his investment in Fever Tree, that has shaken market leader Schweppes to its core. The panel discussed several areas where there might be other similar opportunities. Small and nimble players in the telecoms markets for example, or within the Kennox portfolio Neopost (competing with Pitney Bowes) or M6 (competing with the TF1 the state-owned French TV broadcaster).

Family owned business: We also revisited the main topic from the last Advisory Panel. Many family run businesses are conservatively managed, shun leverage and often make sensible decisions on a longer timeframe than those run by management with remuneration that is dominated by short term performance rewards.

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

April 2018

In a break from our usual format, Alastair MacLeod joined the Advisory Panel to bring a fresh perspective and keep the usual faces on their toes. Alastair has spent over twenty years in investment and hedge fund management, in London, Edinburgh and North America. We outline a couple of the topics discussed during the meeting below.

Diversified Holding Companies – aligned with long term investors
One of the topics that the Advisory Panel focused on, was why it is that diversified holdings companies (often large family-owned businesses) have outperformed over the last 20 years. John Elkann (CEO of Exor, the holding company controlled by the Agnelli family which owns Fiat Chrysler, Partner Re, CNH, Ferrari and the Juventus football team amongst other holdings) highlights some of the reasons in his excellent letter to shareholders after the 2017 year:

While Kennox are not (currently) invested in the holdings companies, we agree with the analysis that for fund managers with a long investment horizon, family owned businesses are likely to be well aligned. The S&W Kennox Strategic Value Fund owns several companies with large family or founder shareholders: almost half of all the companies we have ever owned have a significant shareholder (i.e. one that owns more than 25% of the float). Many of these are family owned or controlled.

A couple of other noteworthy points

On dividends: We are not an income fund, and whilst we enjoy being paid to wait, there are often times when companies should hold onto their cash. In the long term, equities have been able to make double digit returns on equity, is there not therefore a case for re-investing all of the cash at a 12% return, that is better than fund managers have done, and more tax efficient. At Kennox, we favour companies that balance shareholder returns with investment, and at times encourage management to cut dividends if we feel they would be better investing in their own business (sometimes to pay down debt, but at other times to invest in growth)

On measuring investments against book costs: Marking individual investments against their historic book cost (i.e. what the Fund paid for the investment) is pervasive in the investment industry, but is perilous and illogical. It encourages managers to hold companies that are below book cost, even when they have become poor investments, and It encourages managers to sell companies that have made a good return to “bank” the profits, when holding is often a better decision. At Kennox, we measure our portfolio against our estimate of their sustainable earnings (i.e. look at the multiple of Sustainable Earnings at which the investment is trading) to gauge whether an investment is a good one today, regardless of sunk costs or profits.

Peter Hollis, Russell Napier, Angus Tulloch and the Kennox investment team.

QUALITY & SUSTAINABLE EARNINGS

As Investment Directors at Kennox, we have 100% of our equity wealth in the Kennox Strategic Value Fund. Our objective is to make excellent, risk-adjusted returns for us and our co-investors in the Fund, delivering annualised performance over the long term which is in the high single digits or better (currently 9% net of all fees). At the same time, we are conservative individuals and we look to accomplish this with as little risk as possible. We believe that we have the best chance of achieving both – excellent annualised returns with limited risk – by sticking to a clear but powerful philosophy.

Core to our investment philosophy are two key tenets: quality and valuations. Quality, because we believe equities are risky (reducing quality increases the risk) and valuations, because the price you pay is the primary driver of returns you will make.

The valuation of a company, fundamentally, breaks down into two components: an assessment of a company’s earnings and the multiple an investor is being asked to pay for those earnings.

Typically, when discussing earnings, investors are referring to 12 month trailing, current or 12 month forward. At Kennox, when we look at earnings, our focus is on Sustainable Earnings: a conservative estimate of what profits (and cash flows) we expect the company to deliver in the future on a ten- or twenty-year time frame.

With a focus on the sustainability of earnings, we are naturally biased against peak earnings. In our company analysis, we discount peak earnings significantly seeing them as a risk better suited to growth managers and, in our view, best avoided. Why? Because at peak earnings, a company will almost always be facing increasing competition as new entrants are attracted to the most profitable and fastest growing sectors and industries (Capitalism 101).

