The collapse of Carillion showed the perils inherent in complicated businesses. Look for simple firms with powerful intellectual property instead, fund managers Nick Train and Tristan Chapple tell Sarah Moore.
On the morning of 15 January this year, firefighters in Oxfordshire were put on standby. But rather than preparing to go out and tackle a fire, they were waiting to be called on to deliver school meals to children. The staff usually responsible for that job worked for the outsourcing provider Carillion, which had that morning announced that it was going into liquidation.
While Carillion wasn’t a household name, most people will have used one of its services in one way or another – the company provided services that varied from serving those meals to children, to carrying out maintenance for Network Rail. In essence, it was a giant bundle of contracts covering a vast range of services to clients across varying industries and parts of the world. Before its collapse, Carillion held roughly 450 governmental contracts alone, spanning the justice, education, defence and transport ministries. As well as the UK, it operated in the Middle East, the Caribbean and Canada, employing 43,000 members of staff. In 2016, it had revenues of £5.2bn.
To many investors, that seemed very attractive. Outsourcing had been growing fast for years as governments and companies attempted to get various responsibilities and assets off their books. The margins on many of these contracts seemed good (hence the frequent rows about whether the public sector in particular gets good value from outsourcing to Carillion and its peers). The range of markets in which these companies operated seem to provide valuable diversification. So what went wrong?
There were of course problems that were specific to Carillion that pushed it over the edge – problems that are still being picked through in exhaustive detail in various inquiries and reports. But a series of high-profile problems and profit warnings at other outsourcers such as Capita, Interserve, Mitie and Serco point to a wider headache for investors in businesses such as these.
Looking under the bonnet
Before you invest in a company, you need to understand exactly what it does. That sounds incredibly obvious – but in some sectors such as outsourcing, it’s more difficult than it sounds to be confident that you have a firm grasp on the underlying businesses and the risks they pose.
One of the problems with outsourcers is that they are quite opaque and provide few financial details about individual contracts, Murdo Murchison, the chairman of asset manager Kiltearn Partners, told the Financial Times in March. Kiltearn had owned around 10% of Carillion’s shares in the first half of 2017, but a year later Murchison was describing it as “a model I wouldn’t want to invest in again”. Among other problems, the firms have limited intellectual property or tangible assets and are “essentially offering labour management skills with a little sauce on top”.
And as the outsourcers grew, even the management teams sometimes seemed to be struggling to keep track of all the responsibilities that they have taken on. For example, when Serco’s current chief executive Rupert Soames was brought in to “pull [the firm] back from the brink of bankruptcy in 2013 he found that the company lacked a single, coherent register documenting its 700 businesses”, says the FT’s Gill Plimmer. These ranged from “dog walking in England to running air traffic control towers in Iraq”.
Send in the mystery shoppers
In short, the outsourcers showed themselves to be a complicated kind of business – and that means complicated in a bad way. The services they produce are often simple and low-skilled – they are keeping the streets clean, not developing medical technologies. Yet their structure is suprisingly complex and the way that they operate makes it hard for an outsider to monitor how well the underlying business is doing.
This lack of transparency isn’t just an issue with the outsourcing industry. Financial-services firms are also a problem, says Tristan Chapple, manager of the Aurora Investment Trust, who avoids them due to their “opaque” businessess. “You can’t ‘mystery shop’ an investment bank,” he notes. A less obvious example is aeroplane-engine manufacturer Rolls-Royce, which this month announced it was cutting 4,000 jobs after several tough years that included five profit warnings and the arrival of a new chief executive on a mission to turn it around. Although the company has a high market share and a decent return on invested capital, “it fell down on transparency”. Rolls makes its money from people paying for engines and services, but many of its customers are getting special deals, making it more difficult to predict future profit streams.
“It is far more important to invest in what you know and understand, rather than to apply any particular rule in selecting an investment,” says Chapple. While it may be tempting to buy into any company that has had spectacular returns over a couple of years and seems to be growing strongly, if you can’t confidently explain to a friend exactly what the company does and how it makes its money, there’s no way that you can be confident that it will still be making money for investors in the future.
