Investors would be better off considering the sustainability of revenues and cash flows rather than earnings multiples and dividend yields according to Troy Asset Management’s Sebastian Lyon, after recalling one of his first stock picks on the Trojan fund. 
Describing his purchase of EMI as a contrarian value play, which he hoped would benefit from industry consolidation, the Alpha Manager said the company was beset by a similar type of technological disruption now being observed in other industries.
“Originally the Gramophone Company, established in the late 1890s and formerly known as Electric & Musical Industries, EMI had recently demerged from Thorn [when] I acquired the shares in 2001,” he said.
“From a glorious past, EMI benefited in the 1990s from the growth in CD sales, but by the time of our purchase it had become dubbed ‘Every Mistake Imaginable’.
Lyon said that after CD sales peaked in 1999, shares were depressed amid a series of attempted bids and mergers. Without a suitor, “EMI limped on with little protection from the onslaught of digitisation”.
The manager acquired the shares before the full force of the internet began to take its toll on music industry revenues, admitting that it would take until 2015 before earnings began to recover.
From a peak of $38.6bn in 1999, music industry revenues slumped to $14.3bn by 2014, said Lyon.
“In recognition of the deterioration in future profitability, we sold the holding in 2003,” he added. “Subsequent performance and ultimately the private equity buyout could not save EMI, which fell into the lap of its lenders a decade after my initial purchase.
“With hindsight, the company’s past was greater than its future.”
As such, there were several “painfully learned” lessons that the Alpha Manager took from the experience.
“Buying a stock after its first profits warning is often problematic,” he said. “There may well be more to follow – almost every six months in the case of EMI.”
In addition, simple valuation metrics of current earnings multiples and dividend yields are not enough on their own to make an investment decision. Instead, Lyon recommended considering the sustainability of the revenues and cash flows that are funding those dividends.
Finally, he said that while it is impossible to predict what the future holds, investors can attempt to model long-term trends.
“An investor attempting to buck those trends, rather than benefit from them, will lose,” he added.
As a counterpoint, he offered the example of Microsoft which he first purchased in summer 2010, saying it “has been profound in shaping our thinking”.
Performance of Microsoft over 10yrs
Source: Yahoo Finance
“We first bought the shares believing that Microsoft’s headwinds for its core productivity software tools were more apparent than real,” he said. “This was a contrarian call at the time and I still have the doubtful client e-mails to prove it.”
Lyon said that, like most other people, the team underestimated the potential from Microsoft’s transition to cloud computing and its “capacity for rejuvenation under new leadership”.
Given its position in the cloud computing space, the company has been able to reinvest high free cash flows back into the business to capture further growth.
Lyon said Microsoft chief executive Satya Nadella also highlights the importance of good leadership and governance for long-term returns.
Yet, as the stock – along with other tech names – has risen strongly over the past nine years, there have been times that the manager has been nervous about the valuation.
“Investors interrupt compounded growth at their peril, and absent any structural deterioration in operational performance, the best thing to do in these rare situations is absolutely nothing,” he said.
“The investment in Microsoft has grown sevenfold since it was first made, a 23.3 per cent annualised total return, and while most investments won’t work out nearly as well, it is essential that the investment process is flexible enough to solve them.”
This experience and 30 years in the industry have taught Lyon the primacy of return on capital employed and how businesses with sustainable high returns will be rewarded.
He said the survivors and failures of the FTSE 100 serve to remind investors that time is against the weak but benefits the resilient – and of the importance of debt.
“Banks seemed attractive investments when returns on equity were high before the crisis, but this was only made possible with huge leverage that was not available to other industries,” he explained.
“After all, no bank would lend to an industry financed like a bank.”
He also warned of “modern day EMIs” among the value stocks that have seen a resurgence more recently, including those companies that are disrupted by technological change and the erosion of pricing power.
Nevertheless, he said there were few signs that the global economy is bottoming out, even if growth is weak. He added bouts of stock market rotation are not uncommon – particularly after such a long period of outperformance – and should lead to some opportunities.
The £4.3bn Trojan fund is managed by Lyon with colleague Charlotte Yonge. It invests in a range of assets aiming to deliver capital growth ahead of the UK retail prices index rate of inflation over five-to-seven years.
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
Since launch in May 2001, the Trojan fund has made a total return of 253.75 per cent compared with a 132.68 per cent gain for its average IA Flexible Investment peer and a 67.05 per cent rise increase in the UK retail prices index. The fund has an ongoing charges figure (OCF) of 1.02 per cent.