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Fund in Focus: US Multi-Cap Income

In this episode of Fund in Focus, investment advisor Nick Peters is joined by Brad Weafer, manager of the Marlborough US Multi-Cap Income Fund.


Fund in Focus: US Multi-Cap Income


[00:00:00] Nick Peters: Hi, I'm Nick Peters, Investment Advisor at Marlborough Group. And today I'm joined by Brad Weafer, the Fund Manager of Marlborough's US Multi-Cap Income Fund.

[00:00:18] Nick Peters: Hi Brad, how's it going?

[00:00:19] Brad Weafer: Hey Nick, good to see you.

[00:00:21] Nick Peters: So Brad, we usually start with a fairly straightforward question, please take the listeners through the philosophy and process of the fund.

[00:00:29] Brad Weafer: Sure, and it might actually be easier to explain how we're different from sort of the traditional fund manager. You know, I think many investors fall in one of two camps, and we see both having major challenges.

[00:00:41] Brad Weafer: In one camp, the investor will tell you that the companies they own have dramatic and underappreciated growth opportunities.

[00:00:48] Brad Weafer: Often they're investing behind a theme that relies on Nostradamus like view of the future. We think this is really, really difficult, and often these stocks are very expensive.

[00:00:58] Brad Weafer: In the other camp, investors will choose stocks that are statistically cheap. In this case, they'll tell you expectations are too negative.

[00:01:05] Brad Weafer: Unfortunately, this approach also has another challenge, that the stocks are often cheap for a reason. Either their results are highly cyclical, the companies have tons of financial leverage, and they have a history of poor profitability. We take a decidedly different approach. We focus on the durability of companies profits and growth.

[00:01:23] Brad Weafer: We're looking for quality businesses that meet an exacting standard of predictable returns on capital, cashflow and profitable growth opportunities. You know, to use a little bit of a cliche, we're looking for all weather businesses. We want businesses that can prosper no matter what the next great investment theme is, no matter if the economy is in a cyclical upturn or downturn.

[00:01:45] Brad Weafer: And what I'll tell you is those businesses are exceedingly rare. Because of that, we think it's critical to keep our standards high and we manage a very highly focused portfolio. And this portfolio looks very different than the standard equity index.

[00:01:58] Brad Weafer: The index gives you an average business. We're looking for extraordinary businesses.

[00:02:03] Brad Weafer: It's important to note though, a good business can also be a bad stock, and we have to make sure that we don't overpay for this quality. We sometimes wait years for opportunities to get the right price for a company that trades at the right price to make it a proper investment and, you know, worthy of inclusion in the portfolio.

[00:02:21] Nick Peters: It's probably worth highlighting that it's a pretty focused list as well, yeah?

[00:02:25] Brad Weafer: Yeah, we're looking for, you know, essentially 25 to 35 companies and again, you know, we really do think these are more rare than most investment managers would suggest and we want to make sure that portfolio returns benefit from each of those companies, and we hold a focused group of companies.

[00:02:44] Nick Peters: And can you maybe talk us through one of the recent purchases to bring the philosophy to life?

[00:02:49] Brad Weafer: Sure. How about we start with a company we just recently purchased, a company called Rollins. This is a company we've waited for the right price on for years and admired from the sidelines for almost a decade.

[00:02:59] Brad Weafer: The company's claim to fame is they own the second largest pest control company in the US. Pest control is a really attractive industry, but it might not seem like it on the surface. Extermination is an essential service that customers are loath to do without.

[00:03:16] Brad Weafer: Nobody likes bugs. They can do damage to your house, they can do damage to your business. Just think about what would happen to the reputation of your favorite restaurant if you saw a roach.

[00:03:25] Brad Weafer: I don't think that those restaurant owners are going to skimp on pest control in a recession, 80% of revenue is considered recurring, and the company boasts 85% customer retention. So, predictability is a major feature of this business.

[00:03:38] Brad Weafer: You can see that this business should be durable through a full cycle. Pest control also has a low risk of technological obsolescence. We don't want to get caught off guard by, you know, businesses that can change on a dime. The old joke that the only thing to survive a nuclear war are cockroaches and Keith Richards, I think really rings true when thinking about Rollins.

[00:03:58] Brad Weafer: The business isn't capital intensive, capital expenditures are quite low annually, and you know, I just mentioned a lot of good qualitative things about Rollins, but you know, the results are borne out in their financials. The proof is really in the pudding. The company's grown sales and profits consistently for decades, proving remarkably resistant in the slowdowns of 2002, 2008 and 2020.

