SORBUS VECTOR: Manager commentary March 2024

Fund performance for VECTOR in February was rather disappointing, with the fund down (3%). The two main detractors over the month were PZ Cussons and Reckitt Benckiser.

PZ Cussons has been adversely impacted by the devaluation of the Nigerian Niara, which fell by 51% between 31 May 2023 and 2 December 2023. The devaluation of the currency is the result of market reforms by the Nigerian government to remove its currency peg. Nigeria represented around 35% of PZ Cusson’s revenue in 2023. This currency movement led to losses for PZ Cussons and the need to cut its dividend. This is an annoying feature and known risk of exposure to emerging market currencies, but they are not fundamental value drivers. Despite these short term difficulties PZ Cussons continues to possess high quality brands and underlying growth remains robust.

Reckitt Benckiser was the other detractor from the portfolio during the month. Annual revenue was reduced by £55m for 2023 due to compliance issues in two middle eastern markets, where trade spend had been underreported. While Reckitts claims the incidents were isolated and that they have dealt with the individuals involved, this has damaged the credibility of management. Reckitts currently trades at 15.5x earnings compared to a five year average of around 19x. We expect revenue growth will resume for the company and at these prices we are happy to remain investors.

During the month we made some further changes in the VECTOR portfolio. We have added two new holdings to the fund, Domino’s Pizza and Games Workshop. These were financed through the sale of our holding in Hargreaves Lansdown and a reduction in our holding of Lindsell Train Investment Trust.

There are three main rules for deciding when to sell an investment:

1. when the investment case changes;
2. when the stock is trading above our perceived intrinsic value of the business; and
3. when there is a better opportunity elsewhere.

The sale of Hargreaves Lansdown (HL) follows reason one. The investment case for HL was two-fold; its market leading position in the UK and the significant discount it was trading on compared to US peers and the high level of corporate action and takeovers in the space. When there is this level of takeover intensity in the space any material difference in valuations typically erode away rapidly as arbitrage trading (hoping that cheaper competitors will be acquired at a premium) pushes the valuations closer together. However, the dominant element in the share price performance has been continuing and escalating competence issues with the strategy and execution of the management team. A regrettable feature, in some instances, of market leading positions is complacency and HL has clearly been subject to that. Chasing short term profitability it has overcharged clients, invested ineffectively in its platform and has lost market share and relevance (having been a pioneer it is now undifferentiated). The chance of HL staying independent now is considerably reduced, but that is never a good investment case – takeovers can take years to arrive and the company valuation is often significantly lower as its travails persist.
 
Lindsell Train fits in with reason three. Nick Train is the outstanding fund manager of his generation in the UK and exposure to Lindsell Train Limited, the fund management company, has been an excellent long term investment for those who have owned shares. However, we can see better value elsewhere.

Our first new purchase is an old friend. Fantasy as a genre has been and continues to grow in popularity.  Games Workshop is the most well established company and brand in the miniature wargame market. Its best known products Warhammer and Warhammer 40,000 represent high quality and well established brands and intellectual property. We bought Games Workshop at £17 and sold the last of our holding in 2021 at £116 – a great company had become just too expensive. Since then the share price has drifted down even as profitability continued to grow – the standard operating procedure for shares that got too expensive. But as the share price drifted and as the profits have grown then value is emerging. It still trades at 23x earnings, which is not cheap, but its earning and earnings quality has increased to the point where we believe it offers great value again.
 
A key factor was the announcement in December 2023 of an agreement with Amazon Content Services LLC, for the prospective development of Games Workshop’s Warhammer 40,000 universe into films and television series, together with associated merchandising rights. Rumour has it that Henry Cavill (the British actor and keen Warhammer fan) will be both acting and producing this initial project. We believe the realisation of the value in its intellectual property is nascent and has a long way to mature. This will drive value over the coming years in a way that is not currently priced into the shares.
 
Our other new investment, Domino’s Pizza, is a new holding in the fund, though a name we are sure is familiar to all our readers. It possesses an excellent business model, based on franchising, that makes it highly cash generative and asset light. However, it has been deeply unattractive as an investment for a number of years for three reasons.
 
First, Domino’s has been dealing with a three year stand off between UK franchisees and management. Second, it failed to grow and be profitable in its international businesses, forcing it to exit those markets. Finally, the company has had to deal with the impact of high food inflation in the UK on its products (the ONS estimates that food prices rose 25% in the two years to January 2024).

These issues have now ameliorated. The dispute with the franchisees has been, at least optically, resolved. Last year saw the arrival of a new CEO Andrew Rennie, who has experience as both a franchisee and franchiser within the Domino’s global group. The noises emanating from extensive dialogue with franchisee’s are positive, the international businesses have all been exited and the rate of food inflation is declining.

With these factors in the rear view mirror it appears to us that Domino’s is quite the ugly duckling as far as investors are concerned. The market has been fatigued with recent years of negativity surrounding the company and it is unloved to a degree that is unjustifiable. We’ve picked up a slice.