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The overlooked defensive sectors to size up · On The Money

• 0:00
  Dave Baxter: Whether you're a bull or a bear, there is one topic dominating the conversation right now. That of course is AI, whether you think it's gonna turbocharge market returns, or on the end of the spectrum, you think it's inflating a nasty market bubble. What I want to do today is try and look past that and look at the sectors that are overlooked and potentially defensive against this market backdrop. And we're going to do that from the perspective of an income investor. So welcome back to On The Money, I'm Dave Baxter here at II and our guest today is Nick Clay, manager of the Red Wheel Global Income Fund.
• 0:36
  Nick, thanks for joining.
• 0:38
  Nick Clay: Thanks for having me.
• 0:39
  Dave Baxter: So let's kick off then discussing some of the sectors that are appealing on that front, and maybe some companies that also stand out.
• 0:48
  Nick Clay: So you're right, the whole market is extremely focused upon one particular theme, And utter confidence that the market has at the moment or complete certainty, really, that they've already made up our minds who's going to win and who's going to lose. I mean, so much so that, you know, the JPMorgan data that just came out showed that the top 10 stocks in the S and P 500 are now 41% of the S and P 500. Oh, wow. And if you look back through history, you know, that's twice as heavy a concentration of the S and P 500 than it's ever been for the top 10 stocks going back to 1985. So we're kind of twice as confident this time around that we know exactly who's going to win.
• 1:42
  And the 10 stocks each year, each decade, they change a lot because things get disrupted. And so, you know, every time we're certain we know which the 10 best stocks in the world are and then ten years later we realise that probably wasn't the case. This time around though, we're totally convinced we know what the answer is. And also what's different this time around is it's all based on one theme, not different themes across different companies. And what that means is that that certainty on the other side of that coin has meant that great sways of the market are being discounted as boring, losers of AI, just not interesting enough, not going to make you rich enough.
• 2:24
  That's where we find more interesting opportunities today. And that is based on the belief that AI is obviously genuine, that it's going to go everywhere. We're all going to have it. All our companies will adopt it. So it's not because of a view that AI is not going to happen.
• 2:44
  We're very comfortable that AI is going to happen. It's then working out which companies do we think are going to be best able to utilize AI, best able to transition through that revolution we're going to go through, and remain very good quality businesses the other side of that. But today, a price is if that's never going to happen. And, you know, this strategy has been going twenty years now. And today, we are getting stocks dropping into our yield universe that we can now own, which we've never been able to touch before for the last twenty years because they've never been cheap enough.
• 3:24
  And some of those stocks, for example, are LVMH in the luxury sector, as everybody believes that the Chinese consumer is never going to buy a handbag again. And so it's boring and it's not exciting. Equally, and AI related, is Accenture, the consulting company, which has fallen from its peak share price to today around 70%, 70%, because the market is convinced that Accenture's business is going to get replaced by AI and it's just not fit for purpose anymore. Which is interesting because that was the same accusation put at it when cloud came along and the same thing was going to happen. Although cloud is now 55% of its business and growing at 10%, seem to transition quite nicely into that.
• 4:18
  And AI is already about $3,000,000,000 of revenue and growing, obviously very fast from a low base within the company. And yet, it's on a PE of below 10. It's on a free cash flow yield of 13%, and it's on a dividend yield of around five. It's been priced to effectively go out of business.
• 4:37
  Dave Baxter: So to, yeah, pick up that point, what are those the main metrics you're kind of using to judge this value? So free cash flow Free cash flow yield is everything. Price earnings ratio.
• 4:47
  Nick Clay: Correct. Free cash flow yield is everything, mainly because cash flow is the thing you can lie least about. Everything else in your P and L, you can kind of slightly make up a little bit depending on how you choose to account for certain things.
• 5:03
  Dave Baxter: How would you define that for people who don't know what it is, briefly?