For the Kennox value philosophy, it is much more logical to hunt for companies trading on off-peak earnings, where competition is likely to be shrinking and headwinds decreasing. In other words, we look at a company and ask if it can make earnings in the future that are merely unremarkable compared to its own past. This is not building in any heroic assumptions. Instead, by design and temperament, we are able to take an independently formed, long-term view and stick with it.

As this approach is naturally long-term in nature, we are not worried about the timing and shape of the earnings, i.e. if the earnings are lumpy or are shrinking in the short term. On the contrary, it is often only due to these shrinking earnings, and ensuing negative news, that we will get the chance to buy at exceptional valuations.

At Kennox, exceptional valuations mean not paying more than 12x our view of Sustainable Earnings of a company. There is substantial risk in overpaying, something that appears to have been forgotten judging by today’s market levels. Conversely, there are exceptional returns to be made from buying quality assets inexpensively. We are happy to invest when we find sensible and conservative valuations that imply returns that are commensurate with equities risk.

There are situations where we will get high quality companies at genuine discount prices. However, to really equate to an exceptional opportunity, there is one more, and most important, step – our detailed assessment of the level of quality.

In our assessment of quality, we look for certain hallmarks: a strong franchise, conservative management, low levels of debt, and a long-term track record demonstrating the ability to survive through multiple cycles. It is our aim to have each portfolio position exhibit these.

But to drill deeper on quality: we must truly test our conviction level on our evaluation of those Sustainable (non-peak, possibly-not-growing-in-the-short-term) Earnings, i.e. the quality of the franchise. We conduct in-depth analysis of the strategic positioning of the company’s products currently; looking across its customers, competitors, distribution, supply chain; always including studying past financials for clues and hints, going back two cycles or more; factoring in potential disruptors (new entrants, changes in laws and consumer preferences and working practices, costs); hunting out all the factors that contribute to the future success or failure of a business. In short, we drill down into all the fundamentals that will drive a company’s future profits on a long-term view. This takes time but, for us, is essential. It is only after we have done all the work that we really know our conviction levels about the quality of our Sustainable Earnings – that the headwinds are temporary, that the individual company has enduring strengths that will in turn be able to generate significant profits.

If we’re being offered the share at 12x or less, we have a compelling case. Where we can make exceptional returns is if the company’s profits can move back up to peaks or beyond, or if the shares are re-rated. Being self-reinforcing, these two often coincide, providing some truly mouthwatering returns. And importantly, this can occur irrespective of market direction or economic growth: our stocks have worked through their individual headwinds, giving them the ability to perform even in difficult times (as was our experience in 2008). This is one of the joys of our investment philosophy – in our decade working together, we have seen this outcome many times. We expect to find many more such opportunities in the future.

Our focus on paying only conservative prices and of assessing the quality of earnings on a longer-term view (often via a disregard for the lumpiness and timing of earnings) presents a coherent, logical and sensible value investment strategy. Because this is very different to what most investors do, the market will continue to offer up excellent opportunities for our style in the future. If we are selective about these opportunities and only pick the very best of them, we have a good chance of achieving our objectives – excellent risk-adjusted returns through all market conditions over the long term.

MARKET DISTORTION

As you might remember from our last speech in 2014, we’re devout pessimists. But it’s getting hard, given the distortions we are seeing in the markets, not to become optimistic. We think that the outlook for value is very good.

Before discussing distortions, I will give a brief overview of Kennox value. After all, the interpretations of value amongst practitioners is varied, from Buffett to Ben Graham, and as seen by the range of presentations at this conference over the years. What does value investing mean to Kennox? Risk is at the forefront of our minds, so, to offset this, we buy quality. “You own Nestle?”, some may wonder. No. Our focus on valuation means we don’t pay more than 12x Sustainable Earnings. That knocks out Nestle. How do you find great companies at 12x Sustainable Earnings? Time – you have to think longer term than the market, you have to be patient, and you likely have to buy these companies at a time when they are facing headwinds – certainly not when everyone loves them.

The three fundamentals for us are Quality, Valuations and Time. However, in the last eight years of rising stock prices and unprecedented monetary policy and quantitative easing, the market’s application of these key investment fundamentals has become subtly, but significantly, distorted.

Whilst they may not be immediately obvious, these distortions are highly dangerous. However, if you become aware of them, they can be used to your advantage.

