SORBUS VECTOR: Manager commentary August 2024
We have made two new additions to the fund over the last couple of months,
Spectra Systems provides security technology for bank notes, brands and gaming security software. Notably it has emerged at the forefront for banknote authentication, where it is the first company to develop a polymer substrate that is machine-readable (including via smartphone).
Polymer substrates are a type of plastic material that are increasingly used in bank notes production; the UK switched in 2020 and 60+ other countries have already adopted it. There are also use cases for the polymer in other high security documents such as passports. Overall, the market for polymer substrates is estimated to be growing at a compound annual growth rate of 18%.
As an investment, Spectra also meets the other criteria that we like. It has a sound balance sheet with net cash and a high free cash flow margin (36%). It operates in a niche industry with low levels of competition and high barriers to entry. This is represented in its gross profit margin of around 67% and a net profit margin of around 30%. Critically it has shown pricing power in its negotiations with a recent large central bank customer. The central bank has been a customer for the last 20 years and has committed to remain one for a further 10 years, which highlights the strength of its product offering.
Spectra is well placed to capitalise on the demand for its products and the company has a long track record of growing earnings for investors.
To finance the purchase of Spectra we sold our positions in two holdings: the Lindsell Train Investment Trust and Reckitts Benckiser.
Readers may remember from our February commentary that we were selling down Lindsell Train to fund better investment opportunities we were seeing elsewhere. This is the case with Spectra, which we consider to offer much greater growth potential. For Reckitt Benckiser the litigation over its baby formula continues to hang over the company and has negatively impacted its investment case. For clarity we sold the holding in Reckitt Benckiser prior to the Abbott Laboratories’ ruling in July. The sale of these two stocks has facilitated a 4% holding within the fund with Spectra Systems.
We also made an investment in Rightmove. It is a natural monopoly and monopolies do what they do: generate huge wedges of cash.
It retains the largest and most engaged audience of any UK property portal – its market share of consumer traffic amongst property portals was 86% in 2023 (2022: 85.0%).It is highly profitable with a profit margin of 54% and a broadly equivalent free cash flow margin. As a result Rightmove has been able to produce exceptional returns on capital employed for investors. In both 2022 and 2023 the return on capital employed was over 350% – which is exceptional and consistent with its market share.
Rightmove in April was trading on a price to earnings multiple of 21x compared to a five year average of 31x. That’s too cheap in view of its market dominance.
The largest detractor in the fund over the last quarter has been Burberry after yet more frustrating performance. As discussed previously, Burberry is struggling from a fall in demand for luxury goods and a misguided pricing strategy. We have been pleased with the appointment of a new chief executive; the prior CEO had made a strategic mistake in how it was positioning Burberry within the luxury market. The new chief executive looks set to refocus Burbery on its classic brand heritage, which is welcome. Global fashion brands are usually underpriced by markets because they produce exceptional financial returns over the long term. Burberry needs to remember what made it what it is and to return to delivering the sort of financial performance it is capable of.