After the sharp sell-off in global markets in early August, the UK market has recovered most of its lost ground, now trading back near the all-time high it reached in late July. The Roman emperor and stoic philosopher Marcus Aurelius described the art of living as ‘more like wrestling than dancing’, a sentiment that could be applied to navigating the high day-to-day volatility recently seen in the markets.
The escalating conflict in the Middle East and the outcome of last week’s presidential election currently dominate the news agenda. Set against these risks are some chinks of economic light, however. US economic data has reassured with employment data holding up and inflation continuing to cool. These developments allowed the Federal Reserve to cut interest rates by 0.5% in September and 0.25% last week, with further cuts expected over coming months.
After the rapid rise in rates during the post-Covid inflationary spike, this turning point will provide welcome relief to both the US and the rest of the world. Adding to this positive development was the Chinese government’s announcement that it is willing to deploy a variety of fiscal and monetary interventions to help its ailing economy – the shares of companies with exposure to China perked up as a result.
Patient compounding and share buybacks
On the face of it, Bunzl, the global market-leading distributor of not-for-resale consumables, might look like a dull business. For patient shareholders though, the company has a strong record of capital allocation and long-term value creation, which has helped drive 31 years of consecutive dividend growth.
The company typically makes about 10 small acquisitions a year from a large potential pipeline, often choosing founder-run companies who view Bunzl as a trusted long-term home. As a result, discussions are not primarily driven by price, with valuations typically in a stable range of 6x to 8x earnings across the economic cycle.
This self-funded compounding model, supplemented by bolt-on acquisitions at good rates of return, is reflected in a range of other businesses across the portfolio such as Halma, Diploma, Compass and RELX.
Following a theme we have seen across other holdings: Bunzl, whose free cash flow yield is currently over 6% backed by a strong balance sheet, has announced a share buyback of £250m this year and the likelihood of another £200m for next year (c.4% of its valuation). For long-term shareholders, such repurchases quietly increase the economic ownership of each share in a company.
A global leader navigating a sector downturn
Diageo has faced a very challenging industry backdrop over the past 18 months. The company’s latest trading statement confirmed that conditions remain unchanged. The spirits industry’s downturn is overwhelmingly a cyclical issue, driven by the hangover from Covid-related behavioural changes (both during the pandemic and in the immediate aftermath), extraordinary pressure on consumers’ disposable income over the past two years and the bullwhip effect of the unwinding of the stock levels that built up during the post-Covid inflationary spike.
As the industry is getting close to the end of inventory adjustments in the US market, with wholesalers and retailers holding considerably less stock than they did a year or two ago, Diageo will be well placed to benefit when demand starts to recover.
The company remains a well-invested global market leader with a strong portfolio of brands, a global footprint and its best valuation in a decade.
Diageo’s industry backdrop highlights a wider trend: though Covid began nearly half a decade ago, the aftershocks are still washing through the global economy. As well as spirits, the luxury, recruitment and engineering sectors have been suffering from similar post-Covid related operating headwinds. Their valuations look very interesting as a result.
Continued interest in out-of-fashion compounders
With our long-term approach and holding periods that typically span five years or more, we expect the bulk of long-term returns to come from compounding per share free cash flows, alongside the dividends that this cash generation helps to pay.
We do, though, evolve the portfolio over time. This ‘nudging’ process allows us to manage risk and recycle capital towards areas of the portfolio and investable universe where the combination of quality and valuation looks particularly attractive.
One example of this is Cheltenham-based Spirax Group, a quality engineering franchise with a 136-year history and 55 years of consecutive dividend growth. We initiated a position in July 2023 and have continued to ‘nudge’ this year and have headroom to build further into the position.
The company returned to organic growth in the first half of this year and its medium and long-term outlook appears strong. The need for investment in the world’s industrial infrastructure is significant and is augmented by the structural trends of energy efficiency, electrification and decarbonisation. Spirax’s product portfolio, technical sales force and customer embeddedness put the company in good stead to harness this growth opportunity.
Hugh Yarrow is portfolio manager of the Evenlode Income fund. The views expressed above should not be taken as investment advice.