Beyond the numbers: what makes a great investment?

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In this episode of Connected Investor, Brunner Investment Trust Portfolio Managers Julian Bishop and James Ashworth explore what past capital cycles can teach investors about today’s AI infrastructure boom.

Looking at historical examples such as the iron ore supercycle and US shale revolution, they discuss how surging demand can drive investment and new capacity, potentially affecting future returns. They also consider whether rapid growth in AI and data-centre infrastructure could lead to oversupply.

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Julian Bishop (JB): If you're growing but not creating value mathematically, and this gets quite technical, the value of that growth is effectively worthless.

JB: Hello and welcome to Connected Investor from The Brunner Investment Trust. I'm Julian Bishop.

JA: And I'm James Ashworth.

JB: In past episodes we've talked a lot about portfolio level topics, including how we think about risk and how the energy transition might affect major industries.

JA: In this episode, we wanted to share some more details about how we go about picking individual stocks. Ultimately, the brand of investment trust portfolio comprises more than 50 individual investments. So how do we go about picking them? What broad features are we looking for?

JB: Maybe we should start at the top. What would we want to see in a perfect investment?

JA: Well, I think we can break it down into three areas. We call those quality, growth and value. Now all of them are important and there's usually a trade-off between the three of them, but if we were looking for an ideal investment, we'd want as much quality as we could possibly get, with lots of growth that's value accretive and a really attractive valuation. But unfortunately, we don't usually get exactly what we want.

JB: The way I often describe it is we're greedy. We want as much quality as possible, as much value as possible and as much growth as possible. As you say, there's normally a trade-off. The best quality, fastest-growing companies tend to be quite expensive and vice versa. Ultimately, we want the best balance of those three factors. Let's take them in turn. Let's start off with quality. When we talk about quality for a company, for an equity, for a business, what are we talking about?

JA: Well ultimately, with any investment that we buy, what we're really buying is a cash flow stream from today through to Judgment Day. Ultimately, that's really, as equity investors, what we will get.

When we buy an equity. Now, one thing that we know about capitalism is that it's relentless in trying to eliminate profits from companies. So, every company that has found an attractive market opportunity, an attractive market niche, will have competitors trying to steal their profits.

As Amazon founder Jeff Bezos famously said, your profit is my opportunity. That's what we see relentlessly in capitalism: competition trying to drive profits out of the system, ultimately.

Now, when we think about quality, what we're really looking for is reasons why the profits that a company is making will be sustainable over time, why that company deserves and is able to continue extracting those profits from the ecosystem, from the products they produce, and why they won't be competed away. That's really what we're looking for.

JB: So quite often that comes down to the business school terms: barriers to entry, sustainable competitive advantages, something that means that the business is resistant to competition. Perhaps discuss what kind of characteristics might lead to that.

JA: Yeah, I mean, I think we could probably do a whole podcast episode on this and maybe we will.

Ultimately, we're looking for what Warren Buffett terms economic moats. These are reasons why companies can't compete, why companies can't replicate what this company does and steal their profits effectively. Now, some of these are fairly tangible things to imagine. There may be physical assets that are irreplaceable. For example, there's a company called Aena which is listed in Spain and owns the vast majority of Spanish airports freehold. If you're one of the 300 million people who fly to Spain a year, you are likely to land at a Spanish airport which is owned by Aena. That physical asset is irreplaceable. No one's going to rebuild the physical network of airports that Aena has. We see similar things in, say, natural resources industries. Maybe you've got an iron ore mine that is particularly productive and particularly low cost. You physically own that asset, no one else can copy it effectively. Those very tangible assets can be a reason why companies' profits are sustainable and can't be competed with. But there are lots of other intangible sources of competitive advantage.

We can think of things here like patents or intellectual property, which are protected by law, and other companies can't copy. There are things like market standards. So, there are companies who own, for example, indices. The Brunner Investment Trust has as its benchmark the FTSE All-World and the FTSE All-Share. Those benchmarks are created by FTSE. FTSE Russell is part of the London Stock Exchange Group. That intellectual property, that brand, that market standard is hard to compete with because what people are paying for is trust. They trust that the FTSE Russell Group will create sensible benchmarks that are useful for investors.

We could go on with many others and maybe in another episode we will. But we could also think about the intangible assets that might sit at the customer's side. Many customers have switching costs. If you imagine you've implemented a piece of software in your organisation, switching to another software provider's product would require training all your staff to use the new product and working out how to migrate all the data from one software system to another. This is a very long and painful process. This switching cost might mean that the company is able to protect its position and make excess profits for a long period of time. But there are lots of examples here. There's a lot to fill a podcast episode, but maybe those are just some reasons why a company might have a competitive moat that makes it difficult for someone else to compete with them.

JB: One company I often think is a byword for quality is Apple. I think, remarkably, Apple is worth well over $4 trillion. That's the market cap of Apple. But if you actually look at the capital that was used to create Apple, the total amount of property, plant and equipment on its balance sheet, it's about $30 billion.

JA: That's incredible value creation.