[00:04:20] Brad Weafer: The company hasn't reported a down year in sales in over 20 years. Returns on capital have hovered near 40 percent annually, which is really remarkable. Okay, pest control sounds like a boring business, right? But its growth and returns have been outstanding. The company's compounded free cash flow per share at a 15% annual clip over 20 years.

[00:04:41] Brad Weafer: The stock has outperformed the S&P by 10 percentage points per year during that time frame. Honestly, looking ahead, we see much more of the same. Warm and wet weather breeds more bugs and global warming, while unfortunate, is a good thing for the pest control industry. What's more, if you were to look at demographic trends in the US, people continue to migrate south. There are more bugs in the south. It's warmer and wetter there.

[00:05:04] Brad Weafer: Third party estimates suggest Rollins and the pest control industry can grow 4 to 6% organically from price and volume. On top of that, the pest control industry is highly fragmented. There are lots of mom and pop organizations that Rawlins has and can continue to acquire and improve over time, growing the business even more.

[00:05:25] Brad Weafer: You know, I mentioned we've watched this business for a decade, I think about 40 percent of the company is owned by the founding Rawlins family, which is actually an attribute we often look for in companies. That company underwent a monetisation of some shares to give some wealth to some of the disparate family members this fall.

[00:05:41] Brad Weafer: The stock was weak on that announcement and we were able to capitalise and buy shares at a discount to where they've traded for years. And we were able to be nimble enough to get in and hopefully get right on that growth train that the company's been underway for the last 30 years.

[00:05:55] Nick Peters: Okay, thank you. One of the aspects you mentioned was that sort of enduring growth, but of course, there are times where that can come to an end, but it seems that you're not slow in cutting positions. If there are signs of that, can you maybe talk about one of the stocks that recently exited the fund?

[00:06:12] Brad Weafer: Sure, so if you look at our portfolio, our turnover is quite low.

[00:06:15] Brad Weafer: We're looking for businesses we can own for many years. So, portfolio averages, you know, roughly 10 to 15% a year, so, we're looking at holding periods of close to a decade. But as you say, it doesn't always work out that way and we can get things wrong, but also sometimes management teams can mess things up.

[00:06:31] Brad Weafer: A good example of that is a company called Ritchie Brothers. Ritchie Brothers is the global leader in used heavy equipment auction market. What does that mean? They hold auctions for used bulldozers and tractors and heavy industrial equipment. Marketplaces are wonderful businesses, usually the auction maker gets paid from both sides of the transaction, the buyer and the seller and essentially, these businesses get better and better with scale.

[00:06:58] Brad Weafer: The more equipment you can sell brings more buyers. The more buyers brings more volume to the marketplace. It's a virtuous cycle and it continues to the benefit of the operator.

[00:07:08] Brad Weafer: This business of selling industrial equipment might sound cyclical on the surface, but actually it's much less cyclical than you'd think.

[00:07:15] Brad Weafer: You think about how this would go if the operator of a large construction company has their business slowed down, they'll be much more apt to put volume onto the marketplace by selling some of their fleet. So you've got this sort of defensive profile on volume that helps in cyclical downturns.

[00:07:31] Brad Weafer: The company has generated strong free cashflow and returns over multiple business cycles.

[00:07:37] Brad Weafer: We first invested in RBA after COVID, when frankly much of the auction marketplace was forced online. RBA had The benefit of investing, seeing this coming sort of long term, investing behind their online platform and really leveraged COVID to drive profits and improve their competitive advantage.

[00:07:58] Brad Weafer: It also helped improve their balance sheet, they had great cashflow through that period and you know, they were set up for years of solid growth.

[00:08:05] Brad Weafer: Unfortunately, management had some other plans. Late last year, the company announced they were acquiring the assets of IAA. IAA is actually a decent business, they run a slightly different auction model for salvaged autos.

[00:08:20] Brad Weafer: It's a related marketplace, but not the same marketplace as RBA was operating. And frankly, we know this business quite well. We know their competitor, Copart, quite well. And after a period of significant under investment by their private equity owners, by a previous holding company's ownership. IAA has been ceding share to Copart for many years.

