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Our Investment Process In Practice

A consistent investment process is key to long-term success in investment management. While a process should naturally evolve and improve over time, a simple, yet clear foundation will ensure that it is applied consistently through various market cycles. Our process seeks to identify a select number of good companies, that are well run, and that trade at a reasonable discount to a conservative business valuation. Critical to identifying and taking advantage of such opportunities, is a patient, long-term orientated approach.

Our investment process summarised

Counter Point Private Capital Management Process

The average investor does not have much patience and as a result the movements in share prices can be extreme, depending on the prevailing sentiment. It is difficult to imagine that it was just five years ago that it was an exceptionally difficult task to persuade anyone that quality global equities (for example, Procter and Gamble, Johnson and Johnson etc) were a better long-term investment than domestic counters or other emerging market equities. Those were the days when British American Tobacco was considered a boring, low growth utility that only contrarian investors wanted to own in size.

While we prefer to own high quality names, we have for some time had concerns regarding the market’s willingness to pay up for earnings visibility. Price discipline is the cornerstone of our process, and the key to generating our returns at below average levels of risk. As a result, many of our recent purchases have been seemingly average companies, but when combined with decent management and an exceptionally cheap entry price, we view them as relatively low risk long-term investments.

We have, however, managed to find some opportunities that meet all three of our desired investment criteria and we have been using market setbacks to add to these positions. Qualcomm is a stock we have long admired and is a good example of how our process works. We have always thought it was a very good company, given its unique patent portfolio in 3G and 4G network technology. They collect royalty income on the vast majority of 3G and 4G mobile phones sold globally. Unfortunately, until recently, it has been a popular share amongst growth investors seeking exposure to the growing smartphone market. The resultant valuation has always been an obstacle to us investing in the company. In the past twelve to eighteen months the company has faced a few headwinds that have stalled earnings growth, and the share price has followed. Last year we started using this weakness to start building a position in this high quality business, and we have continued to add to positions in recent weeks. Qualcomm has a cash laden balance sheet, solid management who have returned more than 50% of the current company value to shareholders in the past three years, a starting dividend yield of over 4%, and a single digit (excluding cash) PE multiple on low earnings. Given the quality of the business and the above characteristics, we see little long-term downside when buying at these levels.

Many investors have become nervous that we are entering a bear market for stocks. While our posture remains broadly defensive, we are excited by the fact that we are able to find stocks like Qualcomm that have already had their bear markets. We fully expect that broad economic fundamentals will continue to deteriorate, but we are being careful not to let this hamper our ability to make excellent investments for the next ten years. One does not get to buy companies like Qualcomm on a 7 PE (excluding cash) and 4.5% dividend yield when the news flow is good!

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2016 And Beyond

2015 was a very tough year for value driven stock pickers all around the world, with many of the best investors with very long track records experiencing their toughest year, in relative terms, since the dot-com bubble. While Buffett, Klarman and others have battled to keep up, short-term focused investors have continued to seek gratification in passive and momentum based strategies. This behaviour is not unusual and, as always, will create opportunities for patient investors with a longer investment horizon. The aim of this note is not to make forecasts for the coming year, but to highlight our current thinking around investments we are making for the next five years or longer.

While not a forecast, we do expect that fundamentals, both here and abroad, are likely to remain tough in the year ahead. The start of the year has been a harsh reality check in this regard. This means that company earnings growth is likely to be muted and there is significant room for disappointment. Because of this backdrop we remain very selective investors and are only prepared to own companies that are already priced for a poor fundamental environment and where expectations are low.

During periods of heightened volatility we will look for opportunities to add to our best ideas at better prices. Imperial Holdings is a good example of this. We were buyers of Imperial into weakness last year as the share price declined from over R200 towards R160-R170. At those levels we were of the view that it offered good long-term return prospects, despite the short-term pressures on parts of the business. The weak rand and poor domestic economy are clearly a major headwind for the vehicle import, distribution and dealership division. We think this is more than priced in at current levels, particularly as cash flows are increasingly being redirected into other areas. The charts below show how foreign earnings have grown and that non-vehicle businesses now represent nearly 60% of operating profit.