JB: Exactly. It costs $30 billion to build the entire of Apple, yet it's worth $4 trillion. So that's an incredible example of value creation. If you think about Apple's barriers to entry, about the moat there, I think there's obviously the brand, but then that's interwoven with software. There's also a stickiness that comes with the services that it offers. You might have all your photos stored in the cloud, your calendar, your payment cards, etc., all on your Apple phone. This creates a stickiness, which means that it's very hard to abandon the Apple ecosystem.

JA: It's a switching cost, isn't it? It is a cost to the consumer to switch from an Apple iPhone to an Android phone. It feels like it would be a big step and you might not want to go through with that.

JB: Exactly. Another good example, I think, is GE Aerospace. GE Aerospace makes jet engines. Pretty remarkable statistic, but about three quarters of all commercial flights that take off globally are powered by a GE Aerospace engine underwing, as the industry vernacular has it.

Three quarters of all flights may be by one company. If you think about a jet engine, obviously there's extraordinary engineering skill that goes into that. There's the importance of complete reliability and safety, while fuel economy is obviously really, really important. If you're an airline or if you're Boeing or Airbus, you are never going to accept a new entrant. You're never going to get a Temu jet engine. That's another good example, I think, of a business with really high barriers to entry. I don't think there's been a new entrant in the jet engine industry for over 50 years. Therefore, these businesses make persistently, again using industry terminology, supernormal profits.

Apple is that example with 30 billion of invested capital worth 4 trillion. Apple makes over 100 billion in profit a year for that 30 billion of investment. That return on investment is exceptional. In financial terms, that's how this often manifests itself. You get businesses that make an awful lot of profit compared to the amount that they originally invested. That's what we would call a high return on invested capital.

JA: Those businesses are high quality. That's the first of the three areas we looked at. Quality is super important. We spend a lot of time trying to understand and really underwrite the quality of a business, really understanding why that profit stream might continue. I guess the second area would be growth. Maybe you can talk to us a little bit about how we think about growth and the importance of growth. Is it important, and is all growth good?

JB: Good question. I think you get some very high return on invested capital businesses that struggle to grow. Then it becomes a bit of a moot point about whether that is good or not. I think the classic example probably would be the consumer staples industry, which a decade ago people might have regarded as amongst the most quintessential high-quality, good investments. They do have those quality characteristics. Consumer staples companies like Nestlé have brands like KitKat, Nespresso and Purina. Companies like Unilever have Dove, and Procter & Gamble has Ariel dishwasher tablets, Fairy Liquid, etc. They tend to be quite high return on invested capital businesses. But they struggle to grow. There's just no growth in the end market. That changes the equation slightly. I think if you look back at the best equities in history, they generally combine those high returns on invested capital with growth, pricing power and growth in the market. For example, in jet engines, the number of planes flying all over the world has basically gone up every year since the aeroplane was invented, with a small dip during Covid.

So, the end market is growing all the time. Likewise with Apple, the end market for smartphones grew pretty consistently. Once the smartphone market in unit terms matured, they were able to take up prices quite considerably and then grow the services that they sold. The profit streams just grew and grew and grew and grew. It's an important combination. But no, not all growth is good. Again, this comes down to this idea of value creation. If you're growing but not creating value mathematically, and this gets quite technical, the value of that growth is effectively worthless. You do see some very big businesses which have grown an awful lot that have never really created value. Just to come back to jet engines, what for you is an obvious area where there's always been growth, but no value created?

JA: Well, airlines would be the classic example. Clearly an amazing invention, an incredible technology from the consumer's perspective. It's absolutely wonderful that you can get to Australia in a day rather than it taking six weeks.

But the airline industry historically has been terrible. You've had effectively no profits created by that industry cumulatively in the decades since man first took to the skies.

I think even Warren Buffett quipped that, if he had been present at Kitty Hawk when the Wright brothers first demonstrated human flight, he owed it to future capitalists to shoot down that plane because it's been such a terrible area of investment. Yes, there's been huge growth. The number of air passenger travellers increases every year, as you say, but the value has not been captured by the airlines. It's been captured by the jet engine manufacturers and other suppliers to the airlines, also really by the consumers. Right. The fact that you can fly to America for a few hundred pounds is, from the consumer's perspective, a huge value proposition. The consumer surplus, as economists would call it, is largely captured by the consumer rather than the provider of the service, the airline.

JB: The big difference is barriers to entry. Jet engines: yes, airlines: no. The airline industry is ferociously competitive; all profits get driven out. As you say, the value accrues primarily to the consumer.

So that's growth. We have quality, growth, and the final one, of course, is value. Every equity has a price. As you've already mentioned, when you buy an equity, you're buying a cash flow stream that stretches into perpetuity. That cash flow stream is uncertain. We can do all the financial modelling we like, but we never know precisely what the profits of a company are going to be in the future. But what do you think is the best way to approach value? What do we look at when we're talking about valuation?

JA: Yeah. I think you've hit the nail on the head there. As investors, we value these businesses based on the cash that they are able to generate. We worry about how certain that cash flow stream is and how it will evolve over time. Conceptually, what we want to do is adjust the cash flow that is likely to accrue from now to Judgment Day, adjusted for what economists call the time value of money. The fact that a dollar in a year's time is not worth the same as a dollar today, and a dollar in ten years' time is worth even less than a dollar in a year's time.