In what follows, I’m going to discuss our view of these distortions, what an investor can do about it and maybe even take advantage of them. Finally, I will look at one of our current portfolio stocks this perspective.

Fundamental 1 – Buy Quality

Most would say the quality of the business they buy is critical – very few would say they are buying garbage. However, here’s the distortion: the market’s definition of quality has narrowed – narrowed so much that quality now means only near-term growth. The other hallmarks of quality, as we see them – sector leadership, conservative management, strong and defensive balance sheets – no longer seem to count.

This narrowing creates a great opportunity to buy companies that don’t fit this limited and flawed definition of “quality”, but remain exceptional, sustainable business franchises. For Kennox, quality is fundamentally about sustainability.

Fundamental 2 – Valuations Drive Returns

We all know that valuations are important but expressions like GARP (growth at a reasonable price) better reflect common thinking today. Valuations certainly no longer feel like the primary driver of equity returns. It has become no more than a secondary consideration – maybe just an inconvenience?

If you don’t believe me, just look at the valuations that stocks are commanding, the only way this can make sense is if investors are focusing on growth and not valuations. For those of you who, like us, think the cyclically adjusted PER is a useful number, the S&P number is now on 29x – it’s only been more expensive twice in history – 1929 and in 2000.

When this applies across the entire market, the basics of economics and economic history will tell you it’s risky.

Fundamental 3 – Timing matters

Well yes, but not in the way that most people think. Most people now think the time to buy companies is when the outlook is great and it’s all smooth sailing. That’s the distortion – the danger is that you always pay a full price for this level of comfort.

Currently, “buy low, sell high” doesn’t feature, as it feels as if all investors are chasing the same thing. “Buy high, hope to sell higher” feels closer to what what’s driven markets recently.

But it’s also the opportunity. Look at how hard companies are being punished when they go through tougher periods.

As has always been the case, the best opportunities are when quality companies go through (temporary) headwinds. That’s the only time you get these companies at great prices.

Kennox Stock Profile – Kingmaker

Let’s look at some of these distortions with a quick concrete example, over an investment cycle, i.e. a stock we bought and sold – in this case, the company is Kingmaker. It makes shoes, but for today, we’re not going to talk about what Kingmaker does, we’re going to look at market psychology.

Before we start, let me explain something about our process. Our analysis of a company is always based on finding the long term Sustainable Earnings of a business (often quite different to the short term stated earnings). This takes time and effort, this is where you really dig, and more often than not, we still don’t get conviction and we drop it. For the few where we do get conviction, we plot valuation lines of 10-, 15-, and 20x Sustainable Earnings.

So how did the market distortions impact Kingmaker?

Phase 1: the company was growing fast, and the market fell in love – valuations no longer mattered, and it traded at heady valuations, well north of 20x Sustainable Earnings.

Phase 2: Kingmaker lost a contract, earnings stopped growing, heaven forbid, it even shrank. This was no longer deemed to be a “quality” company, and, through 2005-2007, the share price reacted accordingly.

That’s when we did a lot of work on it and had to decide whether we could gain conviction as to the long term Sustainable Earnings of the company. In other words, were those headwinds temporary or permanent? In this case, we felt they were temporary.

Phase 3: Timing mattered.

This is how to take advantage of these distortions – picking up quality at very attractive prices when a company is facing headwinds. And be patient while these headwinds turn to tailwinds. We didn’t buy at the bottom and we had to endure lower prices, but we topped up and it was worth it. – Kingmaker recovered from its temporary problems, the market re-rates it and Kingmaker moves from 7x to over 20x Sustaniable Earnings. At this point we exit our position.

The Kingmaker example shows how rewarding the style can be. It’s not comfortable to buy when there are headwinds – this takes nerve and it’s not always easy. But it’s also why value investing works.

Kennox Stock Profile – Texwinca

We’re excited because we see a lot of Kingmaker in Texwinca. As we were considering which stock to highlight, Texwinca had a profit warning – a classic headwind that allows a great price. This is value investing. It might be noted that this is a conviction position for us – it’s the fourth largest stock in the portfolio.

Texwinca is a $1bn company, listed in Hong Kong, a manufacturer of specialty and hi-tech fabrics including anti-UV, wicking, stretch, on behalf of major blue-chip retailers. Its clients include names such as Uniqlo, Tommy Hilfiger, Abercrombie & Fitch, Kohl’s, Gap. Texwinca also has a non-core retail business, called Baleno, offering casual, affordable clothing.

