Fund in Focus Podcast: Marlborough US Multi-Cap Income May 2023
Marlborough US Multi-Cap Income - May 2023
[00:00:00] Nick Peters: Hi, welcome to this week's podcast. My name's Nick Peters, investment advisor at Marlborough, and this week I'm joined by Brad Weafer, the lead portfolio manager of Marlborough's US Multi-Cap Income Fund. Welcome, Brad.
[00:00:15] Brad Weafer: Hey Nick, Thanks for having me.
[00:00:17] Nick Peters: So today we're gonna talk about the general market, talk about the performance of the fund, obviously, touch on the process and then get Brad's views on the state of the US economy.
[00:00:29] Nick Peters: So just starting off with the performance of the index this year, the banner is a index is up close to 6%. However, it seems to me it's been driven by a very narrow number of stocks. Without the tech sector, it'd only be up two and a half percent and without big tech.
[00:00:46] Nick Peters: So the likes of Apple, Microsoft, it would actually be down over 1%. Brad, what are your feelings on the market at the moment?
[00:00:54] Brad Weafer: Well, I think you're 100% right that it's a tale of two markets with the largest companies, specifically some of those tech large companies that you've talked about and the general market.
[00:01:04] Brad Weafer: So, you know, when we look at the headline index, most folks, I think consider the S&P 500 when they're thinking broadly about US stocks, particularly on the larger capitalisation side and the S&P 500 is year to date up about five and a half percent in British Pounds, which sounds pretty good. You know, given I think most folks concerns about the state of the global economy and interest rates rising rapidly over the last year, most folks would be pretty happy with that.
[00:01:33] Brad Weafer: I think the challenging piece is if when we look at the index, not cap weighted, so not, you know, weighted by size of companies, an equal weight of those same 500 companies, that index is actually down year to date 2.6%. So the average stock is actually negative on the year, you know, using that as a context.
[00:01:52] Brad Weafer: The challenging thing for active managers, so for funds like ours is, you know, you consider how big of a position you'd have to have in some of those large names that are driving the index, makes it very difficult to compare against a passive benchmark like the S&P 500.
[00:02:08] Brad Weafer: Good example is two of the best performing large cap stocks this year have been Microsoft and Apple. We own both in the fund at very large weights at four to 5% weights, but because the index holds those particular stocks at larger weights, they're actually detriments to our relative performance.
[00:02:25] Brad Weafer: Even though they're some of our best performing stocks this year.
[00:02:28] Nick Peters: And another interesting phenomenon, I think, is the performance of the smaller company's index. What's your thinking there?
[00:02:35] Brad Weafer: So, you know, again, you know, in a similar vein, the small cap index, US investors generally look at the Russell 2000 for small cap performance.
[00:02:44] Brad Weafer: The Russell 2000 in British pounds is down 1.2%. So much like that equal weight index of S&P 500 companies. That's, you know, 6 or 7% behind the S&P 500.
[00:02:55] Brad Weafer: A few things going on there. One, the smaller index has a lot higher concentration of banks and financial companies in that index. We've generally, in our fund, avoided in big parts, banks.
[00:03:08] Brad Weafer: You know, we look for companies that have lower leverage and banks are leveraged by their nature. Banks are also definitely pro-cyclical. Something we also try to avoid generally, or you know, overwhelmingly in the fund. So you see smaller cap indices with a lot of banks, a lot of leverage, a lot of pro cyclicality underperforming their larger cap peers.
[00:03:26] Nick Peters: So with that as the backdrop, how has the fund fared in the short term?
[00:03:31] Brad Weafer: So I think the fund has fared very competitively this year. So as of today's date, May 24th, the fund's total performance year to date is roughly flat.
[00:03:40] Brad Weafer: So that is trailing that headline index, but it's well ahead of that sort of equal weight index, so that average list, much better than the small cap indices and it's a multi cap fund, right? So you know, we, we do have small cap and medium size cap companies as well, and is pretty competitive when we also consider that the fund will only invest in companies that pay growing dividends.