The-Friday-Filter-08.01

The-Friday-Filter-08.02

During December and early January the share price of Imperial has fallen further (trading at R114 at time of writing) and we have been adding to positions in what we think remains a good company, with excellent management, that is now trading at an exceptionally cheap price.

In addition to adding to existing holdings like Imperial, any further market weakness is likely to lead to new opportunities in companies that we do not yet own.   Having some cash available for such opportunities is core to our approach.

Despite the tough environment, 2015 was a reasonable year for our client portfolios, despite not owning some of the big winners (SAB, Naspers).   Not owning these shares was partly balanced by the offshore portion of portfolios where the weak currency was a major tailwind, but perhaps more importantly, it allowed us to buy good quality global companies at a reasonable price, something we have been battling to do in the domestic market.

As we head into 2016 we expect market conditions to remain challenging, but are optimistic about the long-term return potential of the companies we own, both locally and globally.   We have resisted the call to invest all of our cash and are ready to take advantage of any opportunities that Mr Market might present us.

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Rolls Royce Revisited

Rolls Royce Revisited

A few months ago we outlined our investment thesis on Rolls Royce. Last week the company provided a poor operational update and outlook and the share price fell sharply on the news. This note is a review of our thesis on Rolls Royce where we have continued to accumulate shares into market weakness.

Rolls Royce provides sophisticated power systems (engines) and services for use in the air, land and at sea. It is important to note that the company no longer has any link to the well-known auto-manufacturer. The aerospace division represents roughly two-thirds of company revenue and is the key to our thesis.

Our investment thesis can be summarised as follows:

  1. Air travel is a structural growth market
  2. Within the industry, demand for more efficient engines will continue to grow
  3. Rolls Royce has a strong competitive advantage within its core market (engines for large aircraft)
  4. As their installed fleet of engines grows, recurring service revenue will follow
  5. A new CEO will be able to simplify the business and improve group margins and cash flows

The two charts below show the expected growth in their core market as well as the expected engines to be delivered by Rolls Royce over the next 10 years.

Civil-Large-Engine-Fleet

 

The-Friday-Filter-20.11

 

Given the nature of the industry, the timing of this large backlog of engine demand converting to sales and cash flow is uncertain. It is this uncertainty that is allowing us to buy shares in the company at very depressed levels, even though we acknowledge that we have probably been early in our staggered purchases.

Despite the negative update, we remain comfortable with the long-term industry dynamics as well as the competitive positioning of Rolls Royce who operate in a duopoly in the wide-body aircraft engine market. This is supported by the fact that they are the exclusive engine provider for most of the Airbus wide-body fleet. We look forward to the new CEO providing a strategic review later in the month as to how he plans to capitalize on this strong competitive position to grow cash flows for shareholders in the years ahead.

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Sport And Investing Success – What We Can Learn From The All Blacks

Sporting analogies are often used to explain the complex world of investing. There have been recent articles highlighting how the Springboks might have fared were they listed on the stock market. With the World Cup over, I do think that there are a few key characteristics of the winning All Blacks that are also required to achieve success in the investment management industry.

Consistency in approach

A key strength of the All Blacks has been the consistency in the style of rugby that they play. While it may be easy on the eye, the fact that they have adopted the same approach over a lengthy period of time is what is important and hasbeenakeyingredientoftheirsuccess. Investmentmanagementisnodifferent. Whilethereisscopefordifferent approaches or philosophies, the important thing is to be consistent and not make changes at inopportune times.

Process versus results

It is a natural tendency to be too focused on short term results and many view this as a key weakness of the Springbok team. Good sports and investment teams, like the All Blacks, are focused on the process, confident in the fact that following a sound process will lead to the desired results. Games will be lost and investment mistakes will be made, but the key is to learn from these and try to improve the process going forward.

