Illuminator: August Update
The Illuminator is a proprietary database and stock selection tool that identifies high-quality companies based on 10 characteristics. We have now published The Illuminator for over ten years. We adhere to the fundamental premise that, over the medium to long term, quality companies outperform the market. Since its inception in July 2008, the Illuminator has returned more than 800% compared to the FTSE All Share index return of 111%.
Since the beginning of the year, the Illuminator has outperformed the market by a wide margin of 24%, having delivered a relative outperformance of 726% since inception. Last month, the Illuminator has slightly underperformed the broader market. In the four weeks to 13 August 2019, the main Illuminator screen of 10 stocks lost 5.8% compared to a 3.1% reduction in the FTSE All-Share index. Since our last update in July 2019, there were no changes in the list of the top 10 names that make up the Illuminator.
We have put together an updated illuminator screen that has a somewhat more forward looking angle compared to our headline illuminator portfolio presented above. Among other things, the key difference is that the updated illuminator algorithm is designed to better capture changes in investor sentiment as it monitors fluctuations in consensus earnings expectations for each stock in the FTSE All Share index. It also applies different weights to different screening factors.
These two factors are unavoidably interlinked and have a foundation in basic classical economics.Differentiated products and services, which are often highly specialised or value added, help provide defensible (and often first-mover) advantages that are typically seen in terms of dominant market share. Tangible examples include the existence of patents, advantages in low-cost production, superior distribution or IT. More intangible examples could include human capital, customer service and branding. We do not (as yet) have an objective mechanism for capturing this and rely on our more subjective analysis and experience. Against this background, for each company that appears in our screen, we feel it integral to with management face to face and subsequently maintain an active ongoing dialogue.
While somewhat subjective, assessment of management quality represents as important a consideration to us as the fundamentals of a business. We use total shareholder return (TSR) as a mechanism for capturing this. For companies that we add to our portfolio, we look to meet with management and expect to see evidence of a well-defined business plan with clear targets; we also look for focused businesses. In addition, we expect management teams to be pioneering, with clear vision, the ability to anticipate change, adapt and – above all – act in the interest of shareholders.
High earnings growth over a business cycle should be the logical companion of high-quality products/services and superior management teams. We acknowledge that in an environment where flexibility over pricing and margins has its limitations, (product/service) demand must be sustainable for earnings growth to be generated.
Economic cycles happen and can cause significant variations in a company’s operational performance. Our contention, therefore, is that if there are recurring patterns of demand for a company’s products/services, it should be less at risk to changes in the economy and its earnings, correspondingly, should be more predictable. Investors will also likely recognise consistency and predictability by attributing a higher multiple (of earnings, etc) to that business. We measure this factor in terms of a standard deviation, where the closer the figure is to zero, the better a company’s earnings consistency.
While track record is important, we feel future earnings potential also matters. We rank companies by forecast earnings growth for the next three years. We use consensus estimates and will look to roll forward our three-year time horizon regularly. Longer-term growth is, in our view, indicative of the ability of companies to grow above the rate of the economy and have sufficient pricing power to offset inflation. Against this background, investors should be willing to reward a higher projected growth rate via higher multiples.
We expect companies to be in a position to finance their own growth: over the course of an economic cycle, we look at overall financial leverage. Robust balance sheets can help reduce earnings volatility and write-downs.
Expansion, and delivery on growth and profitability strategies are shown by improving capital return levels. Moreover, companies with high levels of returns on capital should be in a stronger position to return capital to shareholders. Investors also tend to reward improving capital return levels in the form of higher multiples.
Well-managed businesses typically have strong free cash flow-generating abilities, a function of the fact that they tend to be less capital-intensive in nature and/or produce high capital investment returns relative to their assets. Shareholders are often the beneficiaries of management’s ability to generate free cash flow and are typically rewarded via dividend payments and/or share buybacks. As with return on capital, there are a number of ways in which free cash flow generation can be defined.
This factor is not applicable to all companies in our universe, but our contention is that globally leading companies with sustainable competitive advantages and/or differentiated propositions (as in our first quality characteristic) have the ability to develop via geographical expansion, resulting in market share gains. Global competitive decisions may also have a greater influence.
We are believers in growth at the right price (GARP) investing: high-quality companies with above-average growth prospects, good financial discipline and an attractive valuation typically generate above-average returns. We recognise that investors should be willing to pay more for higher quality, but context is everything. We assess ‘reasonable’ purchase price using forward earnings and EBITDA multiples, and assess ‘reasonability’ in an absolute, sector-relative and market-relative context.
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