Six key ingredients to UK stock success

With the LF Gresham House UK Multi Cap Income Fund passing through its six -year anniversary, co-managers Ken Wotton and Brendan Gulston share their six key investment ingredients.

UK stock markets have been confronted with numerous challenges in recent years. Headlined by the major impacts of Brexit and the pandemic, the Russian invasion of Ukraine, the mini-budget calamity, and the vengeful return of inflation, these headwinds have led to a number of companies with attractive fundamentals being unfairly derated.

As a result, corporate and private equity buyers are increasingly being drawn to the discounted valuations on offer across many high-quality resilient companies. However, as major headwinds persist, it is crucial to dig deeper to discover the true discounted gems. By carefully evaluating specific indicators, investors are best placed to identify robust revenue streams and mitigate overall portfolio risk. Below, we highlight six essential rules to guide investors through the selection of resilient stocks.

1. Ongoing agility

A competent management team is crucial in order to achieve long-term success. Executives must not only demonstrate industry expertise, but also the flexibility to adapt to all eventualities as being able to embrace change early can greatly impact a company’s ability to navigate challenges.

To assess whether a team possesses these qualities, we rely on our years of investing experience and our proprietary network of independent references. We look for proven track records and skill sets that align with the business strategy. Two crucial components to the continuity of success in this area are an incentive structure that rewards outperformance, motivating the management team to meet shareholder expectations and competitive packages to retain top talent.

2. Cash generation

Cash generation is a key financial indicator of the resilience of a business. Cash drives shareholder returns through reinvestment into growth and allows distributions to shareholders.

Businesses with asset-light models are typically more cash generative, due to the lack of investment needed in physical assets, which often require capital to be set aside for depreciation, repairs, and maintenance.

More than 80% of our portfolio is comprised of services or software businesses, which carry modest capital expenditure requirements. Additionally, 90% of our investments are in companies we consider to have low capital intensity, with a capex-to-sales ratio of less than 10%.

3. Safety margins

Resilient companies often have one common trait: high margins. Alongside potentially helping increase shareholder returns, high margins provide a buffer enabling businesses to absorb cost inflation and other setbacks caused by the tougher environment. As a rule, we invest in businesses with high and sustainable margins – our top ten holdings have EBITDA margins of 21% on average, and the majority have margins in the double digits.

Businesses with a competitive edge or operating within a growing structural market can often benefit from robust gross and net profit margins due to strong pricing power. Consequently, we also target companies with inherent operational leverage, as these businesses can increase revenues without corresponding cost growth, leading to margin expansion. Without a doubt, strong business fundamentals are essential for maintaining high margins.

4. Sustainable growth

An attractive feature of a company is its growth potential. For businesses with structural and sustainable growth opportunities, it is crucial to identify long-term market trends. To do this, management teams must develop solid strategies and demonstrate an ability to carefully execute growth plans.

One way to assure sustainable growth is to have net cash positions or low leverage which is particularly important in tougher environments. Our investment strategy leans towards companies that do not consume cash excessively or expand too rapidly. Instead, we opt for businesses pursuing manageable growth, and therefore maintain capacity to reinvest.

5. Consistent dividends

Another indicator of resiliency is the ability to pay dividends. Despite it being a multifaceted aspect to measure, as it requires sustainable earnings streams, healthy profit margins and strong cash generation, we are drawn to the dividend cover metric. This is the ratio of a company’s profits divided by the dividend paid to shareholders.

A high dividend cover means a company can reinvest while maintaining consistent dividend payments. The businesses in our portfolio typically have a two-times dividend cover – or 50% pay-out ratio, which means reinvesting 50% of profits and returning 50% to shareholders. This ensures a safe margin for maintaining dividend payments even during economic uncertainty. In the current climate specifically, identifying businesses with sustainable dividend growth over inflation is important in order to deliver a positive real return.

6. Stable earnings

A company’s earnings quality is crucial for survival during turbulent times. Evaluating the visibility and predictability of future income streams requires a careful examination of a company’s revenue line. We favour recurring revenue over transactional business, as the latter can be less predictable.

We also examine a company’s customer base and the concentration of revenue across specific clients, demographics, sectors, and geographies to understand the diversification of revenue streams. This is essential for maintaining resilience during unexpected events.

We also examine a company’s cost-base capacity. If a company needs to add an office or new facility, this could represent a significant increase in fixed costs and reduce cash generation. As a result, we look for companies with ample existing capacity, whenever possible.

One prime example of a company meeting all six criteria is Bloomsbury Publishing, best known for the Harry Potter series. It has a dividend yield of 2.5%1, generated 25% more cash in the last year than in 2021, and reached an 11.7% EBITDA margin at the end of 20222. The company’s robust financial position, along with its strategic acquisitions, underpins its long-term growth strategy. Additionally, its unique approach of combining academic and general publishing has proven effective in producing solid earnings — balancing the volatile nature of trade publishing with the consistent, high margins of academic publishing.

Moving forward, we anticipate these key metrics to remain instrumental in navigating the future investment landscape. Our ultimate goal remains the same – to continually support risk-adjusted returns for our investors, whatever the environment may hold.

Ken Wotton Managing Director, Public Equity	Brendan Gulston Director, Public Equity

All opinions expressed are their own and not necessarily those of Gresham House.

Key risks

• The value of the Fund and the income from it is not guaranteed and may fall as well as rise. As your capital is at risk you may get back less than you originally invested
• Past performance is not a reliable indicator of future performance
• Funds investing in smaller companies may carry a higher degree of risk than funds investing in larger companies. The shares of smaller companies may be less liquid than securities in larger companies
• The opinions expressed are those of the investment team, are correct at the time of writing and are not to be construed as investment advice

Important information

This document is a financial promotion issued by Gresham House Asset Management Limited (Gresham House) under Section 21 of the Financial Services and Markets Act 2000.

Gresham House is authorised and regulated by the Financial Conduct Authority.

The information should not be construed as an invitation, offer or recommendation to buy or sell investments, shares or securities or to form the basis of a contract to be relied on in any way. Gresham House provides no guarantees, representations or warranties regarding the accuracy of this information.

This article is provided for the purpose of information only and before investing you should read the Prospectus and the key investor information document (KIID) as they contain important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the Fund (Tel. No. 0345 922 0044).