Temperament

The All Blacks players and coaching staff displayed a calmness of true champions during the latter stages of the tournament, making sound decisions under intense pressure. Strong temperament is one of the key ingredients for long term investment success as well. The ability to think clearly and independently, remain calm and be decisive in times of market turbulence is a key differentiator in the investment industry.

The bench

The All Blacks substitute bench was also a major factor in their success. We think of the Special Value Situations portion of our portfolio as our bench. While the contribution (position size) may not be as significant as the starting fifteen (Core Blue Chip Holdings), during the full course of the game they can make a large contribution to the end result. Like Steve Hansen, it is our job to utilise them wisely in accordance with our long term objective.

Value versus growth

Were the All Blacks and the Springboks listed at the moment, it is likely that the All Blacks would be a popular, high flying growth stock trading on a PE of 50. They would be very difficult not to own. The Springboks, on the other hand, would be trading on a single digit multiple and feature in the portfolios of value managers only. We would be attracted to the Springboks as an out of favour Blue Chip operating below potential, but we might have some concerns around the strategic direction of management.

Humility

Despite their dominance in the tournament the All Blacks remained grounded and humble at all times. The lack of arrogance after such a lengthy period of outperformance can only be admired. Humility is another key attribute of most good investors. If one does not have it, the market is likely to teach one sooner or later.

Summary

Despite all the similarities between sport and investing, there is one key difference. In sport one knows when the World Cup is going to take place and can prepare accordingly. In investing the real test comes in times of market panic, but investors are not forewarned and the big games usually arrive unexpectedly. We remain focused, looking at different combinations, whilst patiently selecting a squad of businesses that we think will enable us to win most games in the years that lie ahead.

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Hunting for Hidden Treasure

Most investors seek some form of margin of safety in the investments that they make and this can come in many forms. For some it will be paying a very low price for a low quality asset, whereas for others it will be paying a reasonable price for an asset of high quality. We use both of these approaches when constructing portfolios and are guided by the prevailing opportunity set. From time to time we find investments that are a combination of the two, something that features strongly in our managed share portfolios at the moment.

Businesses are often made up of different divisions or assets with very different economics. When you are able to find a business that in total is of poor or average quality, but has an asset or division that is of high quality that is not being correctly valued, there is often a mispricing that creates opportunity for patient investors. While we own a number of companies that are laden with such hidden treasure, one of them is about to come out of hiding and we are watching it with great interest.

ferrari-458

Fiat Chrysler Automobiles is a global automaker with a strong portfolio of motor vehicle brands. These include Jeep, Chrysler, Maserati, Alfa Romeo, Dodge, Fiat and Ferrari. A key part of our investment thesis in Fiat Chrysler Automobiles is their 90% ownership of Ferrari. A Ferrari is more of a luxury good than a car, as is demonstrated by its recession proof nature. It was the only global automaker to grow revenues in the financial crisis. It has a two year waiting list and the cars are appreciating assets, especially the limited edition vehicles.

Ferrari is due to list this month, appropriately under the share code RACE, and the initial valuation range has just been set. Looking ahead, a careful increase in production should maintain the scarcity factor of the vehicles, but could lead to a large improvement in margins and profitability. Just like its

vehicles, the shares will have limited availability with only 10% being sold by Fiat to new shareholders. They plan to distribute their remaining 80% during early 2016.

ferrari-symbol

Ferrari provides a solid underpin to our investment thesis, but we do think the rest of the business is worth considerably more than the stake in Ferrari. The Jeep brand continues to grow and has shown 24% annualised volume growth since 2009. Aided by the planned rejuvenation of Alfa Romeo and an expanded Maserati range, group margins and profitability are on an upward curve.

Fiat Chrysler Automobiles operates in an industry with poor economics. It is because of these poor economics that we are able to own one of the world’s most iconic brands at a very reasonable price. While Ferrari may be the treasure, we think that Fiat Chrysler management is in the process of bringing a shine to the other brands as well. This combination creates a very compelling long-term investment opportunity and is a core holding in appropriate local and global portfolios.