Fashions come and go, but retailers will still need fabrics to manufacture clothes and this company is are very good at what it does.

Let’s start by looking at quality – remember that quality for us is sustainability and the long-term health of a company and therefore it has to have certain hallmarks: market leader, conservative management, solid balance sheet. Why do we think Texwinca will be around, and thrive, long into the future?

It is a market leader: One of three main competitors in the area of providing high tech fabrics to leading international brands. Texwinca has developed the systems and skills to deliver to the tightest schedules, a key consideration for retailers. It’s commonly known as the Zara effect: shortening the time from design studio to shop floor.

A further consideration for retailers and their suppliers is in the area of ESG. They have to be cleaner than clean regarding environmental and social issues. Are factories polluting? Do they employ underage or mistreated workers? Conforming to these standards, and, being able to prove/document that it does, raises the competitive bar enormously. This has been a game changer over the last 20 years. This severely limits competition. And, an additional ESG bonus, it is good for the environment and social welfare. Texwinca is very good on all fronts.

Next, does the company have competent and conservative management? We all know how important management is. But for us at Kennox, we want sustainability, so we want safe hands, looking after what the company already has; not excitement, not heady growth. The family owns about 50% and has been making good business decisions for decades. We think the franchise has the best chance to be well looked after for the longer term.

Lastly, it must have a solid balance sheet for a rainy day. Texwinca has no debt and has been storing away cash reserves since 2009, and it’s squirreled away everywhere you look on the balance sheet. That cash is worth 50% of the market cap. That’s a lot of rainy days.

Quality is about sustainability, and Texwinca has all the hallmarks.

Quality doesn’t work for us if we’re paying through the nose for it – we make sure we’re getting this quality at very attractive prices.

On Texwinca, we did our research and digging to get a view of Sustainable Earnings and here are our Sustainable Earnings lines again. You can see that the company has been getting de-rated since 2015, as Texwinca, and its profits, face headwinds and the market goes looking elsewhere for growth and excitement.

Which means we can see Texwinca with an enterprise value of just 6x our view of Sustainable Earnings. It’s also got a great history of generating cashflow and paying it out in dividends – historic dividend yield, excluding specials, is 10%. EV/EBITDA between 3 and 4x.

There is a significant margin of safety in these valuations.

Lastly, time. Texwinca is facing current headwinds (that gives us an opportunity), that we think are likely to turn into tailwinds in our investment period

Its core fabrics business has been soft, and its cyclical retail business has fallen to break even.

Due to Texwinca’s quality, we think the softness in the core fabrics business is temporary. And we think it will fix Baleno or exit it, only at a reasonable price, and either way, this will be beneficial to the share price.

The time to buy is when you’re getting a bargain and that time is now.

The underlying company changes but rarely as much as the market thinks. It’s rarely so good as the good times portray, nor as dire as it appears in the bad times.

Like Kingmaker, we think Texwinca is a stock overlooked by a market with all its inherent biases. If you can look past the current headwinds, and have the courage of your convictions, this is where you can take advantage, this is where there are juicy opportunities.

The last eight years have been fascinating. Undoubtedly, the next eight years will be very different – it is even possible that bull market conditions might not prevail. What to do?

We propose to you that Quality, Valuations and Time taken together form a sensible, logical, risk aware investment strategy. Applied consistently, investors can find real bargains. Importantly, it also has the advantage of being different to what most of the market is trying to do, and therefore offers real diversification to most portfolios.

As we said at the beginning, we’re struggling not to become optimistic. The market’s perspective has been distorted, but that’s our advantage: the greater the distortion, the greater the opportunity.

Delivered to the London Value Conference 2017 (amended)

November 2017

An early and ongoing supporter of the Kennox Strategic Value Fund, Angus Tulloch has served on our Advisory Panel since its inception. Angus confirmed his recent retirement from First State, where he headed the Asia ex-Japan Fund and the panel took the opportunity to ask Angus for his thoughts and lessons learned over his highly successful career. Here are a few of the highlights:

Managing a Portfolio – Lessons learned

The Industry – What needs to be changed?

If you are just starting out…

Charles L Heenan, Investment Director at Kennox, was a member of Angus Tulloch’s team before launching the Kennox Strategic Value portfolio with Geoff Legg.