Liontrust Responsible Capitalism Report 2024 - Flipbook - Page 77
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: assessing the value of a business
relative to a basket of peers with similar attributes. By investing
in value-generating companies with a long-term time horizon, the
valuation paid at entry is somewhat less important to the share
price return than the ability of the business to compound equity
value. Often, potential investments 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.
Equity ownership for smaller companies
The Economic Advantage team requires every smaller company to
have at least 3% of its equity held by senior management and main
Board Directors (PDMRs). The team monitors the equity ownership
and a position will be sold if the shareholding of directors and
senior management falls below 3%.
The team believes that equity ownership motivates key employees,
helps to secure a company’s competitive edge and leads to
better corporate performance. It aligns the interests of employees
with outside shareholders. The team also finds that an ‘ownermanager’ culture creates a more risk-averse approach with
a focus on organic growth over acquisition-led growth and a
healthy aversion to debt.
Risk scoring
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
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.
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.
Monitoring and analysis
The team monitors potential ESG issues associated with an
investment. These may include the impact of company operations,
governance practices and/or products and services that allegedly
violate national or international laws, regulations, and/or other
commonly accepted global norms. The team may also conduct
fundamental analysis on each potential investment to further assess
the adequacy of ESG programmes and practices of a company to
manage the ESG risks it faces. In addition, the team monitors ESG
risks on an ongoing basis through reviewing ESG data published
by the company (where relevant) or selected data providers to
determine whether the level of ESG risk has changed since the
initial assessment was conducted. Where there is an increase in
ESG risk, the exposure to the relevant security may be reduced,
taking into account the best interests of investors in the fund.
Impact on weighting/portfolio sizing
The information gathered from this analysis will be taken into
account in deciding the size of the position that the investment
team might take on behalf of a fund through the risk scoring
process outlined about. The investment team may grade securities
differently to data providers where the investment team believes
that their ESG rating does not fully reflect the position of the
relevant company or has not captured recent positive ESG related
changes which have been implemented by the relevant company.
Equally, the team may impose an ESG risk score on a matter not
identified by MSCI.
Difficulties of limited data
Some companies (for example smaller companies) may not be rated
or covered by data providers and may publish little information on
their ESG policies and sustainability risks. In these cases, the team’s
scope for analysis of ESG risk will be more limited.
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