We follow a simple process to allow our portfolio to generate real returns over the long term. The process comprises stock selection and risk management. In stock selection, we are trying to find companies that satisfy three crucial criteria.
One, economics: it must make an economic return, meaning that the outputs are more valuable than the inputs and there is some reinvestment opportunity. Two, sustainability: a qualitative assessment of whether the economic return determined in point one can be continued into the foreseeable future, meaning a decade or so hence.
Three, management: the company must be stewarded by competent people whose incentives are aligned with shareholders and – crucially – act with integrity and honesty.
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How to manage risk
Risk management is where we consider what can go wrong. There are two elements to this process: concentration and valuation. As far as the former is concerned, we want to ensure a balanced portfolio. We can gauge how our selections are geared to disparate economic outcomes, which helps us recognise when the portfolio could become overly skewed towards one scenario – perhaps an over-optimistic one.
Valuation is where stock selection and risk management meet. We concentrate on where a company sits within its cycle: rather than focusing simply on price, we look at earnings too. We avoid investing when earnings are too high, not simply when the price relative to those earnings is too high. This helps us steer clear of companies whose profits are peaking and set to fall.
The pick of the banks
Banking stocks in general are attractive to us, but we consider Barclays (LSE: BARC) particularly compelling. The years of gruelling balance sheet repair are behind us and what is emerging is a franchise that we believe can generate decent returns in a relatively low-risk manner.
Investors remain reluctant to consider banking stocks, which has created a scenario where we struggle to find a greater divergence between the quality of a business and investors’ perceptions of it.
An exemplary publisher
Notwithstanding the current global crisis, we believe that Euromoney Institutional Investor (LSE: ERM), a financial publisher and events organiser, is well positioned for the future given its recurring revenue streams coupled with sustainably high returns and exemplary balance sheet strength. The strong balance sheet is to be expected given that Euromoney is a capital-light business.
With regard to sustainability, Euromoney is a business where we can make a strong case that profitability could actually improve over the long term. Nevertheless, because a part of the business is involved in events, the shares have been marked down substantially recently.
Superbly managed construction materials group
Finally, Breedon Group (Aim: BREE), a construction materials group whose products include specialist concrete and clay products, asphalt and aggregates, has a simple but hugely effective business strategy with predictable earnings power and a superb management team at the helm. Not only are quarries highly lucrative, but the company would also be a prime beneficiary of a probable fiscal stimulus resulting from the extreme economic slowdown.
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