Language And Country
Dear Co-investors, we are writing this letter to share some ideas with you in a less formal (but equally valuable) way than through our periodic reports. We believe that a good relationship must be based on transparency and trust. It is important to us that our Co-investors share our philosophy, beliefs, approach and patience. To this end, we want to explain what we do as simply as possible. We describe you as 'Co-investors' because we see our relationship as a partnership in which your role is crucial and because we manage this fund as if it were our own money – which is indeed partly the case... ('Skin in the game!’; 'We eat our own cooking!'). Happy reading!
‘Investing consists of one thing: dealing with the future. As none of us can know the future with certainty, risk is the essential element in investing.’ – Howard Marks
Let's start by reiterating our objective, which is to provide a higher risk-adjusted total return than the global equity markets over a full cycle, by investing in high-quality companies offering attractive, sustainable and growing dividends.
What do we mean by risk? Risk is largely unmeasurable.
To better understand this point, let's look at Guardiola’s Barça. This team won every possible trophy, not by having the best attack in history or a defensive wall preventing a record number of opponents’ goal-scoring opportunities, but instead through its very high ball-possession rate, averaging around 70%. This means that the team had twice as much ball possession as its opponent, which greatly reduced the risk of the opposition's potential scoring opportunities. The strength of the team lay in an invisible, unmeasurable element: opponents’ opportunities that never materialised.
The same goes for equities. For example, achieving a 10% performance with 'a Unilever' (bought at a reasonable valuation of course) is, in our opinion, much more valuable than achieving a 10% performance with 'a niche biotech' since the number of potentially (un)favourable scenarios is very different for these two companies and the probability of survival/success bears no comparison. Unilever is a very profitable company with a strong balance sheet, a leader in 81% of its categories/countries by virtue of many strong brands that have been meeting the primary needs of billions of people every day for decades. It also has a huge distribution network in 190 countries, low-cost production capacity on every continent and enormous innovation and marketing power. In contrast, the ‘niche biotech’ needs external capital and a 1 in a X,000 chance of its drug reaching the market before it could ever become profitable.
There are also many possible routes to finally achieving this 10% performance. Although volatility offers opportunities for long-term investors, most women and men on our planet are more comfortable with shortcuts rather than journeys that include a 50% loss in the process and require a strong heart and the courage not to sell in the meantime...
Simply admiring the performance of investment funds without meticulously studying the method and above all the risks involved makes no sense to us. It is a bit like judging the work of an architect by admiring the beauty of some of her or his bridges while ignoring the fact that other badly designed ones have collapsed.
Appreciating short-term performance makes even less sense although it is becoming increasingly fashionable by the day. The shorter the period of time over which a performance is observed, the more it is influenced by chance.
Worse still, but no less common, is drawing conclusions about fundamentals based on short-term price movements, a mistake that is all the more dangerous given the human tendency of looking everywhere for causality and taking subjective experience as reality.
We hope that you view your shares in BL Equities Dividend as a long-term participation in the success of high-quality companies.
Your role is crucial because, the more you share our philosophy and approach – and extend your investment horizon – the more you help us to work wisely and increase the chances of success, our common goal.
The roller coaster of 2020
Over full-year 2020, BL Equities Dividend’s total return net of fees in euros came to 1.37% for the retail share (B share) and 2.07% for the institutional share (BI share). If you want a yardstick for comparison, you can pick the one most to your liking, at your own risk...
- The MSCI ACWI Net Total Return Index (the index is supposed to represent the global equity market) shows a 6.65% increase (excluding fees).
- The MSCI ACWI High Dividend Yield Net Total Return Index (the index is supposed to represent the global equity market for attractive-dividend stocks) shows a 6.56% decline (excluding fees).
- The Lipper Global Equity Income category (‘dividend funds’) is down 4.47%.