[00:08:40] Brad Weafer: We really didn't see RBA being able to turn around that trend at all because the synergies to the deal just weren't quite as strong as the company was suggesting. We also saw RBA spend a fortune on this deal, diluting equity holders, adding balance sheet leverage, not exactly what we wanted to see and frankly, we weren't the only one.

[00:09:01] Brad Weafer: A proxy battle ensued trying to stop the deal, and RBA's management went as far as to increase the offer price to IAA holders, to what we saw as the detriment to current RBA holders. The proxy failed to stop the deal, and after the deal went through, we exited the position.

[00:09:19] Brad Weafer: It's the old adage that good businesses can be run by bad management teams, you know, held true here. We still like the assets, frankly, but did not see this deal as positive for shareholders, and we, we licked our wounds and moved on to greener pastures.

[00:09:35] Nick Peters: Okay, thank you for that. I suppose talking about good businesses, I mean the fund's done very well in recent years against the peer group, even given the performance of the, the Magnificent Seven, as they've been called, has been stellar.

[00:09:47] Nick Peters: Of those seven tech stocks, you own Apple and Microsoft. Why just those two?

[00:09:55] Brad Weafer: We do own two of the magnificent seven, and why do we own those two? Well, hopefully it makes sense given what we just said about our philosophy and our process. Let's take Microsoft as an example. As a finance professional myself, I can't imagine a world where operating in my job without the tools like Microsoft Excel is possible.

[00:10:13] Brad Weafer: Every year that I create more spreadsheets, PowerPoint presentations, etc. It becomes harder and harder to imagine transitioning away from Microsoft products. They've developed such an entrenched position in business productivity software that they can largely take price every year on their recurring base of software revenue.

[00:10:30] Brad Weafer: This has created an almost, you know, magical cash flow stream and their returns are just amazing. What's more, they've done a really excellent job behind Satya Nadella the last 10 years, of investing that cash flow and building additional platforms for growth, most notably in cloud.

[00:10:46] Brad Weafer: As we sort of look forward, they're in a pole position to take advantage of the move to artificial intelligence, helping productivity within their suite of software solutions and the main owner behind ChatGPT's developer and in quite the position to continue their dominance.

[00:11:03] Brad Weafer: What about Apple? Well, the iPhone and all the services contained therein has become an an absolutely essential product for the vast majority of our population.

[00:11:12] Brad Weafer: I would take a kind of simple litmus test for the competitive position. As you walk into the office the next few days, count how many people bump into you because they have their head stuck looking at their phone and they don't hear you because their iPods are stuck in their ears. Until that stops happening on a regular basis, I think Apple's competitive position is in quite a good place.

[00:11:31] Brad Weafer: It's just a remarkable platform for profitable growth, and it's a staple in our portfolio.

[00:11:36] Brad Weafer: So that's why we own those, those two. Why don't we own those other magnificent companies?

[00:11:41] Brad Weafer: We talked earlier about looking for all weather companies, those that can withstand a cyclical downturn with ease. As you look at the business models of those other wonderful companies, we see a lot of cyclical risk in each of them, frankly.

[00:11:53] Brad Weafer: Amazon's a discretionary retailer. Tesla sells expensive electric cars. Google and Facebook make money off of cyclical advertising dollars, and NVIDIA is a semiconductor company, which that industry typically goes through significant inventory cycles. Those are clearly over and simple generalizations to be sure and don't do those companies real justice.

[00:12:13] Brad Weafer: But at their size, it's really hard to imagine them not facing a real cyclical risk should the economy falter. Expectations are also quite robust for these companies and the downside in our opinion to those companies over the next several years is too high and we're frankly happy to look for better opportunities elsewhere.

[00:12:29] Nick Peters: Okay, thank you. Just taking a step back and looking at the market environment, it feels like there's been a pivot from the Fed in terms of their view of when rate cuts are coming. That's been interesting to see how the market's reacted to that, but what are your companies telling you about the current environment?

[00:12:45] Brad Weafer: Yeah, it's been a pretty wild few months for interest rates, capped most recently by a big move lower here in the States, after Federal Reserve officials statements have suggested they're likely to cut interest rates next year. It's difficult to make too many generalisations about our companies but at a high level, when you think about it, we look for companies that can self fund their growth.

[00:13:06] Brad Weafer: Typically those companies are less reliant on the capital markets and that's a good thing, right? Balance sheet leverage tends to be much lower than the typical company. So many of our companies were spared some of the strongest effects of rising rates last year.