• 5:08
  Nick Clay: So basically, it's how much cash does the business generate, and then when you take off that, what they require to keep the business going. So maintenance, CapEx, and anything that just keeps the business functioning and effectively keeps that cash flow being able to be generated into the future. And then whatever's left at the end of that is the free cash flow that the company benefits. And that free cash flow that that company then generates, they have some decisions to make with that. They can either reinvest it back into the business to try and grow it even faster.
• 5:44
  They could return it to shareholders, and they can do that by giving us a dividend, or they can do it by buying back their shares. And it's that capital allocation decision, what they choose to do with that cash flow, which is very important because it drives the future cash flow streams from that company going into the future. Now what we want to see is that companies pay us back a dividend, as well as invest in themselves to maintain the durability of that cash flow. So our perfect company doesn't exist, but our perfect company would be a company that's valued at an 8% free cash flow yield, and it takes 4% of that and invests it back into its business for growth, and it gives us 4% back as a dividend yield that it will grow over time as its cash flow grows. And it's that durability of a business model that we're trying to get to the heart of, and if you can get those cheap enough, if you think about what a free cash flow yield means, it's how much cash it will yield back to you every year.
• 6:51
  So if you're in a double digit territory like Accenture, it doesn't take long for you to get your money back. So the market's basically trying to say to you that Accenture is a business is basically going to go bust over a period of time. And if you do the math, it's about seven or eight years that the center could go busting. And that comes back to this concept at the moment that when markets go up in a straight line and everyone's getting rich very quickly, no one cares about valuation, no one cares about fundamentals, etcetera. It is literally how rich can we be by Monday.
• 7:29
  And in that environment, you get to a situation where even the greatest companies in the world and some of the really big technology companies are unbelievable businesses and probably are some of the greatest businesses in the world. But even the greatest business in the world at the wrong valuation becomes the riskiest business in the world. Because all the valuation of a company is, is the expectations placed upon you of what you have to deliver. So if your valuations are incredibly high, then what you have to deliver has to be exceptional all the time. That's difficult to do for any company, however good you are.
• 8:12
  And so your risk is very high because you've only got to stumble a little bit and everybody panics.
• 8:18
  Dave Baxter: I mean, it's been interesting to see an emerging market. Now I can't remember whether it was Samsung or others, we've seen companies doing, you know, record high revenues or whatever and still the market
• 8:27
  Nick Clay: because it is just wasn't enough to satisfy the expectations and demands that the investors require. But of course, that works to the flip side as well, which is that if you've got a company like Accenture that is priced to go out of business after seven years, well then all it has to do is not go out of business in seven years to do better than what you thought it was going to do. And as an investor, you're trying to work out which risk reward you're willing to take on board, going to Mars or not going bust. It's not that's clear, I know, because many businesses probably will go bust in an AI era. It's not that disruption is not rife, it is rife, and AI is probably going to accelerate that.
• 9:12
  So it's not an easy decision to make, but it's which risk reward you most likely and most comfortable taking, and it has implications for how you generate your total return going forward and the pathway of that.
• 9:26
  Dave Baxter: So these, I mean, we're talking about kind of overlooks and potentially defensive companies and so on, are all the names that spring to mind those cases where the market is pricing in an existential crisis and you disagree, or are there any kind of more sedate ones where it's just because I guess sometimes in those markets what you've seen is companies just don't seem to be sexy enough and therefore they get sort of they fall between the cracks.
• 9:50
  Nick Clay: Correct. I mean, 10% growth used to be pretty good and now people don't even get out of bed unless it's 50% growth type thing. And so you're right, there are many companies, particularly staples companies. You know, so companies like Nestle, like Keering Doctor Pepper, which is fizzy drinks and coffee in America. They're just boring.
• 10:14
  They just don't grow fast enough, you know, they grow GDP in a little bit. And that, quite frankly, is just not exciting enough when you've got other companies who every month can double the size of their revenues. And so in that environment, they just get forgotten about. And again, these are great durable companies, they've been around very long times. Pepsi, for example, has a great stat that if you bought Pepsi in 1987, today Pepsi returns to you as a dividend every year the share price you paid for Pepsi in 1987.