So it was that in 2020, equity markets plunged or jumped based on events as unpredictable as the spread of a virus, reports on the number of infections and rumours about vaccines; political negotiations, measures and elections; or tweets from Donald Trump – and their interpretation by millions of people and algorithms.
In our opinion, the quality of our decisions is neither better or worse when, within the same year, the fund has a clear lead over an index or when it lags.
Is the reputation of a football club determined over the course of one season, good or bad?
Sky is the limit?
- In 2020, there were 480 IPOs in the United States, about 20% more than in the euphoric year 2000. The Renaissance IPO Index (a stock market index based on newly-listed companies) saw performance of 110% in 2020, compared to an average of 13% over the previous 10 years. The proportion of companies with book losses in this index is the same as in 2000.
- In the Russell 3000 Index (index of the 3,000 largest companies listed in the United States), the proportion of ‘zombie’ companies (i.e. presenting 3 consecutive years of operating profit below financial expenses) is at its highest level since 2000, close to 15%.
- The Insider Sell/Buy Ratio (ratio of sales to purchases of company shares by their management teams) for the S&P 500 is at its highest level in decades.
- The GS Non-Profitable Technology Index (a stock market index of US tech companies with book losses) has seen its share price almost quintuple since its low point in March 2020.
- The Bloomberg Galaxy Crypto Index, a cryptocurrency index (not the title of a fantasy film), was up 277% in 2020.
- Today, an investor can be guaranteed a negative return by buying and holding to maturity bonds with maturities of up to 10 years for Spain and France, and 30 years for Germany.
- More than two-thirds of the 2020 performance of the popular MSCI ACWI global index comes solely from the US ‘tech sector’. Just three stocks out of its 2,982 constituents accounted for over half of this performance. The median total return of these constituents shows a 1.7% decline.
- The third-largest contributor to the 2020 performance of the aforementioned index is a company with a stock price increase of 743% over the year and a bigger market capitalisation than Switzerland's GDP, having sold around 400,000 vehicles in the last twelve months.
Our aim is certainly not to make predictions about where the markets are going. We have no idea. We believe that there are two types of people: those who don’t know how to time the market, and those who don’t know that they don’t know how to time the market.
Nevertheless, these figures invite circumspection…
More fundamental, the fundamentals
Despite one of the most severe crises in history, the companies currently held by BL Equities Dividend show positive organic growth on average (over the first 9 months so far reported for 2020), and even a clear increase in their cash flows. ‘
'Felix qui nihil debet.’ As the Latin proverb says, happy is he who owes nothing. Our companies have a reasonable net debt level at 1.7x EBITDA on average.
Of our 33 companies, only two reduced their dividend per share in 2020 (while thousands of companies around the world have cut, suspended or even cancelled their dividends). The remaining 31 companies in our fund have maintained or even increased their dividend per share by an average of 6%.
When it comes to valuation, we value our companies according to our internal model, because the value of a company is the sum of its discounted future free cash flow, nothing else. It is certainly not calculated by an earnings multiple based on the past, the mood, the position of the stars, or by comparing apples and pears...
Nevertheless, to give you an idea, let's look at the FCF/EV ratio (free cash flow divided by the enterprise value, including debt as a precaution). At the end of December, our portfolio had a FCF/EV of 3.8%, compared with a median of 3.1% for companies in the most widely-used indices: the S&P 500, STOXX Europe 600, Nikkei 225 and MSCI Emerging Markets.
We find the idea of owning vintage Porsches at Peugeot prices rather attractive. More seriously, the conclusion is that our portfolio offers much higher quality at a favourable price. Reassuring for the future.
We believe that most analysts and investors underestimate the value of quality companies because they primarily focus on short-term factors rather than the compounding effect of higher cash flows over the long term.
‘If you buy the same securities everyone else is buying, you will have the same results as everyone else.’ – Sir John Templeton
What do all the best investors in history have in common, regardless of their style? Conviction-based portfolios that are very different from the norm (whether indices or competitors). This is logical but difficult to achieve in an industry obsessed with short-term performance, superficial analysis and benchmarks – because by daring to be different, you might make a mistake, get the blame, or even lose your job.
