Income Matters No.5

Troy

Nothing is more expensive than free money

Kevin Walsh, Fed Governor

In Income Matters 4 we laid out our views on the current backdrop. Much has changed in the last few months with some important implications for capital markets.

Many of the trends to which we have become accustomed are in the process of changing. This slow-moving reordering of economies and markets is perhaps most obviously demonstrated by the return of inflation and the very rapid increase in interest rates. Ex-Federal Reserve Board member Jeremy Stein famously observed that interest rates are powerful because “they get in all the cracks”. What he meant was that there are few things in markets and economies that are not influenced by the price of money. Be it immediate, or over time, the probable end of the era of free money is a big change.

The last paper also included the following chart from Ian Hartnett at Bank of America:

Figure 1: Themes for 2010(s) vs 2020(s)

Source: Bank of America, 31 December 2022

We can debate each line as to the extent to which they are true but the sheer number of trends that are fundamentally changing is real. We are unlikely to go back to a world characterised by cheap money, cheap labour, cheap commodities, and experimental policy. Real, after inflation, returns are likely to be harder to come by.

So, what should we do? It is tempting to think that one should change the way one goes about investing to accommodate this new reality. There are many saying just that. Tempting but, in our view, wrong.

Don’t get mad, get even

Those who have read Warren Buffett’s famous article “How Inflation Swindles the Equity Investor” will be familiar with the below. Published in May 1977 in Fortune magazine, the arguments developed are as relevant today as ever. With the current backdrop perhaps resembling the 1970s more than more recent decades this is unsurprising. It is no secret that we at Troy are great admirers of Buffett’s approach and think investors would be well-served by reviewing his thoughts from around that time.

A sound investment approach, as explained so often by Mr Buffett, should aim to buy high quality assets at a fair price, with identifiable competitive advantages, allowing for sustainably high returns on capital. These should then be held for the long term to allow for compounding. We agree.

In addition to this we share his contention that this approach remains sound regardless of the backdrop, notably regarding inflation. After all Buffett honed his approach in inflationary times and still focused on the same sorts of companies and sectors which have created his incredible track record and which we also favour.

In the piece Buffett makes the point that generally the return on capital from equities, in aggregate and across time, is reasonably constant. It follows that there is an argument for viewing stocks as having a bond-like return albeit with inflation linking. The real return, that is after inflation, is predominantly a function of the prevailing inflation rate. Yes, over time good companies can raise price to offset inflation but over shorter periods the return is diminished. This is why inflation is often seen as a tax on wealth creation.

The importance of quality

He then drops in a more subtle point, which is how different businesses cope with an inflationary environment. It is not simply a function of how easy it is for a company to raise prices. To this must be added the inherent quality of the underlying business in terms of returns on capital as well as the capital requirements of the enterprise.

Simply put those companies that have high returns, and relatively low capital requirements are much better placed to cope with inflation.

High quality companies have high returns on capital, which itself is a function of having low capital requirements. This sustains growing free cash flow which allows for both capital growth and income payments while maintaining a well invested business.
This does not change in an inflationary environment – quite the opposite.

We can see this by comparing a high-quality business with a less favoured enterprise and then observing what happens when inflation hits.

Figure 2: The importance of cash flow

Source: Troy Asset Management Limited, 30 April 2023.

Happily, Mr Buffett does this for us in his 1984 letter to Berkshire Hathaway shareholders in an appendix entitled “Goodwill and its Amortisation: The Rules and Realities”. He demonstrates the point by comparing the relative economics of his first ever fully acquired business, See’s Candy, with a less favoured, hypothetical, business.

See’s Candy was purchased for $25m with $8m of “net tangible assets “(capital) and no debt. On this capital base the company was earning $2m of post-tax income. This therefore represents a 25% return after tax on “net tangible assets” (also referred to as return on invested capital or ‘ROIC’).

Incidentally he goes on to explain how the company generates this very attractive return:
“relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price.

Could there be a more succinct summary of why we are committed investors in consumer franchises with well-loved brands in our portfolio? Anyway, we digress.”

Compare and contrast

The comparison between the two businesses is described as follows “…let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in “honest-to-God” assets..”

The numbers look like this:

Year 1See’s CandyMundane business
Earnings 22
Invested Capital818
ROIC (%)2518
Enterprise Value2518
Price to Earnings Ratio12.59
Source: Berkshire Hathaway, 1984.

Buffett then goes on to consider what happens when inflation hits. We quote at length:

“…imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.
Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.”

The numbers after the effect of inflation look like this:

Year 2See’s CandyMundane business
Earnings 44
Invested Capital1636
ROIC (%)259
Enterprise Value5036
Price to Earnings Ratio12.59
Source: Berkshire Hathaway, 1984.

