Most investors do not understand the term “barriers to entry”, according to Artemis’ Simon Edelsten, who says excluding industries where this hurdle is low is the most obvious first step for an active manager to take
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Edelsten (pictured), who runs the Artemis Global Select fund and Mid Wynd International Investment Trust, said that for him to bother owning an equity at all, he needs a reason to believe the company will have a high cash-conversion margin.
And the manager said that this is why barriers to entry are so important.
“If there isn't a fat margin, all the profit ends up being taken over by the debt holder or the bankers in the end,” he explained. “I mean, that's just how capitalism works.
“But ‘barriers to entry’ is an expression a lot of equity investors bandy around without actually thinking about terribly hard – quite often they're eroded, or they're not as high as people think they are.”
The manager said he ignores numerous sectors covering an enormous amount of the investable universe due to the ease with which new entrants can gain a foothold in that industry. He does not use a screen as such, saying that having done the job for so long, he already knows which areas to avoid.
Edelsten pointed to energy as a good example of a sector where barriers to entry are low.
“It's amazing how many oil companies you can have, all of whom claim that, you know, ‘it's a very difficult business to get into’,” he said.
“Then when you've met your second hundredth oil company, you realise that there are a lot of people in it for something so exclusive and so difficult. It seems remarkably easy to get into.
“And there are some industries which involve enormous cleverness and lots of plant. And yet there are still no barriers to entry. The chemicals industry, for instance, has gone from having 50 companies making every chemical to about a half a dozen, and yet the margins are still dreadful, the return on capital is appalling.”
The manager said that it is important to look at the history of different industries to see whether there is hard evidence of a barrier, as often the data flies in the face of conventional wisdom.
For example, one area where the hurdle is surprisingly low is the airline industry. Edelsten pointed out that almost every airline in the world has gone bust at some point in his lifetime, with new entrants continually popping up to replace them.
“People say, ‘surely that's a government licence, it's really difficult to get into’,” he continued. “The evidence is that it isn't.
“And yet, if you take something like the motor industry – which we don't invest in for other reasons – apart from Tesla, actually nobody's managed to develop a new motor brand for 100 years.
“Companies that were in at the start are still the companies that are in it today, oddly, even though the cars are nothing like the cars they produced 100 years ago.”
Trust's sector exposure
Source: FE Analytics
Edelsten said that in the modern economy, a lot of the barriers to entry are in areas such as tech. He pointed to US real estate investment trust Equinix as one example – the main attribute of the stock, one of the best performers in Mid Wynd over the past year, is that it owns large data centres next to the major internet hubs in areas such as Silicon Valley.
“So if you own the real estate, which sits over the internet hub in America, your server farm is closer to the pipe,” he added. “And anyone who hires your space, their bits will get to the other end faster than the next person's bits, which if you're in the trading business, really matters.
“So as the internet grows, things like video, people will need more server capacity and rent more space in their data centres.
“That's an example of a natural monopoly, a business which isn't regulated. So you’ve got growth, you've got rentier returns, i.e. much fatter returns than anyone thought they were going to get out of that land when there wasn't a tube coming out the bottom of it.”
Edelsten likes to swing between growth and value styles of investing. For example, he took profits from many of the FAANG – Facebook, Apple, Amazon, Netflix and Alphabet (Google) – stocks in the past few years on concerns about excessive valuations.
However, he said he was able to pick up Equinix for a reasonable price as it is classed as a property stock and so is not covered by tech analysts.
“This was on a property-company rating, with a yield, old fashioned assets, things like that,” he continued.
“And that's as close as you can get to one of those sorts of really defensive quality, near-monopoly type situations. These are ridiculously attractive compared with the other low risk option, government bonds, which seem as unattractive as anything I've seen in my career in financial services.”
Data from FE Analytics shows Mid Wynd has made 129.92 per cent since the current management team took over in May 2014, compared with gains of 98.57 per cent from its IT Global sector and 91.31 per cent from its MSCI World index benchmark.
Performance of trust vs sector and index under current management
Source: FE Analytics
The trust has ongoing charges of 0.65 per cent. It is not currently geared.
It is on a premium of 2.49 per cent compared with 1.75 and 1.37 per cent from its one- and three-year averages.