In theory, everyone knows that it doesn't make sense to judge short-term performance, draw conclusions without in-depth analysis or compare apples and pears. But in reality, almost everybody does.
There is one indisputable rule: reducing the number of positions in the portfolio forces selectivity... Our portfolio is concentrated on around thirty companies (much less than the industry average) with an ‘active share’, the percentage difference in composition between a fund and an index, of over 90% (much more than the industry average). Despite industry pressure, we do not dilute our convictions with low-quality companies and sectors on the basis that they are present in the indices. Do you prefer to frequent a few good restaurants or go to lots of restaurants, including bad ones, simply because they exist?
Our very different portfolio will inevitably produce results that deviate from the norm. Generally speaking, it would be unrealistic to expect a fund to outperform in all market phases if it stays true to its approach. No team has ever won the Premier League by winning all its matches...
‘The stock market is a device for transferring money from the impatient to the patient.’ – Warren Buffett
Most people admire 100 year-old sequoias but don’t have the patience to wait for a bud to appear. Although patience is becoming less and less fashionable, it is still our best ally.
In the long term, stock market prices tend towards the fundamentals. But in the short term, the scene is dominated by emotions, fear, euphoria and chance. Despite this, the average holding period of a share on the New York Stock Exchange nowadays is only a few months.
For us, buying a share means owning part of a company's capital, not a casino chip...
The companies currently in the portfolio have been held for more than 5 years on average, some even for more than a decade, such as Unilever, Nestlé and TSMC. Our turnover rate (18% on average over the last 3 years) is significantly lower than the industry average.
The more people trade stocks, the more they will need good ideas and opportunities (available in limited quantities) and they will by definition be less selective. In addition, the multiplication of decision-making automatically leads to a lower probability of success. And more orders generate more transaction costs. With a quality portfolio at a reasonable price, not placing an order is often the wisest decision.
When we analyse companies, we always try to take a long-term view and assess competitive advantages rather than drawing conclusions based on quarterly results, an analyst's recommendation, fashionable sectors or news stories on Bloomberg...
Economic and business investment cycles span many years, so why judge equity investments over much shorter periods?
Ideally, equity investors should assess their performance at most annually... after a decade...
Furthermore, time is on the side of quality companies. The more time passes, the more value they create and the more their intrinsic value appreciates (regardless of the short-term performance of their share price), and therefore the greater the likelihood of a pleasant return.
‘I have the simplest tastes. I am always satisfied with the best.’ – Oscar Wilde
Our fund stands out in its category, because first we select companies solely from our very limited universe of high-quality companies, and only then do we analyse the dividend aspect (in the end, only a few dozen companies out of the tens of thousands listed worldwide).
Although we can't make any promises about our future performance, we’d like you to know that you are in good company. Each of the companies held by BL Equities Dividend provides value-added, even sometimes vital, services/products to a diversified client base. In general, their activity is relatively non-cyclical. Each is a leader in most or all of its markets, in a dominant position, an oligopoly or even sometimes a quasi-monopoly (legally…), or holds unique licences.
Their strong competitive advantages and entry barriers (brand, patent, licence, innovation, distribution network, captive clients, network effect, cost advantage, etc.) enable them to create greater economic value over long periods, defying the law of competitive gravity. On average our companies post a ROCE (the return on the money that needs to be invested to enable the company to operate) of 19%, compared to a median of only 8% for companies in the above-mentioned indices.
Our companies need less investment to grow and generate more cash. They have a FCF margin of 17% (for every euro of sales made, they generate 17 cents of cash), compared to a median of only 8% for companies in the indices.
In addition, our companies have strong growth prospects.
‘Compound interest is the eighth wonder of the world.’ – Albert Einstein
We don't scour the major indices for the highest yielding stocks, which may never make it into shareholders' pockets. A very high dividend yield often comes from underlying companies that are poorly valued for the right reasons: structural problems, high cyclicality, low profitability and/or growth.