• 10:51
  So if you put a 100 in in 1987, you're getting a 100 back every year in dividends from Pepsi, what you paid in the first place for it, because it's grown its dividend throughout that period. They are incredible companies, but no one's interested in them because they're not exciting. That's an opportunity because you're able to get into these, invest in these companies on attractive valuations. Right now, the market would argue against that and go, if it's not growing fast enough and it's not transformational in an AI sense, then they're not as attractively valued as you think they are. And you really want to buy the really hyper growth companies and they're the ones where the real They might look expensive today, but they're growing so fast that really they're very cheap.
• 11:39
  But then again, that just comes back to the point we're making earlier, which is about expectations And what risk reward do you want to take on board? That might be true, but they better deliver on it. And nothing better go wrong. Otherwise, you're going to hit a brick wall. Whereas we would rather take the risk in good, durable companies where they don't have to do much to make us money.
• 12:02
  And in an environment which is dominated by greed, we feel having a little bit of fear in our way of thinking about things is appropriate, as would be the case if the market was abundantly fearful, we would then want to start getting greedy. But right now, it's the Staples, it's some healthcare companies, it's some of these areas which in software, luxury, where people are just giving up on those businesses that we think that's where the opportunities lie today.
• 12:34
  Dave Baxter: How is, I mean, you mentioned software, I was going say, obviously that's been a big victim of those kind of existential fears related to AI disruption. How, I suppose, wary and agile do you need to be with this idea of a defensive company? Because what AI is perceived to be doing is suddenly kind of tearing down or is destroying those defensive moats almost overnight.
• 12:58
  Nick Clay: Correct. Disruption is on the rise. I mean, so if you went back to the 1960s, the average tenure of a company in the S and P was sixty years. They didn't really disappear. Today, it's eighteen years.
• 13:13
  Disruption is huge, and it's probably only going to accelerate with the adoption of AI. So you're right, the challenge today is to not rely upon a business which historically has been durable and good quality and just naturally assume that's going to be the case going forwards. Because AI is breaking down what was called moats or protection that companies had previously and it's breaking those down and then they're not moats anymore. They don't defend the company anymore. Companies we've owned in the past, like a RelX, for example, which has been under a lot of pressure, and historically, its database of legal and science and tax, etc, has been the massive moat for that business because the cost and the time required to replicate that was basically impossible and so they were well protected.
• 14:13
  And so could easily transition from paper, where they used to do it before the internet, to online. Today, AI, you can create that database quite quickly, and quite cheaply. And so suddenly, you have to question whether that company has the barriers and the protection it's historically had. And so you have to start to ask yourself slightly different questions about your companies to understand if the way we phrase it is if they can suffer the transition of AI, we do not assume that all of our companies are going to adopt AI and become suddenly super profitable. No technology in the past has really demonstrated that, only for very specific individual companies.
• 15:02
  In the main, technology gets adopted and all it does is just protect the margin that you were running previously, but you had to do it. The internet is a good example of that. And we don't see AI as being any different. So companies need to be able to adopt it, so what they require is the time and the opportunity to transition AI into their business for their clients. And that's the key, we believe, of whether a company is going to be able to suffer.
• 15:32
  So a good example we think of that would be Amadeus. Amadeus does software effectively for airline companies. From the moment you book your ticket to the moment you get off the plane at the other airport, it all happens on the Amadeus system and it enables the likes of British Airways, etc, to get a passenger, put them on a plane, take the plane off and land it and get the passenger off at the other end. It's pretty mission critical, what Brachios have to do. And because it's so mission critical, they use one person to do it for them, which is Amadeus.