[00:04:02] Brad Weafer: So if we look at things like the NASDAQ dividend achievers index that more sort of mimic our style, we've been much more competitive than you might sort of suspect by comparing us to the broader S&P 500 index.
[00:04:14] Nick Peters: So there may well be people out there that say, well, I'll just bypass this then because it makes life a lot easier but of course, the performance of this fund over the longer term suggests actually that active management does come through.
[00:04:27] Brad Weafer: Yeah, it's really interesting if you sort of track the performance of the fund, it doesn't take a long period to really see where the value comes. So the fund has particularly done quite well when markets have been tough. So, you know, I think of periods like the first quarter of 2020, during the pandemic, periods like just last year when all markets were selling off, the fund performed very competitively.
[00:04:50] Brad Weafer: So we might look conservative on a short-term basis when stocks are doing quite well, but sort of an approach that we take looking for companies with durable profits and low leverage tend to do quite well in periods of volatility for the equity markets. You know, we think that over longer periods of time, that of course balances out and you should be competitive enough in up markets, but also defensive and perform quite well in down markets.
[00:05:15] Brad Weafer: And if you look at our five year track record, which has a host of environments, including the pandemic, including fed tightening cycle and rapid expansion coming out of the pandemic. The five year track record of the fund has been quite good relative to our peers, relative to our style and relative to that sort of baseline US index, like the S&P 500.
[00:05:37] Brad Weafer: You know, generally when I think of the types of companies we buy, we're looking to underwrite a total return that is in the sort of mid-teens range, mostly from a combination of dividend yield and growth in profits and dividends over time. That's done using a multi-year timeframe, and if we can achieve that level of return from a total portfolio, we think we'd be competitive against any benchmark over long periods of time if we can be successful in finding companies in that range.
[00:06:07] Nick Peters: I should point out, when you say quite good, you mean first quarter over five years? That's probably my job rather than yours.
[00:06:13] Nick Peters: Just in terms of the process, maybe give us a bit more colour on the type of companies that you like and illustrate that perhaps with a stock that's in the portfolio currently?
[00:06:23] Brad Weafer: Absolutely. So to keep it quite simple, we look for companies that have durable competitive advantages. Some investors might call those competitive moats. Really what we mean is the company has some feature, has some advantage relative to their competitors and relative to industry. That allows them to have above average durable returns on capital, margins, and profitability.
[00:06:48] Brad Weafer: Those companies generally carry very similar characteristics. They don't need the economy to be thriving for them to make profits. They don't carry excess financial leverage. They don't have significant exposure to regulatory agencies. They don't have regulatory pricing. We look for evidence of pricing power and some level of niche and ability to reinvest in their own business to grow.
[00:07:14] Brad Weafer: So that's a high level categorisation of the types of companies we look for. We think that those are reasonably rare, but we have found what we think are some unique businesses that don't jump off the page in terms of name recognition, but do offer investors wonderful returns over time. One good example that I think highlights some of the niches that we end up finding is a company called Watsco.
[00:07:38] Brad Weafer: It's one of the fund's largest holdings. And the business is a distribution business, so they sell heating and air conditioning parts, and let's focus in on the air conditioning part of their business because it's very important. So there are a handful of air conditioning manufacturers out there, consolidated into a few, and Watsco is by a factor of at least five, the largest distributor of parts.
[00:08:03] Brad Weafer: What's nice about the distribution business is they pass price through. So when the manufacturers raise pricing, that flows right through the distributor's profits, so you get real good pricing power and what's also nice about air conditioning specifically is it's not nearly as discretionary as you might think.
[00:08:21] Brad Weafer: If you live in the southeastern part of the United States and the air conditioner goes in your house, you are replacing it without question. You cannot live through a Florida summer without air conditioning working. So when a plumber comes to fix your air conditioner, they're gonna go to the distributor and you are gonna pay whatever price they offer.
[00:08:41] Brad Weafer: Not only that, you are going to pay whatever it is necessary to maintain the system. So you'll pay dearly for parts that only the scale distributors have. So it's non-discretionary, and on a product like an air conditioner, there's a life cycle.