First we look for high quality companies that are able to reinvest their cash flows to develop their competitive advantages and entry barriers, grow profitably, and then distribute the surplus in the form of attractive, sustainable (because they are covered by cash flow) and growing dividends.
By the way, equities are the only asset class in which your cash flow is automatically reinvested tax-free (at high rates of return in the case of our companies).
And, unlike bond coupons, dividends can be increased. At the end of the year, BL Equities Dividend offered a gross weighted average dividend yield of 2.9% (cash included). The companies currently held in the fund post an average compound annual growth rate of their gross dividend per share of 7% over the last five years.
This seems attractive to us, especially in the current environment...
‘Anyone can hold the helm when the sea is calm.’ – Publilius Syrus
Clearly, our fund is not the right option to speculate on a rebound in cyclical stocks or ‘deep value’, or to benefit from an ultra-euphoric market or a bubble of in-vogue companies that generate no cash flow.
Nevertheless, very few funds in our category have gone through two major economic crises and present a similar risk/return profile.
Would you dare to take a trip in the mountains in a car whose brakes have never been tested?
Since its launch over 13 years ago, the fund has so far always been more resilient when global equity markets have fallen.
That is part of our objective, given the risk aversion of the majority of homo sapiens and the asymmetry between losses and gains (a share that falls by 50% must go back up by 100% to return to its starting price).
But obviously we could do better, and that is our goal.
‘Failure to handle psychological denial is a common way for people to go broke.’ – Charlie Munger
Investing in equities requires finding the difficult balance between confidence and humility. The confidence to invest differently and hold fast to your convictions despite fluctuating share prices, news, fashions, criticism, etc. And the humility to see reality as it is objectively, to recognise and accept your mistakes and not to keep repeating them. We keep a record of the mistakes we make. Don't panic, think of it as a good thing, because it means that (i) we are aware that we have made mistakes; (ii) we don't hide the fact that we have made them; (iii) we have the honesty to write to you about them (quite rare in our industry...); and (iv) by studying these mistakes, we reduce the probability of making them again.
‘Selecting a marriage partner clearly requires more demanding criteria than does dating.’ Buffett & Munger
For more than 13 years now, this fund has been invested with the objective that our Co-investors can sleep peacefully at night (and so can we).
We take the fact that you entrust us with your capital or the capital for which you are responsible very seriously.
We are circumspectly optimistic. Optimism is absolutely necessary for any equity investment and when considering the ability of our solid, high-quality companies to grow in value over the long term. The circumspect dimension reflects the discipline of being ready to question our investment theses, never forgetting that negative ‘black swans’ might surface, and always applying reasonable assumptions in our valuation models, whatever the environment.
BL Equities Dividend is managed with the idea that every day the portfolio is invested as if we should hold it forever without being able to modify it, enduring every possible good and bad scenario along the way, and consequently compounding both the good and bad performances ad infinitum. This type of approach makes a big difference when it comes to selectivity.
‘It is better to have a permanent income than to be fascinating.’ – Oscar Wilde
We don't take the huge risks of betting that perhaps one day Trust-Me Biotech will invent a magical treatment, Blabla-Oil will discover a gigantic oil field twenty thousand leagues under the sea, or that Trendy-Car will quintuple its sales and become profitable. We invest in companies that are already winners.
The companies owned by BL Equities Dividend were on average founded in 1927. They have withstood numerous recessions, crises and even wars and are still dominant and highly profitable today.
For example, PepsiCo has increased its dividend per share every year since 1972. L'Oréal and Nestlé haven’t reduced their dividends for six decades. Union Pacific has paid a dividend every year since 1900, Colgate-Palmolive since 1895.
Although things may change, that still gives an idea of the strength of the companies in which we invest.
Thank you for your trust.
Wishing you a happy new year and good health.