• 16:05
  They don't use a multitude of providers of systems. So then the question becomes, can AI replicate what Amadeus do? Most likely, it will be able to do that at some point. Are British Airways going to take the risk with their business to go, you know what, there's someone over there with headphones on and a beanie cap who's vibe coding something that you can do, Amadeus, and we'll do it at a fraction of the price. We're going to risk the whole of our business on him and kick you out.
• 16:38
  We think that's an unlikely scenario that someone will make that decision. And so we think that the mission critical nature of something like Amadeus buys them the time to integrate AI into what they do in their software for their clients, and then to deliver it to clients and deliver the efficiencies it will bring to their clients, not charge them more for it. And maybe it will allow them to do more stuff for their clients, and therefore that's the growth in their business going forwards. Whereas other companies, it might well be that they're not the only provider. And if you're not the only provider and there's a whole multitude of people, well then that company's risk of taking on yet one more provider and giving it a go, the vibe coding AI, why not?
• 17:27
  It's not mission critical. And if you can let them in, then suddenly you realize, wow, look at this, more importantly, at the price it could do it at. So even if we don't take you, we're going back to the other provider and going, well, you need to half your price. And so the dynamics, that's what we're trying to look for in terms of what we say is an ability to suffer.
• 17:47
  Dave Baxter: So I guess it's less about kind of metrics, because maybe I imagine fund managers are often tempted to look at whatever it is, like market share or something, and it's more about traits and whether you have assessing what a real motive is. I guess there's a mission critical point, there's also I guess there's been the argument that, you know, if you're a heavily regulated business, again, that might be another kind of protection.
• 18:10
  Nick Clay: Correct. Or if it's that the data with which AI is going to work with is yours, rather than publicly available. So for example, a lot of data in the insurance industry belongs to the insurance companies, and so they have a competitive advantage with regards to if they've got the most data, and maybe they can get the better answers from applying AI to that data to therefore be able to price. You know, motor insurance, if you think about motor insurance, you know, the insurance companies will tell you that it's quite technical and they're very good at subdividing the risk categories, etcetera. But in reality, as teenagers, people who are not teenagers and old people, you know, it's pretty basic the way it's split up.
• 18:54
  Well, technically, it could get down to the individual with AI down the road, which would mean their ability to price the risk properly in regards to claims, etc, goes through the roof and it should be able to make their profitability more sustainable, less cyclical, etc. And if the data is all theirs, because they dominate the industry and therefore they've collected the most amount of data over the years, then they might be able to do that even better than their competitor. And it's those kind of things that we think are going to be key when we go through, which is starting now, the adoption phase of AI as it comes into businesses, and understanding who can do it, who would therefore retain their business at the end of it doing with their same clients, and therefore be the ones who can suffer this. And a lot of those companies today are priced as if they can't do it, they're not going to suffer and they're going to get disrupted by it.
• 19:56
  Dave Baxter: Yeah, yeah. Is there any it's a basic question, but is there any kind of regional element, like, there geographies where you're finding more of this kind of opportunity than elsewhere?
• 20:08
  Nick Clay: No, it's not as clear cut as that. So concentration in the market of AI has kind of infiltrated everywhere. It's even worse in emerging markets than it is in The US, for example. I think it literally, think I saw some statues, if you took the performance of Samsung, Hynix, TSMC out of the emerging market benchmarks, they're basically flat this year rather than not. And so it's more about what's been left behind in various markets for whatever reason it might be.
• 20:44
  And it's not always AI related, so the Chinese consumer has been very lacking in confidence since COVID, quite frankly. And so anything kind of exposed to that is seen as that's gone, they're never coming back, the Chinese will never spend any money again because they're in financial ruin. Yeah, all the data will show you they're not in financial ruin, it is just a confidence thing, and there is evidence to show you that when they get the opportunity to spend, invariably when the yen is weak, everybody travels to Japan, buy stuff in Japan, and sales of certain things in Japan go through the roof. You can see that the appetite to spend is still there, it's just a confidence thing. Well, are the Chinese consumers going to remain lacking confidence forever?