[00:08:57] Brad Weafer: So every 15 to 20 years, you've got replacement demand that you know is coming and as air conditioners get, increasingly energy efficient, they cost more money. So there've been margin, gains and revenue gains for years and years and years for a company like Watsco. Watsco in individual territories has sort of geographic contracts where they own the relationship for the manufacturers.
[00:09:20] Brad Weafer: So competitors cannot enter their markets, and because they're scaled, they can offer their services at better value, they can invest in technology and offer better services to contractors and you see all of this play out in their returns on capital, which are excellent relative to peers and excellent relative to sort of cyclical industrial type companies and they've been wonderful stewards of capital over time and just a pure example of the kinds of companies we look for.
[00:09:47] Nick Peters: And how do you consider valuation when you look at those sort of companies?
[00:09:51] Brad Weafer: So if you were to sort of look at a lot of our companies, Watso included, it trades at a premium to the market.
[00:09:56] Brad Weafer: Not surprisingly, because they've been able to grow and earn higher returns on capital than most. So we consider valuation. We expect when we look for a company like Watsco to have to pay a premium, but we do balance what that premium is versus what their growth opportunities are and what else is available in the market.
[00:10:14] Brad Weafer: We've owned Watsco for a number of years. It's always screened as expensive and always supported its valuation over time. It happens to also pay an almost 3% dividend yield, which is pretty attractive in the US market today.
[00:10:28] Nick Peters: And then lastly is the direction of the US economy. What's your feeling about the outlook?
[00:10:33] Brad Weafer: Maybe it was obvious when I was sort of discussing the kinds of companies we like, but I like to take our opinion of what the macro environment's going to do out of the equation and back the companies management teams that can handle their industries and have a much better outlook on their industries.
[00:10:47] Brad Weafer: So with that aside, of course we have an opinion. You know, the US economy has been kind of teetering along with some growth, but not sort of robust growth.
[00:10:57] Brad Weafer: Seems to be a lot of industries also digesting two things, both covid hangover, where inventory levels are not exactly great in a lot of industries but also the interest rate environment in the US has gone from near zero financing costs to something much higher, with our central bank raising interest rates over 5%.
[00:11:16] Brad Weafer: So that's created a number of challenges specifically for interest rate influence sectors like housing and, and the like.
[00:11:23] Brad Weafer: A lot of forward looking indicators of sort of economic activity look like they're suggesting that things will get weaker but we have not seen any evidence of it. And actually, if you look at the stock market, again, avoiding that high level index, stocks have just moved sideways for the better part of the last year.
[00:11:40] Brad Weafer: I think a lot of folks, including us are pretty undecided on what the outlook's going to be, that if we can continue to kick the can down the road and eek out some economic growth without sort of forcing ourselves into recession, we might be okay.
[00:11:54] Brad Weafer: Recent stresses in the banking sector call that into question and recent dysfunction of our own government and with the debt ceiling debate also call that into question. So that's a long-winded way of saying it's a pretty uncertain environment out there.
[00:12:09] Brad Weafer: You know, the debt ceiling has gotten a lot of attention. Our view on the debt ceiling is largely it's political theater, and it would just be too catastrophic for just about everything for them not to get a deal done. Certainly, could create some volatility in the short run. You know, we had a very easy example in 2011 of the same thing happening.
[00:12:30] Brad Weafer: We didn't have a European debt crisis occurring at the same time. But you know, you can see a lot of parallels and we had a lot of volatility in 2011 but it was transitory to use a popular term these days, and that weakness came through with the fundamentals, you know, driving through that.
[00:12:45] Brad Weafer: So we would expect something similar this time where lots of noise over the coming month but ultimately the returns are gonna be driven by the companies driving the economy and the companies driving the portfolio more, more specifically.
[00:12:58] Nick Peters: Excellent. Thank you very much, Brad. Very interesting as always, and best of luck with the volatility and uncertainty over the coming months.
[00:13:06] Brad Weafer: Thanks a lot, Nick. Thanks for talking with us.
[00:13:08] Nick Peters: Thank you.
Nick Peters and Brad Weafer
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