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Risk Versus Uncertainty

Our core objective when managing client portfolios is to produce “above average returns at below avereage risk” over a full market cycle. Our expectation in managing client portfolios is in line with the profile outlined by Warren Buffett in his 1960 partnership letter:

Our service and approach is client centric and we are of the view that this sort of return profile is in the best interests of most investors. We are happy to lose out on some of the gains made during frothy, momentum driven periods, but expect to thrive in tougher market conditions. Given the recent raised levels of market volatility we thought it appropriate to revisit our approach to risk management within a portfolio context.

We deliberately distinguish between what we call Core Blue Chip Holdings and Special Value Situations when constructing portfolios. We do this so that clients understand how we construct portfolios, but also to help us manage position sizes and risk. We prefer to hold established Blue Chip counters, but also seek exceptional value opportunities in companies that are perhaps less well known. We do not necessarily view this portion of the portfolio as more risky given the discount at which we look to purchase these companies.

At the moment the market is paying up for earnings growth and punishing companies or sectors where there is greater uncertainty. This has created an extreme difference between the popular and unpopular areas of the market not seen since the dot-com bubble. This has created an extremely challenging environment for active investment managers, with many of the great global investment managers going through one of their worst ever short-term performance periods. Franklin Templeton recently wrote on this topic and I’ve included a chart from their note below.

Risk-versus-uncertainty

“I have pointed out that any superior record which we might accomplish should not be expected to be evidenced by a
relatively constant advantage in performance compared to the Average. Rather it is likely that if such an advantage is
achieved, it will be through better than average performance in stable or declining markets and average, or perhaps
even poorer-than-average performance in rising markets.”

We are very wary of debating the merits of different styles of investing as a growth investment of today can become the value investment of tomorrow, or vice versa, and in reality all investors try and buy bargains. What we can say is that we think the future will be brighter for active stock pickers than the recent past has been. Our Blue Chip Value approach will prevent us from betting the farm on potential value traps, but we will also embrace volatility and uncertainty as an opportunity to buy companies at large discounts to their worth. As we have highlighted in recent commentary, this may increase the short-term volatility of returns, but will sow the seed for the long-term returns we seek on behalf of our clients.

Here is a short note on a few of our current holdings that are currently facing significant uncertainty, but where we think the valuation mitigates the risk.

Group Five

It is difficult to imagine that it was a mere 7 years ago that construction stocks were the darlings of the market that portfolio managers were ridiculed for not owning. Given the high level of industry uncertainty Group Five shares are now very cheap, the balance sheet is solid and we are encouraged by new shareholder friendly management eager to extract value in the years ahead. We are comforted by their investment and concessions business which has a large annuity income component, is a good quality business and which management has stated may be worthy of a separate listing in due course. While the market may be focused on the lack of domestic infrastructure spend and the fact that the Winelands Tolling Project is unlikely to happen, looking a few years out we think the investment and concessions business could be worth the current share price. Given that this division only makes up 7% of group revenue, any recovery in building margins would be extremely rewarding for patient shareholders.

Glencore

Despite being underweight the resource sector, we do have exposure to Glencore which has been in the news for all the wrong reasons recently. A very sharp selloff gathered pace on the back of an analyst report that has driven the share to extreme levels. Key to our investment thesis in Glencore is the large shareholding of management, who added to their stake just two weeks ago. We are by no means commodity bulls, but think that the panic selling is overdone, that Glencore will be one of the survivors in the commodity space and that significant value will be realized from current levels.

Sustainable Capital Africa Alpha Fund

Much has been made of the growth opportunity in Africa, yet for every success story there are probably two or three failures, Tiger Brands being a notable recent example. Our investment in Africa is one of diversification and valuation when local equities are far from cheap – taking profit in an expensive market and allocating it to one that is extremely cheap. We do not have the expertise to select stocks in Africa, but we know the team at Sustainable Capital well and are comfortable investing alongside them as they buy into what are extremely depressed, sentiment driven valuations on the continent.

