September 10, 2020
Fairlight’s investment strategy focuses on identifying and owning wealth creating businesses – those that generate returns well above their cost of capital for the long term. Such businesses possess two key traits:
· a resilient earnings profile which allows them to survive unexpected periods of economic distress, industry turmoil or company-specific setbacks; and
· a set of enduring advantages that sets them apart from the competition.
When the operating environment for business is benign it can be tempting to loosen or overlook the hurdles for resilience. However, it is times of stress, such as the COVID-19 related shutdowns, that indicate whether appropriate discipline was maintained in the investment process prior to the crisis. Results from the most recent reporting season provide an excellent litmus test for the resilience and durability of the Fairlight portfolio.
Analysing revenue and earnings resilience
Using data from the 2Q20 reporting season (1 April to 30 June) two metrics have been used to quantify the resilience of a business. Firstly, the underlying change in revenues in a period which indicates how dependent a business is on external factors. Secondly, the change in earnings (EBIT) which indicates the operating leverage inherent in a business and the ability for management to dampen the impact through cost actions.
Figure 1 compares the change in revenue distribution of the Fairlight portfolio with that of the constituents of its relevant benchmark, the MSCI Global SMID Index. Using Figure 1 we can see that 48% of Fairlight portfolio companies actually grew revenues in 2Q20 (vs only 36% of the Index). Further, 43% of companies in the Index suffered a >10% revenue decline compared to only 20% of the Fairlight portfolio. During the COVID shutdown the median change in revenues for the Fairlight portfolio was flat year over year, a resilient performance in our view.
In Figure 2, which illustrates the change in earnings (EBIT) of the Fairlight portfolio against the Index, we can see that 46% of companies in the Index suffered a >30% earnings decline in the quarter compared to 20% of Fairlight holdings. In addition, despite the COVID shutdown 48% of Fairlight holdings managed to grow earnings in the quarter. For the median business in the index earnings declined 24% compared to only a 2% earnings decline for the median Fairlight business.
Thrive not just survive
Under the classical model of capitalism, businesses that generate high returns on capital quickly attract determined competition, exerting downward pressure on returns towards the cost of capital. For this reason, Fairlight not only focuses on the resiliency of portfolio candidates but also continuously assesses the durability of their competitive advantages. In a crisis it is businesses with conservative balance sheets and seasoned management that are able to invest and capitalise on weakened competition. With this in mind, it is pleasing to see that most of Fairlight’s investment companies are treating this crisis as an opportunity to expand their market leadership further. Power tools manufacturer Techtronic Industries epitomises this behaviour best.
In stark contrast to competitors which turned to cost cutting through the pandemic, Techtronic increased production, accelerated new product development and expanded sales coverage globally. These moves allowed the company to fully take advantage of a surge in demand from DIY customers which more than offset a weak professional market. Techtronic’s organic sales in North America grew 15% over the first half of 2020 whilst sales at main competitor Stanley Black & Decker fell circa 10%. Given the platform nature of cordless power tools, Techtronic is likely to hold onto these market share gains as batteries can be switched amongst Techtronic tools but not across brands, incentivising customers to turn to the company again when buying additional tools. Techtronic’s journey of profitable market share gains is far from over.
The Fairlight View
The Fairlight strategy is designed to reduce risk within the Global Small & Mid Cap asset class and we are pleased by the performance the Fund was able to deliver during this difficult quarter. Our portfolio holdings continue to generate attractive returns on invested capital, with low leverage, whilst being operated by capable management teams. We find the outlook statements accompanying the Q2 earnings releases encouraging and believe the Fund is well positioned to deliver on our stated investment objectives.