Investing in your circle of competence
Taking this kind of prudent approach means you need to be realistic about what kinds of businesses you can analyse in sufficient depth, reckons Nick Train, manager of the Finsbury Growth & Income Trust and the Lindsell Train Investment Trust. “When I started, I thought my job was to have a view on everything,” he says. “But in hindsight, I only had a superficial knowledge and understanding of lots of the market.” Over the longer term, he has focused on gaining a deep understanding about relatively few sectors. Consequently, there are “big swathes” of the market to which he hasn’t devoted much thought, such as oil exploration. Though he is “full of admiration” for those who do invest in the sector, Train admits that he has “no insight or knowledge about who will be successful in that world”.
Instead, he has focused on a handful of sectors, such as consumer brands and providers of entertainment and information. Some of these areas lend themselves to some useful, simple rules of thumb when it comes to market research. One “infallible bit of advice” is to find a company whose products taste good, says Train. It might sound an odd metric to apply in investment decisions, but this is actually a “powerful screen”, he says. “If you can think of a company like that which hasn’t been a great investment, let me know.”
That’s why the the top ten holdings of his funds include brands such as Diageo, the drinks maker behind Baileys, Tanqueray, Guinness and Johnnie Walker; Heineken, which owns brands such as Fosters and Bulmers as well as the eponymous beer; Irn-Bru maker AG Barr; and Unilever, the multinational conglomerate that sells everything from Hellmann’s sauces and Ben & Jerry’s ice cream to Dove and Vaseline products. These are the brands that people are familiar with, have been buying for years, and that they will continue buying in the future, says Train. Good brands “add value to inanimate objects”.
Investments that capture the mind
In a similar vein, Chapple is keen on what he describes as “hobby” companies. Although some investors may write off this type of company as being too vulnerable to unpredictable levels of demand, he places a great deal of emphasis on the “hobby mentality”and how that can deliver solid earnings. The key is that people often see their hobbies as indulgences that they “deserve” when perhaps they are not spending money on things like new cars or a holiday. Hobby spend is very resilient, even though rationally it should not be. Often people’s hobbies are frivolous (by nature – you’re not feeding or clothing yourself), but people will often sacrifice other things to leave enough in their budget for these passions.
A good brand “captures a part of your mind”, says Chapple. If it means something to somebody and generates an emotive response, then it probably promotes an element of irrationality in the purchase. So whereas retailer Sports Direct (which is also one of Aurora’s holdings) has pricing power because it is the lowest-cost producer, a good brand has pricing power because of its ability to generate emotion in the person buying the product. That could be Hornby, the model railway company (see next page); it could be Hermès, the luxury accessories brand; it could be tech giant Apple. “If you can delight hobby customers, they’ll be loyal and they’ll spend a lot of money with you.”
The staying power of a great brand
It’s these brands and the emotional connection people have with them that can make seemingly simple products and businesses surprisingly durable. When you buy a consumer brand, you are essentially investing in a piece of intellectual property, says Train. For example, the Johnnie Walker brand of whisky is Diageo’s intellectual property. The brand, including the whisky’s blending and provenance, is the label on what would otherwise be a blank bottle. Without that, the consumer would have no immediate way to distinguish what’s on the shelf from a retailer’s own-brand product (such as Tesco’s Finest) or a cheap generic whisky. With it in place, the product instantly becomes more valuable. Other branded products elevate even more humble ingredients to a huge extent. Marmite, owned by Unilever, is made from yeast extract and began as a way to use up a byproduct from the brewing industry. Coca-Cola is essentially fizzy water with sweeteners and flavourings, plus an immensely familar brand. The kind of brands that make especially good investments are those that most people would know to some extent, says Train. Companies with that kind of global recognition are “both incredibly valuable and really quite rare”.