Gold

Gold is a contentious investment for many. We are unemotional in our analysis of gold, but have recently added a small position to both local and global portfolios via Anglogold and Barrick Gold. While the position is small, we view it as a portfolio hedge and not an investment. In a way it is a humble admission that we do not know how this unprecedented period of financial engineering ends. The fact that it is a hedge that is unloved, under owned and very cheap on most metrics is a bonus. In some way we hope that demand for gold as a safe haven is not restored, but we do think a small holding is appropriate.
It goes without saying that as custodians of our clients’ capital, we are very risk conscious and manage each weighting according to the risk of each investment. We are also invested alongside our clients in each of the companies we own.

Summary

Investing amidst uncertainty is uncomfortable, but unfortunately it is a prerequisite for generating superior long term returns. We have been through an extended period of comfort in global markets, but more and more cracks are starting to appear at a company level. We embrace the uncertainty as an opportunity to selectively apply cash to investments that offer attractive long term risk/reward characteristics. In short, we think that very often it is uncertainty that creates low risk entry points for brave investors. It seems appropriate to end off with more words from Mr Buffett himself:
“Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”

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Buy The Dip?

Investors have become conditioned to “buy the dip” in recent years. Every small set back in markets has been a buying opportunity, largely on the back of central bank support. Every time markets fall a central bank official, at the least, issues some soothing word store as sure nervous markets, and this week has been no different. The question is should we be buying this dip as well?

To answer the question we need to put the setback in context. Despite some of the dramatic headlines, valuation levels remain very elevated. Given that valuations are the main driver of future returns, the recent changes in price have by no means presented a mouth-watering buying opportunity.

Local market PE – stll expensive

Buy-the-dip-28-August-2015-2

World markets – no slam dunk

Buy-the-dip-28-August-2015-3

Even though we manage client portfolios on a bespoke basis, our investment goal is the same across portfolios. We aim to compound long-term wealth by providing above average returns at below average risk. We try and do this by patiently building a portfolio of companies that exhibit the following three simple characteristics:

  • Good business
  • Good price
  • Good management

Despite the sell-off, there are not enough companies that meet our criteria for “good price”. As a result we do not view this as a great buying opportunity, particularly in the domestic market. We do view it as an opportunity to continue to accumulate stakes in good businesses that were already trading at a discount, but where that discount has now widened (i.e. a good price has become a great price).

One such business is Imperial Holdings, a company which we own and have added to in the sell-off. Imperial is not a great business, but we are of the view that it is a good and improving business, has exceptional management and, most importantly, trades at a very good price. During the company results presentation this week, CEO Mark Lamberti made a very interesting point. He commented that “the 2nd and 3rd order effects of a response to slowing Chinese growth have yet to be fully understood”.

In my view this is a critical point and one that requires a great deal of thought. Thus far the market has only priced in the 1st order effects of slowing growth in China, largely through the pricing of commodities and emerging market assets and currencies. While our market has held up better than most because of the make-up of the index, other emerging markets have seen very sharp declines.

Buy-the-dip-28-August-2015-5

If the scale of some of these price changes in the most cyclical assets are to be believed, I find it difficult to imagine how the knock on effects for other industries and companies will be as muted as the market is implying. As a result we are very wary about paying up for anything at the moment. Buying at the right price is more important now than ever.

Concluding thoughts

A more uncertain market environment is certainly challenging, particularly given the easy ride investors have had in recent years. It is likely that at some stage the same complacent investors who have confidently been buying the dip for the past few years will lose their nerve. Portfolios that offer lower than average prospective returns at higher than average risk will start to be questioned. We welcome any decline in sentiment and are ready and waiting to continue to add to our stakes in companies that are already undervalued, regardless of the macro environment.

So to answer the original question – no, we do not think one should be blindly buying the dip, but rather continue to selectively accumulate, but to do so with caution!

