Mick Dillon, portfolio manager at Brown Advisory, co-runs the Global Leaders fund with Bertie Thomson. It invests in 30 to 40 companies that the portfolio managers view as leaders within their industry or country and that are capable of delivering sustainable high relative return on invested capital (20% at least).
Customer outcome prevails as a key component to the fund’s stock assessment and picking. “If a company serves its customers well, that benefits shareholders. The first thing we look at in a company is if what it does for its customers is special. And the second part is: if this firm was not there tomorrow, would customers care? This is about your customer wanting you to be in business. Why? Because you served them in an unique way and customers value that,” Dillon suggests.
Microsoft, Alphabet, Visa, Unilever and JP Morgan Chase & Co formed the top five positions of the portfolio as of end May 2018, all being major brands most of the worldwide population is familiar with. Nevertheless if the fund manager reckons that a brand association matters to customers, he underlines it needs to achieve two things for meaningfulness.
“The brand shall inspire loyalty or it enables you to price things at a premium but the customer is still getting value. Most powerful brands do not use prices. A brand only pushing up prices could end with a bad reputation and the consumers would eventually reject it when they can. They would leave as soon as they will have the opportunity,” points Dillon.
Brown Advisory’s portfolio manager perceives loyalty as a fascinating topic and links it to advertising.
“When you think about brands, there are two types of advertising. One is called – reach and addresses a broader audience to establish the presence of your brand. The other is more transactional and called performance marketing, building immediate revenues. Reach advertising is old school marketing but you cannot measure how it performs.
“Loyalty serves shortcut decisions in the supermarket when you are facing 50 brands for the same product and you need to speed up your shopping. It is more about infrequent purchases than highly frequent ones, which are of higher volume but lower loyalty,” Dillon expounds.
He adds that the choice of the distribution channel for a brand has become crucial and that if Internet seems an easier way to launch a brand and market its products, selling them may be harder than in real life given items need to well positioned on platforms such as Amazon to be noticed, thus creating a possible form of online lock.
In Dillon’s view however, brand loyalty or customer preferences are far from enough to turn stocks in great investments. What shareholders are expecting from the customer outcome is another key component. A third point raised by Dillon is to not overpay for a sustainable business.
In the current era of digitalisation, information technology is definitely a play of Dillon and Thomson in the fund. A reason why the team is overweight tech is because the portfolio managers see demand aggregation.
“Microsoft is our biggest position. In the last four years, it has transformed the company’s activity. It shifted from a company trying to sell you Windows products to a company providing services you look for. If you work on a Mac but have an Android mobile and a PC at home, as a consumer, you don’t want to pay three licenses.
“Microsoft changed from selling something which depreciates over the five next years to selling best softwares with greatest security and constant update whatever your device and system is. This is a great customer outcome. It is a massive change for small businesses who cannot afford to spend too much Capex for their infrastructures,” argues Dillon.
He pursues: “We are still overweight tech but how much of that tech is real tech. My co-fund manager and I are often arguing around Visa. Is Visa a financials company? A utility company? An infrastructure one as they set up the infrastructure for payments in the 21th century. It is a business that is enabled by tech but it is not tech. Microsoft is 100% tech on the contrary.”
Dillon assesses that tech companies could become utilities in the near term as we move towards a multi-services business model (bills payment, administration, online shopping, etc) and to stand out of the tech crowd, he says a company will have to provide a service no peer can.
“You need huge Capex to achieve this. Not that many companies can spend $10bn in Capex. It is a scale barrier to entry. FAANGs are not yet competing heavily against themselves but it could occur in the near future. What has come through as a barrier to entry in recent years is the amount allocated to R&D projects,” Brown Advisory’s portfolio manager outlines.
Speaking of FAANGs, the Brown Advisory Global Leaders fund invests in Facebook and Google’s parent company Alphabet. The portfolio managers’ view on Amazon remains mixed.
“We don’t hold Amazon even though it is a great business. As a quality measure, we expect a 20% return on capital for our positions. We think Amazon Web Services will have a ROC of 25% over the long run. Amazon’s third party retail business will generate an enormously high return on invested capital but we can’t estimate it as we don’t know how much capital they will need to achieve that. Amazon’s traditional business (books, etc) is losing money.
“The company did not show a lot of profits since listing even if it is a first class company in terms of management. The cashflow-based valuation of the company remains unclear. So is the source of the cashflow generation. That doesn’t mean it is not a great investment. Netflix is pretty similar to Amazon in our view,” argues Dillon.