Five rules for resilience amid rocky markets

Barrage of headwinds

clock • 5 min read
Ken Wotton and Brendan Gulston, co-managers of the LF Gresham House UK Multi Cap Income fund
Image:

Ken Wotton and Brendan Gulston, co-managers of the LF Gresham House UK Multi Cap Income fund

Stocks are facing a barrage of headwinds – but this is nothing new for UK markets. After Brexit, Covid-19 and the war in Ukraine, investors may be thinking UK equities are forever ill-fated.

Now, more than ever, is the time to double down on British businesses. There are many high-quality resilient companies to be obtained for reasonable prices.

Simply by prioritising certain quality metrics, investors may be able to access strong income streams while reducing their portfolio risk. Below, are five measures to guide investors in selecting stocks that can ride out the storm.

Margins of safety

As a rule, invest in businesses with high and sustainable margins. For instance, our top ten holdings have EBITDA margins of 21% on average, and the majority have margins in the double digits. This creates a cushion allowing businesses to absorb cost inflation and other setbacks caused by the prevailing environment - in addition to powering growth and potentially increasing shareholder returns.

Companies with a competitive advantage or operating in a structurally growing market, which affords them a degree of pricing power, often boost elevated gross and net profit margins. Companies also need to have inherent operational gearing as they will be able to grow revenue without having to grow costs at the same rate, and this should lead to expanding margins. Meanwhile, strong business fundamentals are critical for ensuring the consistency and sustainability of these elevated margins.

EMIS Group provides a patient management software to GP practices in the UK. Due to its mission critical nature and lack of competitors - as NHS approved suppliers must pass rigorous testing - the company has substantial pricing power and high margins of 30%. As a leader in its area, with more than 58% market share in the UK, these margins are on track to expand further.

Cash is king

Another indicator of resilience is a business' ability to generate cash. Cash is important, as it ultimately drives shareholder returns through reinvestment into growth as well as distributions to shareholders.

Asset-light businesses are typically more cash generative, as they do not have to expend capital on physical assets, such as machinery or factories, which often require ongoing repairs and upgrades. 

XPS Pensions Group is an actuarial consultancy with low capex and high cash conversion as a result of being a people business. The technology-led platform is gaining market share in the pensions market, where top-tier firms have failed to invest in technology and services to trustees. The business should also demonstrate operational gearing, and should continue to grow fast enough for wage inflation not to impact profits.

Low levels of leverage

Investing in companies with net cash positions or little leverage is an indicator that they can continue to grow sustainably - whereas businesses that rely on leverage to grow are inherently higher risk as they have less margin for error when things do not go according to plan

We look for companies that are not consuming cash too fast, and growing at breakneck speed, but rather those that are targeting manageable growth, and can continue to reinvest in the business while generating additional cash for shareholders. On average businesses in our portfolio have a two times dividend cover - or 50% pay-out ratio. This means they are reinvesting 50% of profits into the business and 50% is being returned to shareholders providing a margin of safety to maintain dividend payments even in uncertain economic times.

This is much easier for asset-light companies, such as antibody licensing business Bioventix, whose value resides in its intellectual property. The business has a net cash balance sheet, and keeps £5mn aside for a rainy day, paying out anything beyond this as a special dividend. As a result, the company has seen impressive dividend growth over the last five years. A small company with only twelve employees, it reinvests the remainder  of profits into R&D.

Enduring earnings

The quality of a company's earnings is paramount to surviving turbulent times. It is important to assess both visibility and predictability of future income streams by unpicking a company's revenue line. Recurring or repeat revenue is ideal, as opposed to transactional business, which can be less predictable. However, we can also obtain comfort by examining a company's customer base and concentration of revenue across particular clients, demographics, sectors and geographies. Diversified revenue streams are important to mitigate unexpected events.

It is important understand is a company's cost base capacity. If, in order to grow, a company needs to add an office or new facility this could represent a material step up in fixed costs, which would reduce cash generation for a period. Companies should have ample capacity in their existing business wherever possible.

Smart Metering Systems (SMS) exemplifies the type of contracted, long-term visible income streams we look for. Backed by the government's 2024 target for installing smart meters in every British home and the country's net-zero aim, we are comfortable the smart meter business can continue to grow over the next five years. On top of this, SMS revenues are typically generated from inflation-linked contracts, providing further comfort in the current climate.

Management makes it

A high-quality management team can make an enormous difference in a company's ability to navigate macro headwinds. For this, we use our judgment, honed over many years of investing, and underpinned by independent   references sourced through our extensive network.

Every leader has different qualities, and not every CEO of a previously successful company will be able to navigate the choppy waters ahead. Additionally, alignment of interests is crucial. The incentive structure should motivate the management team to also meet our expectations as shareholders.

Ken Wotton and Brendan Gulston, co-managers of the LF Gresham House UK Multi Cap Income fund

More on Equities

Chris Hutchinson of Unicorn Asset Management

The Big Interview: What I learned after being dropped from Hargreaves Lansdown's Wealth Shortlist

'I’ve no interest in falling out with people'

clock 04 August 2022 • 6 min read
Darius McDermott, managing director, FundCalibre

FundCalibre elite radar: ASI Global Smaller Companies

'Good contender'

Darius McDermott
clock 01 August 2022 • 4 min read
Link Group now expects headline dividend growth of 2.4% to £96.3bn in 2022.
UK

UK dividends jump to £37bn in Q2 as the pound stumbles

Second-largest payout on record

clock 26 July 2022 • 2 min read
Trustpilot