Result:

See’s CandyMundane business
Valuation gain2518
Investment1636
Required investment
(xY1earnings)
259
Source: Berkshire Hathaway, 1984.

The important point is that for a given level of inflation the better business can increase earnings without having to increase capital expenditure nearly as much as the more mundane business. This creates enormous value. Essentially the same competitive advantages that allow for high returns on capital also allow business to weather the effects of inflation more effectively.

Present day

Recent results in our portfolio have been consistent with the above. Companies such as Procter & Gamble (P&G), Pepsi and Reckitt Benckiser have all produced results ahead of expectations driven by pricing – as well as some signs of post-COVID margin expansion as input cost inflation has weakened.

Hence in the first quarter of 2023 (formally Q3 for the company as it has a June year-end) P&G delivered 7% organic sales growth (4% was expected) which allowed the company to raise long term expected growth to 6%. This was mainly a function of raising price, volume growth while lacklustre is expected to continue to recover. Gross margins also expanded for the first time in two years.

Pepsi managed a remarkable 14% organic sales growth and 18% full year earnings per share growth. Forward guidance was also raised. Again, Pepsi was able to increase prices to deliver these results. Gross margins also expanded.

Finally, Reckitt Benckiser, which it should be acknowledged is recovering from several stock specific issues, reported 7.9% organic sales growth derived from both pricing and improving (albeit still negative) volume.

In each case this shows an admirable degree of resiliency and adaptability in an inflationary backdrop. The combination of brand strength, distribution power and habitual customer behaviour allows these companies to raise prices without unduly diminishing demand. When combined with the attractive underlying economics of these businesses, robust results should continue to be able to be delivered. This consistency, at a time of great uncertainty, is valuable. It has reminded investors of the quality of these franchises especially at times of adversity.

Having established this point Buffett then goes on to describe why, logically, asset-heavy businesses are less well positioned:

“Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“In Goods We Trust”). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars.”

There is nothing new under the sun

Doesn’t all this sound terribly familiar? 40 years after this was written I read the same arguments quoted above regularly recently. The existence of inflation does not mean we should suddenly invest in cyclical and capital-intensive businesses even if they are currently having their day in the sun.

The chart below is a distillation of the arguments laid out above, by sector.

Figure 3: Our investment universe

Source: Troy Asset Management Limited, 30 April 2023.

There will always be a temptation to invest in what is performing right now, and for which there is doubtless a beguiling investment thesis, but which makes little sense when viewed through a long-term investment lens. It is only over time that this reality is revealed.

This underpins our distinctive investment approach which is highly selective about the businesses in which we invest. We seek to concentrate our efforts and resources in sectors and businesses that have the attributes described above. Having established such a high-quality portfolio, we interrupt the compounding of our businesses reluctantly as evidenced by the very low turnover in our funds. Further we seek to limit losses by being disciplined about valuation. This also enhances our ability to generate an attractive level of income. We have an absolute return mindset (as opposed to relative to a benchmark) and consider risk to be the permanent loss of capital rather than positioning relative to a benchmark.

A consistent approach

We continue to strive to produce above average returns with below average volatility and to deliver a return balanced between capital and income growth. Recent events have not caused us to change the way in which we approach this task. This should enable us to deliver growing free cash flow and income from the portfolio in the coming years even if inflation remains a problem.


1Warren E. Buffett, Fortune Magazine, May 1977, http://csinvesting.org/wp-content/uploads/2017/04/Inflation-Swindles-the-Equity-Investor.pdf

2https://warrenbuffettoninvestment.com/goodwill-and-its-amortization-the-rules-and-the-realities/


Please refer to Troy’s Glossary of Investment terms here. The document has been provided for information purposes only. Neither the views nor the information contained within this document constitute investment advice or an offer to invest or to provide discretionary investment management services and should not be used as the basis of any investment decision. The document does not have regard to the investment objectives, financial situation or particular needs of any particular person. Although Troy Asset Management Limited considers the information included in this document to be reliable, no warranty is given as to its accuracy or completeness. The views expressed reflect the views of Troy Asset Management Limited at the date of this document; however, the views are not guarantees, should not be relied upon and may be subject to change without notice. No warranty is given as to the accuracy or completeness of the information included or provided by a third party in this document. Third party data may belong to a third party. Past performance is not a guide to future performance. All references to benchmarks are for comparative purposes only. Overseas investments may be affected by movements in currency exchange rates. The value of an investment and any income from it may fall as well as rise and investors may get back less than they invested. The investment policy and process of the may not be suitable for all investors. Tax legislation and the levels of relief from taxation can change at any time. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. Issued by Troy Asset Management Limited (registered in England & Wales No. 3930846). Registered office: 33 Davies Street, London W1K 4BP. Authorised and regulated by the Financial Conduct Authority (FRN: 195764) and registered with the U.S. Securities and Exchange Commission (“SEC”) as an Investment Adviser (CRD: 319174). Registration with the SEC does not imply a certain level of skill or training.© Troy Asset Management Limited 2023.