We're essentially going through that exercise of bringing back all the future cash flows to a value today. Often that's done through heuristics like price-to-earnings multiples, which is effectively a way of doing this in one quick calculation. We will look at things like how other businesses are valued and how sophisticated private buyers in the industry would value a business. We triangulate the valuation any way we can to try and understand whether we're really getting the business with a margin of safety, whether the value is compelling. Now, as you said, some of the best businesses in the world have really high quality, highly competitive moats, big barriers to entry, really strong growth prospects, and the ability to deploy capital at really high rates of return for a long period of time.

The valuation today might look optically expensive. But if we're certain about the growth prospects and the high returns on capital, actually it could still be a very compelling investment. There's a great stat that if you bought Walmart in 1972, you could have paid some ridiculous multiple of profits. You could have paid something like 5,000 times the profits they were then generating and still would have beaten the S&P 500 over the subsequent 50 or 60 years. It's not just about looking at stocks that are trading on low price-to-earnings multiples. That's not what we mean by value. We're really looking at what we're paying versus what we're getting in terms of the future cash flows.

JB: So, there's always value in the context of the quality and the growth, and then trying to find the optimal balance. I mean, some of the companies we've talked about there, for example, Apple, we don't own at the moment. It's a very richly valued equity. We think so, on balance, we don't go there. We admire it a great deal as a company. We think it has fabulous quality attributes, probably the right to grow in most years, in most circumstances. But because of the valuation, the PE is very high. We are not there at this point in time.

JA: So that brings us back really to where we started, that it's always a trade-off. We can assess the quality; we can assess the growth. But often there is a trade-off. The wonderful businesses, the high-quality businesses with good growth, may have a valuation that's not as compelling as we would like. But maybe sometimes the valuation is also compelling. Do you think there are times when we can get all three? Can we get really huge amounts of quality and lots of growth at compelling valuations?

JB: Yes. But I think the opportunities for real bargains tend to be quite occasional and tend to be quite short. Normally it's because of a scare or a dislocation. Some of the best quality holdings that we have in Brunner in the travel space, for example, GE Aerospace and InterContinental Hotels, we bought when the share price was quite depressed because of Covid. Obviously, these businesses were hugely impacted by the pandemic. There was a lot of concern that that impact would be permanent, and obviously it proved not to be. At that point in time, these equities were trading at very attractive levels, and the quick-footed buyer could then go in and acquire them at an unusually low price. I think today an obvious example, and again a controversial area, would be software. Perhaps you could tell us a little bit about what we're seeing in the software space at the moment.

JA: Yeah, absolutely. Investors are focused on artificial intelligence, on AI, and the impact this is likely to have on all our lives, on businesses, on work processes. There's an expectation that AI will revolutionise lots of what we do today, day to day. There's particular concern that artificial intelligence will create new competition for software vendors, whether that is allowing new companies to create software more cheaply or replacing software entirely. There is a concern in the market that software businesses are likely to be doomed. And that's probably not too strong a word. There are companies where you look at the valuation, and the market is basically telling you it doesn't think they're going to survive. The market thinks they're going to decline into irrelevance, really disrupted by this new technology.

We have seen similar disruptions in the past. Right, companies do go through life cycles and industries do go through life cycles. Some companies don't survive to the next generation. But today's software is squarely in the crosshairs of people worried about disruption. Many software companies are now trading at valuations that imply they are going into terminal decline.

JB: Yeah. If we look at quality, software generally will meet all the criteria we look for in terms of quality. At the moment, at least, they're growing quite nicely. But this fear around terminal value, their long-term relevance, has meant that the valuations have come down. At the moment we're having a little sniff around that area. I think if that narrative around disruption does not play out, this will be a very good time to pick up some software shares on the cheap. I think this shows one of the requirements of being a good investor is to be very patient. Wait for these dislocations, do the work, perhaps be a little bit contrarian and then pounce. To make a football analogy, there's a quite famous stat about Messi during the World Cup that he spends a lot of time walking. He walks more than most other players. But of course, when he bursts into life, it's with extraordinary skill and accuracy. I think maybe there's an analogy here for investors: be patient, walk and then occasionally act.

JA: Be like Messi.

JB: Be like Messi.

JA: Okay, Fantastic.

JB: We are the GOATS of investments!

JA: Okay, Julian, that's a good point to wrap the conversation up as we seem to be drifting into football analogies. Maybe if we come back to the central question: if we could build the perfect investment, what would it look like?

JB: Generally, what we look for is a combination of quality, value and growth, and we try and look for the optimal combination. Most of the time there is a trade-off. A good quality company costs more. More growth costs more. That means value is the trade-off. But occasionally you get these dislocations where you want to pounce. I think it's important to be flexible enough to do that.

JA: That's what makes this job endlessly fascinating. That's a good point to wrap up. Thanks very much, Julian.

JB: Thanks, James. Thank you for watching and listening to Connected Investor. If you enjoyed this episode, do follow us, subscribe and we'll see you next time.