There has been much written in recent weeks on the resurgence of inflation and traditional ‘value’ investing, a view we have sympathy for and, as quality investors, continue to be paranoid about. 
We are vigilant on valuation risk whilst also remembering that growth and the sustainability of return on capital (quality) are key components of long-term value. A high PE stock can therefore be a formidable ‘value’ stock, as can a low PE stock - generalising can be dangerous.
Regarding inflation, we seek out companies with strong market positions (enabling pricing power), are asset light (do not get weighed down by high reinvestment inflation or capex) and have sensible balance sheets to avoid interest cost headwinds (if inflation and associated bond yields do rise) therefore making them more competitive to more levered peers.
That said, whilst not core to their investment cases, higher rates would be a good direct driver to a number of our holdings if this scenario were to play out, for example Charles Schwab, AJ Bell, Hargreaves Lansdown and ADP.
We don’t have blinkers on, and we recognise the potential upside in stocks/sectors we have typically shied away from, particularly the oil & gas and the banking space. Taking the oil sector as an example - amidst supply side rationalisation, cost cutting and pragmatic changes in capital allocation policies (lowering the dividend pay-out ratio), there is a good argument to make decent returns. So why does our quality-focused approach to UK equity income mean we avoid the sector?
There are a few reasons and a number of lessons gleaned from my childhood growing up in the world of arable farming, which helps bring them to life:
1) Focus on what you are good at growing
As a farmer you grow crops that you think you can grow well, whilst keeping a healthy crop rotation. If the soil on your land is not suitable for cabbages, say, and nor do you have the expertise and tools to grow cabbages well, you avoid them.
Similarly, as investors we have expertise and tools which make us better at picking certain stocks/sectors than others – those within our circle of knowledge. To me, the oil & gas sector is a ‘cabbage’ due to all the unknowns. What we do know is that many of the desirable business, financial and capital allocation traits we look for are not typically exhibited in these companies.
2) Do not grow cabbages just because your neighbour does
I struggle with prevailing interpretations of risk within our industry and question whether you should invest in companies purely because they appear in a benchmark, even when the companies don’t exhibit the desirable qualities you seek. Would a farmer grow cabbages just because the neighbouring farm does?
3) Structural growth is a tough gig
You shouldn’t overlook the challenges in achieving growth in many commodity businesses, nor that scale does not necessarily create a better business. To really grow an arable farm you must acquire (preferably adjoining) land which can be costly (depending on when you invest in the cycle and/ or how opportunistic you are).
Consequently, farms will typically have the same acreage for sustained periods. Thus, growth is reliant on improving crop yields – challenged by the unpredictability of the weather - and a resurgence in commodity prices. Costs should therefore be kept as low as possible to account for the volatility in annual earnings impacted by external factors.
Oil producers face similar challenges as seen in their adjusted EPS (earnings per share) over time. We favour capital light businesses which barely have any incremental cost to grow and are less exposed to unpredictable externalities – AJ Bell is a good example.
4) A structurally lower cost base is key
Given the unpredictability of the commodity price, it is essential to not be a marginal industry player and operators need to do everything they can to be sustainably efficient. This demands farmers to adequately reinvest in their businesses to structurally lower their cost base and operate at the lower end of the cost curve.
This is illustrated in our recent investment in Mondi, which operates in the first and second quartile of the paper and packaging cost curve, ensuring a reasonable through cycle return on capital. The same concept can be applied to our team’s investment in Ryanair in the airline space, JD Wetherspoons in the pubs space and Charles Schwab in the US platform space.
Using scale to reinvest in price can provide a healthy flywheel dynamic which we observe across many of our holdings, but we are unable to make these arguments for UK big oil.
5) Capital allocation is equally important
Given the difficulty in growing volumes/yield, successful farmers not only need to be good at growing their crops coupled with the support of favourable commodity prices, but also to be mavericks when it comes to reinvesting, i.e. invest counter cyclically. Buying another farm when farmers’ incomes are low due to unforeseen commodity price headwinds is often an astute strategy, but it requires patience and a build-up of capital before the event.
2020 could have been a great opportunity for oil & gas companies to allocate capital for growth, but their balance sheets would not allow it to happen as the pre-2020 period was spent levering up to feed unsustainable dividends, rather than hoarding capital. Whilst it’s encouraging to see their dividends have since rebased to more sustainable levels, I would welcome counter-cyclical investment in this sector.
Hopefully this brings to life why we naturally avoid certain areas of the market, especially if we cannot identify stand out industry leaders who reinvest to sustainably fortify their existing market positions and make efforts to stand out from the crowd. Low costs and astute capital allocation are everything in commoditised sectors. We accept that this approach will lead to a divergence in shareholder returns versus our benchmark but going back to the farming analogy, we would sooner grow crops we understand as opposed to cabbages that we do not.
Ben Needham is manager of the Ninety One UK Equity Income fund. The views expressed above are his own and should not be taken as investment advice.