Website Terms and Conditions

Welcome to the website of Troy Asset Management Limited (“Troy”, “we”, “our”, “us”).  Please read these terms and conditions carefully.  By accessing this website you are indicating that you have read, acknowledge and agree to be bound by the following terms and conditions and that you have read Troy’s Privacy Notice (which can be accessed here).  If you do not agree to these terms, you must stop using this website immediately.

This website uses cookies and similar technologies.  Information about our use of cookies is included in our Privacy Notice accessed here.  You can edit your cookie settings on this website.

Troy Asset Management Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom which can be contacted at 12 Endeavour Square, London E20 1JN.  Troy is registered on the FCA’s register with firm reference number 195764.  Troy is registered with the U.S. Securities and Exchange Commission (“SEC”) as an Investment Adviser (CRD: 319174).  Registration with the SEC does not imply a certain level of skill or training.  Troy is the owner and operator of this website and can be contacted using the details set out in section 11 below.

This website describes Troy’s capabilities and is for information purposes only.  Nothing in this website should be construed as investment, tax, legal, accounting or other advice.

The securities described on this website are not intended for use and are not offered in the United States of America or to U.S. Persons.  Please see section 2 for further detail.

  1. Who may access this website – subject to local restrictions

The information on this website is directed at persons in the United Kingdom (“UK”) and not otherwise. The availability of any funds managed by Troy or services provided by Troy mentioned on this website in any jurisdiction other than the UK is subject to local restrictions.  Except as specifically set out below the funds mentioned on this website have not been registered or approved for distribution under the laws of any jurisdiction other than the UK.

If you are accessing this website from a jurisdiction other than the UK, you are required to inform yourself of and observe any applicable local restrictions.  If you choose to access the website and you do so from a country other than the UK, you do so at your own risk and Troy will not be liable for any breach of local law or regulation that you commit as a result of doing so. The information available on this website does not constitute an offer of, or an invitation to apply for or purchase, any securities.

Trojan Investment Funds and its sub-funds are UK funds established under the provisions of the European Directives on the co-ordination of laws, regulations, and administrative provisions relating to undertakings for collective investment in transferable securities (“UCITS”) (Directive 2009/65/EC) as implemented in the UK.  Trojan Investment Funds is authorised by the FCA.  Certain sub-funds are available for distribution in Ireland (for professional investors only), Singapore (for institutional investors only), Switzerland (for qualified investors only) and are registered for distribution to the public in the UK.

Trojan Fund (Ireland), Trojan Income Fund (Ireland), Trojan Global Income Fund (Ireland) and Trojan Ethical Fund (Ireland) are sub-funds of Trojan Funds (Ireland) plc which is an Irish UCITS subject to the laws of the Republic of Ireland.  Each is authorised in the Republic of Ireland by the Central Bank of Ireland, and is a scheme recognised by the FCA under the Financial Services and Markets 2000 Act (“FSMA”).  Trojan Fund (Ireland) and Trojan Income Fund (Ireland) are registered for distribution in Austria (certain share classes only), Germany (certain share classes only), Ireland, Italy (for institutional investors only), Singapore (for institutional investors only), Spain (certain share classes only), Switzerland and the UK.  Trojan Fund (Ireland) is also registered in Portugal (certain share classes only). Trojan Ethical Fund (Ireland) is registered for distribution in Ireland, Singapore (for institutional investors only), Spain (certain share classes only), Switzerland and the UK.  Trojan Global Income Fund (Ireland) is registered for distribution in Ireland, Spain (certain share classes only), Switzerland and the UK.

  1. Important information for U.S. Persons

This website as well as the securities described on this website are not intended for use and are not offered in the United States of America (including the District of Columbia or any other territory occupied or possessed by the United States of America) or to U.S. Persons (including residents of the United States of America, residents within an area subject to its jurisdiction and U.S. Persons who are resident outside the United States of America).  As such, by accepting these terms you represent and warrant that you are not a U.S. Person as defined under Regulation S of the United States Securities Act of 1933, as amended.

U.S. Persons interested in services provided by Troy should instead contact us directly on [email protected] or call +44 (0)20 7499 4030.