[00:13:19] Brad Weafer: However, we have seen some of our companies benefit. The companies that their business models support additional leverage. I'm thinking very specifically of cell phone tower operator, Crown Castle. They've seen a big benefit from lower rates, at least in the stock market over the course of the last month.

[00:13:34] Brad Weafer: And we appreciate their CFO and we would expect them to continue to manage their debt load as rates have moved sharply lower. We've also seen a benefit in our housing related names. We own a few, Sherwin Williams, Wattsco as examples. With mortgage rates moving lower and housing activity expected to benefit from lower rates, we've seen an uptick there.

[00:13:56] Nick Peters: Okay, there's been more commentary these days of an equally weighted S&P index as possibly a strong alternative to the S&P 500, which is obviously dominated by those mega cap tech stocks. What's your thoughts on that?

[00:14:11] Brad Weafer: Well, I mean, 2023 has had the cap weighted index outperform the equal weighted index by more than any year outside of the height of the dot com bubble, so it's not a surprise that this is coming up.

[00:14:21] Brad Weafer: Will that come to an end this year? That's a tough question.

[00:14:24] Brad Weafer: We tend to believe more in the power of preparing rather than predicting. I'm not sure if the Magnificent Seven will outperform next year. I'm not sure what the Federal Reserve will do, and I'm not sure if there will be a recession next year or this year.

[00:14:37] Brad Weafer: Frankly, I don't think there are a lot of investors who can answer those kinds of questions well consistently. But I am confident in our companies and the opportunities they have for durable growth. And frankly, we see a credible path for each stock to earn investors a consistent rate of return, no matter what the macro environment looks like, whether or not the Magnificent Seven carries the day next year or doesn't.

[00:14:57] Brad Weafer: Would it be great to have owned companies like NVIDIA this year? Of course, but we don't need to own all the good stocks. We just need to own a concentrated group of companies that can consistently deliver over time. You know, if we do that, I think that the relative performance will work itself out and we'll be just fine.

[00:15:13] Nick Peters: Excellent. It's very clear that this is a very much a bottom up driven fund, but I can't end the podcast without highlighting that it is of course election year next year in the US. What are your thoughts on the impact of that on the stock market?

[00:15:28] Brad Weafer: Nick, you're full of the easy questions. You know, I'd like to say that the state of US politics can't get worse. But frankly, my expectations are pretty low. It is almost embarrassing, you know, how bad politics have been in the US and I think it's probably going to ramp up this election year.

[00:15:44] Brad Weafer: I do think that the experience of the last two elections is worth bearing in mind. In 2016, the idea of Donald Trump as the president was unheard of and ahead of the election I think many would have predicted a complete market disaster if Mr Trump was elected, that's not exactly what happened if you remember.

[00:16:02] Brad Weafer: In 2020, the prospect of a Democratic president was equally panned and considered bad for big business. Again, not what happened, we, we had a several years of very good returns.

[00:16:13] Brad Weafer: So any assumptions on the election that I might provide to you, I would take frankly with a grain of salt. And I think it's a little early, honestly, to, to make too many predictions either. There's questions of, uh, will we get a third candidate? Will former president Trump be indicted and convicted? Will Joe Biden be the ultimate candidate for the Democratic Party?

[00:16:33] Brad Weafer: Lots of things to consider, but near term, I like the prospect of an incumbent sitting president running for re election. Voters tend to vote with their wallets, and we'd expect consumer friendly policies to be in place as much as possible to help President Biden get re elected.

[00:16:49] Brad Weafer: The unemployment rate today in the US has been below 4% for over 22 straight months. US consumer confidence has been showing signs of improvement of late as well. Both gas prices and interest rates have been falling. These are all sort of good signs for the consumer and some additional support, favorable for voters, could certainly help things next year.

[00:17:09] Brad Weafer: So if we're wrong about that, if things get dicier from here politically, frankly, I like the chance our companies have of dealing with that better than any forecast that we can provide on the election.

[00:17:19] Nick Peters: Excellent, Brad. That's a really great update. Thank you very much for your time.

[00:17:24] Brad Weafer: Thanks Nick. Great to talk.

[00:17:26] Nick Peters: That was Brad Weafer, Fund Manager for the Marlborough US Multi-Cap Income Fund, and if you'd like to find out more information on the fund, please go to our website marlboroughgroup. com. Thank you.