Liontrust Responsible Capitalism Report 2024 - Flipbook - Page 53
Companies with economic advantage – the investment universe
Identifying companies with these assets gives the team a list of
companies which can withstand competitive pressures. The team
believes that these companies have the ability to deliver sustained
earnings growth ahead of the market’s expectations which in turn
will lead to long-term share price outperformance.
Financial advantage
Having identified whether a company possesses economic
advantage, it is next assessed for evidence of this theoretical
advantage showing up as superior financial returns. The primary
metric for this evidence-based approach is to use the Quest
database (owned by Canaccord Genuity) which examines the
cash flow return on capital (CFROC) to measure the economic
return on gross invested capital. CFROC is real, post-tax and
takes asset life and asset mix into account. For a company (or
indeed any project) to be economically successful, it must make
a higher return than the cost of the capital invested in it. Quest
uses a long-run weighted average costs of capital (WACC) based
on the capital asset pricing model (CAPM) as the benchmark
against which CFROC is measured. A company which can earn
a CFROC higher than its long-run cost of capital, and then reinvest
this return back into the business, will benefit from compounding,
which in the long run should lead to equity value creation and
strong share price performance. In the event a company is not
covered by the Quest database, other measures of financial
advantage are examined for evidence of the theoretical economic
advantage being present. Such measures include margins and
cash generation, with a strong focus on the possession of pricing
power. The process will also only invest in profitable companies.
The role of valuation
Valuation is deliberately put last in the investment process. For FTSE
350 companies, five standard valuation metrics are used – P/E,
EV/Sales, EV/EBITDA, Dividend Yield and Free Cash Flow Yield –
the objective being to purchase a new holding at a discount to the
market on at least one of these five measures to avoid overpaying.
For small (non-FTSE 350) companies, a more pragmatic approach
is adopted, as assessing the value of a business is a relative
exercise and comparatives can be hard to find. By investing in
value-generating companies with a long-term time horizon, the
valuation paid at entry is also somewhat less important to the share
price return than the ability of said business to compound equity
value. Often potential investments also lack long-term financial
return data and are in emerging industries or technologies.
At this end of the market, a qualitative, rather than quantitative approach,
is therefore preferred, although as all companies must first be profitable,
it is at least possible to have something on which to assess this value.
A range of standard valuation metrics are used to look at potential
investments from several different angles and the potential growth rate
in earnings is also considered. The aim is not to overpay for the asset
and although some are acquired at relatively ‘full’ prices, ‘bubble’ type
valuations are avoided due to perceived valuation risk.
Risk scoring (contains ESG component)
Risk scoring of investee companies determines stock weightings
within the funds. Each company is graded against nine criteria
to understand if the value of the investment could be materially
negatively impacted by any of the following:
1. financial risk (including balance sheet, accounting risk, capital
requirements and financial gearing)
2. product dependency
3. customer dependency
4. pricing risk
5. regulatory change
6. licence dependency
7. acquisition risk
8. valuation
9. ESG (see below for more information*)
*Integration of Risk (ESG component)
These criteria are continually assessed so that stock weightings
can be managed dynamically. Thus, while ESG factors do not
exclude from consideration any investment which would otherwise
qualify on account of its strong economic advantage credentials,
they will be taken into account in determining the position size of
such an investment.
Data sources and identification of risks: the team uses a third-party
data provider, MSCI, to assist in identifying and understanding the
ESG and sustainability risks of a proposed investment. The team
is able to override the MSCI score if the score is inconsistent with
the team’s knowledge or understanding of a business, in either
direction. For smaller companies not within the MSCI universe the
team will score for perceived ESG risk.
Employee motivation in smaller companies – equity ownership
(ESG component reflecting culture) Economic advantage in smaller
companies is created and maintained by talented individuals. The
team believes that equity ownership motivates key employees,
helps to secure a company’s competitive edge and leads to better
corporate performance:
• equity ownership aligns the interests of employees with outside
shareholders
• an ‘owner-manager’ culture creates a more risk-averse approach
with a focus on organic growth over acquisition-led growth and a
healthy aversion to debt
• every smaller company held in the team’s portfolios has at least
3% of its equity held by senior management and main Board
directors
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