  1. Suitability of products and services

The products and services described on this website may not be suitable for all investors.  Troy does not provide investment advice or make personal recommendations to investors.  If you wish to obtain advice about the suitability, or have any doubt about the suitability, for you of products managed by Troy or services provided by Troy, you should contact a financial adviser.

Should you have any general queries or require support relating to Troy or its products and services, please do email [email protected] or call +44 (0)20 7499 4030.

  1. Risk warnings

The value of investments and the income from them may go down as well as up and investors may get back less than they invested.  Changes in rates of exchange may cause the value of investments to go up or down.  Past performance is not a guide to future performance.

Tax legislation and the levels of relief from taxation can change at any time.  Troy does not provide tax, legal or accounting advice and therefore the information presented on this website should not be relied upon.  Please consult your own financial advisor before engaging in any transaction.

The information on this website is for information purposes only and does not constitute a recommendation, solicitation, offer or invitation to purchase or sell any investment product, perform any other transactions, or conclude any other legal transactions.

Changes to website content

These terms and conditions and the information contained on this website is subject to change without notice and no guarantee is made as to its accuracy, completeness or fitness for a particular purpose. Troy has expressed its own views and opinions on this website and these may change without notice.  Troy is under no obligation to update information and visitors to this website should not rely solely on the information contained on this website in making an investment decision.

We keep our terms and conditions under review.  These terms and conditions were most recently updated on 8 September 2023.

  1. Intellectual property rights

Troy is the owner or licensee of all intellectual property rights (including copyright and database rights) that subsist in this website, and in the material published on it.  No right is granted to use the website:

(i) to create a database (electronic or otherwise) that includes material downloaded or otherwise obtained from the website except where expressly permitted on this website or by written agreement with Troy;

(ii) to transmit or re-circulate any material obtained from the website to any third party except where expressly permitted on this website or by written agreement with Troy;

(iii) in such a way so as to remove the copyright or trademark notice(s) from any copies of any material made in accordance with these terms.

No use of Troy’s name, logos and/or other trademarks (whether registered or unregistered) may be made by you without separate express written agreement being given by Troy (or its licensors).

  1. Liability

Whilst Troy has sought to ensure the accuracy and completeness of the information contained on this website as at the date of publication, save as required by applicable law and regulation, Troy gives no warranty or representation and accepts no liability in respect of the accuracy, adequacy or completeness of such information.

Whilst Troy endeavours to maintain the availability of this website Troy cannot guarantee that your use of this website will be free from error and/or uninterrupted.  Accordingly, the website is provided on an “AS IS” and “AS AVAILABLE” basis without any warranties of any kind.  We do not accept any liability arising from any interruption in availability.

Whilst effort has been taken to ensure that the website is free from viruses, no warranties are given that it is free from viruses and users are responsible for ensuring that they have installed adequate anti-virus software.  Troy shall not be liable for any viruses or any other computer code, files or programmes designed to interrupt, restrict, destroy, limit the functionality of or compromise the integrity of the website or any hardware on which it is hosted.

  1. Third party websites

This website may contain links to external websites operated by third parties.  These links are included to give users the opportunity to access other pages that it is felt may be of assistance to them.  Troy makes no representations as to the accuracy or any other aspect of the information contained on such websites and Troy accepts no responsibility for the content of such websites.

  1. Data protection

On some pages of this website, users are asked to contact Troy to provide, or obtain, further information.  Please refer to our Privacy Notice (which can be accessed here) which provides information about how we gather and use personal information.

  1. General

Each of the paragraphs of these terms and conditions operates separately.  If any court or relevant authority decides that any of them are unlawful or unenforceable, the remaining paragraphs will remain in full force and effect.

If we fail to insist that you perform any of your obligations under these terms and conditions, or if we do not enforce our rights against you, or if we delay in doing so, that will not mean that we have waived our rights against you and will not mean that you do not have to comply with those obligations.

These terms and conditions are governed by English law and are available only in English.  You and we both agree that the courts of England and Wales will have non-exclusive jurisdiction over any dispute or claim arising under these terms and conditions.

  1. Contact details

Troy Asset Management Limited, 33 Davies Street, London W1K 4BP, United Kingdom; Telephone +44 (0)20 7499 4030; Email [email protected].  Troy Asset Management Limited is a limited company registered in England and Wales under company number 3930846 and has its registered office at 33 Davies Street, London W1K 4BP , United Kingdom. Except where otherwise required by applicable law or regulations, all communication and documentation sent to you by Troy will be in English.  You may communicate with us in English.

For more information about this website, including information concerning the personal data Troy holds about you, please contact us by email via [email protected].

© Troy Asset Management Limited 2023. All rights reserved.

 

 

I accept these Website Terms and Conditions