August 9, 2022
With the recent publication of Q2 results, the Fairlight investment team had the opportunity to review and analyse the earnings of the portfolio in the context of the current difficult inflationary operating environment. In this piece we discuss the performance of the portfolio across the three key inflation defences; pricing power, margins and cash conversion as well as comparing the performance to the wider market (we use the S&P 500 as a proxy for the market rather than the MSCI SMID index as the former has more reliable data).
With the earnings season largely complete we can assess which segments of the market have performed best, and in aggregate how successful index constituents have been in passing on costs to their clients. In aggregate the revenue outcome for the S&P 500 was impressive with all sectors delivering positive revenue growth. However, when assessing earnings, the story becomes more nuanced.
Energy, industrials, materials, real estate, healthcare, and technology delivered positive earnings during the quarter. However, of those only energy and industrials saw positive margin expansion. While the positive margin results from the energy market was price related, the industrials performance was due to lapping a poor quarter for the aerospace industry. In other words, for aerospace, results were less bad than last year.
Interestingly, despite the weaker than trend earnings outcomes (ex-Energy) both the sell side (brokers) and buy side (asset managers) were positioned too bearishly during the period. Earnings per share beat sell side estimates by 3.4%, and stock reactions to earning misses were positively skewed during the quarter compared to history. In aggregate share prices were flat for those that missed quarterly expectations compared to a five-year average stock reaction of -2.7% suggesting that asset managers were expecting worse outcomes than were delivered.
As it related to Fairlight, the portfolio delivered revenue and earnings ahead of the S&P despite holding no energy companies which had a particularly strong quarter (Figures 1 and 2). The portfolio delivered a median +10.8% earnings result, outpacing the US core inflation rate of 5.9%.
Critical Business Attributes During an Inflationary Regime
1. Pricing power
On the establishment of the Fairlight strategy, the first input into our valuation framework was the ability of companies to raise prices without losing market share or significantly diminishing demand. In aggregate we have been pleased with how our businesses have delivered against our original assessments during the quarter. All our holdings have increased or held market share during the quarter and in our estimate over 90% have either passed on costs during the quarter or will do so over the coming months.
2. High margins
High margins during periods of inflation is critical. This point is demonstrated with an example of a 10% EBIT margin business compared to a 30% EBIT margin business. If each faces a 10% increase to their cost base that can’t be passed along with pricing, the lower margin business will see a 90% decrease in earnings compared to a more manageable 23% for the higher margin business. The Fairlight portfolio has a weighted average EBIT margin of 27% compared to S&P 500 currently at 18%.
3. Strong cash conversion
During periods of robust inflation, high capital expenditure (capex) budgets result in depreciation schedules being understated in profit and loss statements. In future years this often results in lower margin outcomes as the true costs of running the businesses are realized due to higher costs, which in turn can be a reliable source of earnings downgrades. A way of measuring the likelihood of future capex-driven earnings per share downgrades is via cash conversion. Highly capital-intensive businesses, those with high capex bills, often convert less than 100% of net profit to cash. For the Fairlight portfolio the aggregate cash conversion ratio is currently 106%.
The Fairlight View
We have now seen two full quarters of performance during the post-COVID inflationary environment. We are pleased with the performance of the Fairlight holdings and believe that in the long term it is earnings per share outcomes that drive share prices, not narratives.
While we are always looking for signs of investment thesis drift and opportunities to reinvest behind confirming evidence, recent activity on this front hasn’t been elevated compared to the history of the strategy. Where we have recycled capital, it has typically been to increase the weight of existing holdings – businesses we know well and have been waiting for opportunities to take weightings higher.
Most, if not all investee companies are using a more troubled macro environment to extend market leading positions and drive significant market share gains which will drive positive shareholder returns as the environment inevitably turns more favourable.