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Seeking Safety In Cyclicals

Recent performance numbers by South African equity managers are being heavily influenced by exposure to the most cyclical part of the market, commodity or resource shares. Some managers have taken big bets on the sector and are suffering, whilst others continue to stay away. This note will explore how we see the risks and opportunities in this very volatile sector of the market.

The chart below was extracted from a global macro investment blog highlighting the head and shoulders formation of the global commodity index. Despite the very sharp fall the author expects significantly more downside, a scary thought for anyone invested in a commodity producer.

Seeking-safety-in-cyclicals-7-August-2015-2

We are not guided by technical factors, but have spent a lot of time thinking about the sector. We have tried to remove ourselves from the noise of daily price movements and think deeply about the fundamental outlook for the next 3-5 years. With current commodity prices at their lowest levels of the last 10-15 years, most companies will require much higher prices to produce an adequate return for investors.

Given the low level of expectations in the sector it has natural appeal to anyone with a contrarian mindset. Despite the negative sentiment and very low expectations, we remain of the view that one needs to approach the sector in a circumspect manner. Recent experience will remind investors of a very strong rally in commodities post the financial crisis, but this was on the back of an extreme, credit driven binge in China, something that is unlikely to be repeated. The recent rout in commodities has been very widespread and it is difficult to find a single commodity that has held its ground.

Commodities – percentage drop from peak

Seeking-safety-in-cyclicals-7-August-2015-5

Going forward we think the outlook will vary from commodity to commodity, in line with their individual supply and demand fundamentals. It is possible that some may have entered an environment of structurally lower prices, where as others will see a cyclical recovery in the years ahead. As an example, it is possible that the significant increase in supply of iron ore and oil could lead to lower prices for a long time. We do not know if this is true, but we do see it as a risk to an investment in the more popular commodity counters that make up a large part of the index, i.e. Sasol and Billiton.

Sugar is a commodity that is facing severe cyclical headwinds, but we believe that in time the cycle will turn and production will adjust to lower prices. It is also a commodity with a very smooth demand profile, particularly in growing regions like Africa, where Tongaat Hulett (Tongaat) is increasingly focusing its sales efforts.

Sugar – steady demand, currently oversupplied

Seeking-safety-in-cyclicals-7-August-2015-6

Thankfully for Tongaat their property and starch and glucose divisions are very profitable, enabling the company to continue investing into a poor sugar cycle. The property assets in Kwazulu Natal may produce lumpy earnings, but they are a unique asset and will produce solid cash flows in the years ahead. While these cash flows are currently supporting a poor sugar cycle, at some stage we expect more of them to flow back to shareholders as debt and sugar capex peaks. When the sugar cycle does eventually turn (we have no foresight as to when that might be), current investments will result in greater production at a lower cost per unit of production, leading to improved profitability.

Tongaat Hullett – unique property assets with strong sales momentum

Seeking-safety-in-cyclicals-7-August-2015-7

Seeking-safety-in-cyclicals-7-August-2015-8

In Tongaat, our largest holding in the commodity sector, we are buying into a depressed commodity cycle, but we are doing so in a prudent manner. We are buying a commodity with a very smooth global demand profile (not just China), but the margin of safety is also supported by strong cash flows in other divisions that are not tied to the commodity cycle.

The wild card – the US dollar

Weak growth and excess supply has hurt commodity prices, but a resurgence in the US dollar has played a significant role as well. Speculators in particular are increasingly betting on this inverse relationship.

Seeking-safety-in-cyclicals-7-August-2015-9

Further strength in the dollar is something that we view as a very real possibility, particularly as the Federal Reserve contemplates a “less easy” monetary stance. Should this happen it may well put further pressure on commodity prices, albeit these will be partly shielded by a weak rand. While we do not try and base investment decisions on currency movements, we do bear this potential outcome in mind, particularly when monitoring position sizes. We are also of the view that a significantly stronger dollar would possibly have a larger impact on the prices of some of the more popular areas of the market, even though they may not have a direct link to commodity prices.

