Illuminator: September 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 31%, having delivered a relative outperformance of 786% since inception. Last month, the Illuminator has outperformed the broader market by 2.2%. In the four weeks to 13 September 2019, the main Illuminator screen of 10 stocks gained 5.0% compared to a 2.8% increase in the FTSE All-Share index. Since our last update in August 2019, there was one change in the list of the top 10 names that make up the Illuminator, with Electrocomponents replacing Dart Group.
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.
General disclaimer and copyright
This report has been prepared and issued by Edison. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.
Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.
Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.
No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.
Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison’s policies on personal dealing and conflicts of interest.
Copyright: Copyright 2019 Edison Investment Research Limited (Edison). All rights reserved FTSE International Limited (“FTSE”) © FTSE 2019. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under license. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.
Australia
Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for “wholesale clients” within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.
New Zealand
The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.
United Kingdom
This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.
This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the “FPO”) (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.
This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.
United States
The Investment Research is a publication distributed in the United States by Edison Investment Research, Inc. Edison Investment Research, Inc. is registered as an investment adviser with the Securities and Exchange Commission. Edison relies upon the “publishers’ exclusion” from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.