From brands to copyright and patents
Not all intellectual property is as simple as this, of course. Apple owns vast numbers of high-tech patents that prevent a competitor from simply cloning its products, not just the familar Apple logo and iPhone product name (although the strength of these brands certainly helps maintain its pricing power). Educational publisher Pearson, another one of Train’s holdings (see below) owns the copyright to large numbers of textbooks that are used in schools and universities around the world. However, these firms still typically depend on whether consumers want to keep buying their products, either because they love them (Apple) or because they need them (Pearson). So it’s still easier to monitor the strength of demand for their products than the profitability of a contract with a government or the value of a portfolio of derivatives.
Such businesses are attractive in other ways. All else being equal, the return on selling intellectual property should be higher than the return on physical property, argues Train – you should be able to keep making money from the brand or content without having to invest a lot more capital into that part of the business. That should mean more cash can go to investors. Of course, in today’s markets, firms with strong brands and intellectual property tend to trade on relatively high valuations, creating a dilemma for investors. Have they now become too expensive, despite the quality of what they do?
What makes a great business a great investment is being able to buy it at the right price, says Chapple. You can’t just say, “well Apple’s a good business, Nike’s a good business, I’m not going to look at the share price. If you pay the wrong price, it doesn’t matter how good the business is.” He looks for a balance between quality and value, but adds that he pays more attention to quality than most value investors. “We would rather pay a fair price for a really great business than a knock-down price for a mediocre or crap business.”
Train goes further. A truly valuable company can keep on making money for investors for decades to come. Unilever has compounded dividends at 8% per year for a half a century. It deserves its valuation (currently a price/earnings ratio of 22). With a business like that, “how much is too high a price?” he asks. “Thirty times earnings? Forty times earnings?” It’s hard to say – but it’s probably a lot more than people think when they pick up a jar of Marmite.
Three funds and two turnaround plays
If you are looking to emulate the investment approach of Nick Train or Tristan Chapple, the easiest way to do so is through buying their funds. Chapple’s Aurora Investment Trust (LSE: ARR) follows principles of both value and quality investing and focuses on UK-listed stocks (though the trust has just received authorisation via a shareholder vote to invest in companies listed outside of the UK, limited to 20% of assets). The fund holds between 12 and 20 stocks, and has an ongoing charge figure (OCF) of 0.8%.
Train focuses on a limited number of what he views as exceptional companies. The Finsbury Growth & Income Trust (LSE: FGT) invests mostly in UK companies, with up to 20% of assets invested around the world, and runs a portfolio of up to 30 stocks. It has an OCF of 0.7% and trades at a premium of 1% to NAV. The Lindsell Train Investment Trust (LSE: LTI) is a global investment trust, with a portfolio of up to 25 stocks. The trust’s largest holding (24%) is a stake in the unlisted investment management firm founded by Train and Michael Lindsell. However, the trust trades at a substantial premium to NAV, since many investors consider that the management company is undervalued by the stated NAV.
All three funds are invested in a number of successful businesses, but if you’re a value-orientated investor you may be more interested in the ones that have been struggling – and why these two managers believe they are better bets than the market thinks. Hornby (LSE: HRN), which sells toy trains and accessories to model railway enthusiasts, as well as owning brands such as Airfix and Corgi, is one of Aurora’s top ten holdings. Chapple admits that the firm has been poorly managed in the past. “It’s not enough to have a great portfolio of brands, if they’re run badly for a long period of time,” he says. However, he is expecting a turnaround. “We own Hornby because we think those past missteps are correctable [and] current strategy and management are on the right track.”
Train’s most troubled holding is publisher Pearson (LSE: PSON). In the past few years the company has sold the Financial Times as well as stakes in The Economist and Penguin Random House in order to focus on educational publishing. However, it has seen its shares fall by 38% since March 2015, partly due to drops in its sale of textbooks in the US. Much of the information previously delivered in physical textbooks is now being delivered electronically. Investors are concerned about what this means for Pearson, but Train says that he is confident that the firm can successfully take advantage of the move to digital consumption – and will benefit from lower capital intensity under a digital model, which should make it more profitable in future.