Summary

The current downturn in the commodity sector is extreme and frightening. One only has to look at the muted job cuts in the sector to get a sense of the severity. Local resource shares are increasingly pricing in this very poor cycle, creating potential opportunities for investors who are willing to take a long-term view, as opposed to trying to time the bottom of the cycle. We are spending significant time and effort looking for ways to buy depressed assets in the sector, but will continue to do so very selectively and apply strict risk controls around our exposure to the most cyclical part of the market.

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A Look Inside The Engine Of A Global Leader Currently On Sale

‘Investment success doesn’t come from buying good things, but rather from buying things well.’ (Howard Marks, Chairman Oaktree Capital)

This is a quote I have often referred to and it occupies a permanent position on the wall in our offices. While it may sound like common sense, it is very difficult to stick to a price conscious investment approach in practice. Good prices are only present if there is some form of bad news attached to a particular asset, thus investor attention is usually focused on questioning the quality of the asset. This in turn leads to the attractive price which creates a low risk entry point for long-term investors.

At the moment companies that are of obvious quality (consumer staple companies etc.) are not well priced, thus you may be buying a good thing, but in most cases you are not buying it well. As a result, to find bargains today, investors need to look for less obvious quality. We have recently purchased a few companies that we think offer varying degrees of quality, but where we are very confident that the price we are paying is a good one. This note highlights one of those companies which is a core holding in our Global Portfolios.

Logo-Rolls-Royce

Rolls Royce designs, develops, manufactures and services integrated power systems for use in the air, on land and at sea. Its defence aerospace, marine and power systems divisions are reasonable businesses, but it is the civil aerospace division that we are attracted to. This part of the business designs and manufactures efficient engines for large aircraft, something not many are equipped to do.

A-look-inside-the-engine-of-a-global-leader-currently-on-sale-24-July-2015-5Demand for new aircraft can be lumpy in nature, but the growing demand for more efficient engines is structural in nature. This fact is supported by the order books of engine suppliers like Rolls Royce and the backlog of aircraft manufacturers like Airbus which are at all-time highs. Given this backdrop Rolls Royce has a very long runway to increase its installed base of jet engines, as it currently has the most efficient large engine in the world. As a result, the company has been able to secure exclusive positions on most of Airbus’s wide body planes, which are also the most efficient planes in the world. This run way is well captured by the following paragraph out of the latest Rolls Royce annual report.

‘The future growth of air travel is widely understood and reflected in our GBP 63 billion civil aerospace order book. To give this some perspective, in the past decade we have delivered 1,600 Trent engines. In the decade ahead we expect to deliver 4,000. All of the engines in this expanding fleet will produce service revenues that will extend for decades to come.’

Barriers to entry in the industry are extremely high for obvious reasons and the partnership with the likes of Airbus provide an extremely wide moat around the civil aerospace division. Rolls Royce and General Electric form a duopoly in the wide body jet engine market and it is difficult to see this competitive position changing. As long as people continue to fly, Rolls Royce will produce efficient engines for the global aircraft pool, and collect service revenues for decades into the future on those aircraft. The business model produces most of the profits and cash flows from the service and maintenance of the aircraft, as opposed to the initial sale. As a result once their new, more efficient engines gain traction, the ensuing profitability will be of a very high quality.

Some cyclical headwinds have led to a 40% fall in the share price, providing an opportunity to buy a world class business at a compelling price. Our investment thesis is further supported by a new CEO with a strong track record, who we are confident will allocate capital according to the competitive positioning of the underlying businesses, and drive profitability and shareholder returns to significantly higher levels in the years ahead.

In Rolls Royce we believe we are buying a good thing, and also buying it well. profitability, we are buying a company that has excellent long-term fundamentals:

  • Near-insurmountable barriers to entry
  • A strong recurring service and maintenance revenue stream
  • Accelerating growth profile in the coming decade
  • Highly regarded new CEO at the helm

Despite near term pressure on these solid fundamentals, coupled with low investor expectations, provide a very solid long-term return profile. We are delighted to be an owner of this global leader in its field.

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