Why quality companies will prove their worth

Vladimir Putin’s decision to invade Ukraine, together with surging demand as economies spluttered back into life after COVID lockdowns, has created a new macroeconomic backdrop.

Interest rates had been ultra-low for more than a decade, as policymakers tried to stimulate economic growth and, during this period of ‘almost free’ money, investors were ready to pay a hefty premium for companies with strong growth trajectories.

They piled into businesses like Facebook (now Meta), Amazon, Netflix and Google parent Alphabet – the four tech giants collectively christened the ‘FANGs’ – along with Tesla and many of the other ‘growth’ juggernauts that dominate the upper reaches of the S&P 500. The momentum of these companies helped power the US index upwards.

However, many growth companies, in our view, became eye-wateringly overvalued and when the macroeconomic backdrop changed at the start of this year, they fell dramatically out of favour with investors – and many sold off sharply. The Russell 1000 Growth Index fell by 30.7% between the start of this year and the end of September. Over the same period, the Russell 1000 Value Index fell 17.8%.

The share prices of Meta and Netflix have (at the time of writing) more than halved so far in 2022 and Tesla is not far behind.

World has changed

Investors using passive funds would have had few complaints while the S&P 500 was marching relentlessly upwards year after year, buoyed by low interest rates and relative economic calm.

However, the world has now changed. US economic growth is slowing and warnings are mounting of a global recession, as the world grapples with higher inflation, rising interest rates and continuing geopolitical uncertainty.

In this environment, we believe a highly focused approach to investing in US equities will prove its worth. We hold a concentrated portfolio of 25-40 companies selected from an investable universe of around 4,000 US stocks. We favour this tightly focused approach because companies that meet our exacting criteria are rare, and we want to hold decent-sized positions in those that do, so they can make a meaningful contribution to performance.

We look for well-managed businesses benefiting from stable demand for market-leading products and we want to see durable competitive advantages, pricing power and conservative balance sheets. We believe these companies should be able to maintain their growth momentum without relying on a positive macroeconomic backdrop.

Attractive valuations

An attractive valuation is essential and we will also invest only in companies that are already making a healthy profit and paying stable or growing dividends. This focus on pay-outs to shareholders is important. For one thing, dividends can make a useful contribution to an investor’s total return. But, equally importantly, they demonstrate that the management of a company are financially disciplined and that the cash flows of the business are strong.

Stock stories

Broadridge Financial Solutions is a good example of the type of company we invest in. It has carved out a dominant position in what is a niche but lucrative business, distributing mass correspondence – such as prospectuses, shareholder reports and proxy voting documents – from US companies and mutual funds to their investors.

The New York-based company’s technology gives it a strong competitive advantage and it has pricing power, recurring revenues and a powerful position in a highly profitable and growing market.

In addition to the shareholder communications arm of the business, Broadridge provides back-end accounting systems for equity and fixed income trading by Wall Street brokers and is expanding into software for wealth management businesses. It recently signed a large deal with UBS.

While investment in the wealth management software side of the business means earnings growth may be modest in the immediate term, over the longer term we expect Broadridge to achieve double-digit EPS growth.

Illinois-based IDEX is another company we hold in the portfolio. It operates a collection of businesses supplying vital components and other equipment to high-growth specialist markets around the world. These include parts used in DNA-testing labs, rescue equipment used by firefighters, industrial pumps and even clamps used on a NASA Mars Rover vehicle.

The IDEX business units are decentralised but work in concert through a central office, enabling them to effectively segment markets and identify new opportunities. The businesses have leading positions in niche markets with higher barriers to entry. They have strong cash flows, robust pricing power and attractive growth outlooks.

In more challenging economic conditions, management have a track record of managing costs to safeguard earnings and IDEX has a disciplined policy of investing in growth and seeking out attractive M&A opportunities.

Broadridge and IDEX represent exactly the kind of high-quality businesses we believe will be able to continue to thrive and grow through a period of economic uncertainty and beyond. While the future will inevitably present fresh opportunities and challenges for investors, we believe a tightly focused portfolio of outstanding US companies, purchased at reasonable valuations, represents a highly attractive long-term proposition for investors.

Brad Weafer 21/11/22

Risk Warnings
Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The fund will be exposed to stock markets and market conditions can change rapidly. Prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The fund invests in other currencies. Changes in exchange rates will therefore affect the value of your investment. The fund invests mainly in North America therefore investments will be vulnerable to sentiment in that market which may strongly affect the value of the fund. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or in a timely manner. All or part of the fees and expenses may be charged to the capital of the fund rather than being deducted from income. Future capital growth may be constrained as a result of this.

Regulatory Information
This material is for distribution to professional clients only and should not be distributed to or relied upon by any other persons. It’s provided for general information purposes only and is not personal advice to anyone to invest in any fund or product. Information taken from trade and other sources is believed to be reliable, although we don’t represent this as accurate or complete and it shouldn’t be relied upon as such. Calls will be recorded for training and monitoring purposes.
Issued by Marlborough Investment Management Limited, authorised and regulated by the Financial Conduct Authority (reference number 115231). Registered office: PO BOX 1852 Lichfield, Staffordshire, England, WS13 8XU. Registered in England No. 01947598. Investment Fund Services Limited (IFSL) is the Authorised Fund Manager of the Fund. IFSL is registered in England No. 06110770 and is authorised and regulated by the Financial Conduct Authority. Registered office: Marlborough House, 59 Chorley New Road, Bolton, BL1 4QP. Copies of the Prospectus and Key Investor Information Documents are available from www.ifslfunds.com or can be requested as a paper copy by calling 0808 178 9321 or writing to IFSL, Marlborough House, 59 Chorley New Road, Bolton, BL1 4QP.