• 21:32
  Unlikely. But that's what some of the luxury good stocks, for example, are pricing. Kering and Gucci has been priced if Gucci will never turn around again. We still think we can find evidence to say Gucci is still a relevant brand in the luxuries market. And things like luxury is not something that can be disrupted by AI in the sense of I don't think AI is going to create a new luxury brand which is going to overtake LVMH or Hermes or whoever it might be.
• 22:05
  And in fact, actually, tangentially, it's almost a play on the positivity of it because it's creating wealth for the upper part of society, they're just getting wealthier and wealthier and wealthier, and the thing they buy is luxury, and luxury's price if it won't grow again. Things like that we find quite interesting at the moment.
• 22:25
  Dave Baxter: Yeah. And how do you feel then about the so called halo concept? Is that high asset, low obsolescence? So
• 22:37
  Nick Clay: when you think when you're trying to think about investing, you shouldn't invest invest for certainty because invariably, the future isn't uncertain. And so you've got to think of the range of outcomes that you face. And Halo is about one outcome. But there are other outcomes that we could easily face, which are separated from AI. And you could believe that AI, you know, the view of AI utopia is it conquers all and it can save us from everything.
• 23:17
  But just say, maybe it can't. And so what if we had an inflationary backdrop? Or what if we had a recessionary backdrop? Or things that used to happen in our past? And thinking about the range of outcomes we face and then just thinking about what kind of company characteristics service best in that range of outcomes.
• 23:37
  So we've talked about suffering in an AI world, but do they have pricing power to be able to suffer in an inflationary world? Or do they have more stable defensive business characteristics to suffer in a recessionary world? And then if you can get into those kinds of businesses that are priced better for the range of outcomes we might face, rather than we're just convinced that one outcome is going to happen and we're just going to invest for that, we think that is a more prudent way to try and manage our clients' money. Now, it means that we will deliver our total return in a different fashion to someone who's all about, I'm going to make more money on the way up in one trade. So that's all about upside capture.
• 24:25
  Whereas we want to make our money from the other part of your total return, your capital goes up, you have the compounding of your dividends, and those two things make up your total return. Now, the heart of what we're doing is trying to compound that dividend and so it makes up roughly about 50% of the total return over the long term, did for the first fifteen years, for example. And that gives you a certain characteristic which we think better suits that range of outcomes because my companies only ever pay me dividends, unless I'm an idiot and I keep investing in companies that will cut their dividends to zero, and then I will get fired, then my company is going to keep giving me a dividend. And so every year I receive a dividend, so it just goes up every year because I keep receiving more and more and more and more. And then I can compound it.
• 25:21
  That is very unvolatile, especially compared to share prices that go on the Amaka Yoya. And so if you can get 50% or so of your total return is driven by the compounding of the income, well then your overall total return is going to be less volatile than that of just capital alone. Now when things go up in a straight line to Mars, no one cares about that. It's all about greed and it's nothing about volatility. But if things become more volatile because whatever happens, AI disappoints inflation, recession, whatever it might be, then suddenly you have to think differently and downside capture becomes I don't lose money as much money when things go down.
• 26:07
  Mathematically, that's what matters. And focusing upon companies which are durable in their cash flows and therefore can continue providing you with a dividend stream, then that gives you some downside protection. And that's what gets your downside capture number low enough, and that's what can help you in more volatile times. And we think, where we are today, markets which are close to all time highs, record valuations, complete certainty, having something within your portfolio of funds that you might invest in that thinks differently and does things differently and generates a return in different functions, is quite appropriate for this kind of environment we're in today and where we are today.
• 26:51
  Dave Baxter: Well, thank you for your time.
• 26:52
  Nick Clay: Thank you very much. Thanks for having me.
• 26:54
  Dave Baxter: And thank you for watching and listening. Do let us know what you think in the comments and you can of course contact us directly on otmaii dot co dot uk. Thanks again and take care.