GLOBAL LONG-TERM UNCONSTRAINED

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1 GLOBAL LONG-TERM UNCONSTRAINED THE POWER OF VALUE CREATION JANUARY 218 FOR PROFESSIONAL INVESTORS ONLY Value creation has been a topic of much discussion among investors for decades and yet, for some, it still appears to be considered a niche concept. Rather than pursuing quality (often over-simplified as investing in bond proxies or other defensive stocks), we believe adopting a mindset focused on a business return on invested capital (ROIC), can identify companies which consistently create value that ultimately translates into improved shareholder returns. EXECUTIVE SUMMARY Measuring a company s value creation via ROIC is a more robust measure of its potential for sustainable growth and a better indication of its underlying quality than other measures. Building a portfolio of companies with a high and sustainable ROIC gives investors a superior pool of stocks which demonstrate persistent value creation over time. The short-term outlook of markets means there is a strong potential for high-roic stocks to be mispriced, creating opportunities for long-term investors No two value creators are alike finding high- ROIC companies which can grow sustainably requires an active approach, consisting of in-depth research and extensive company engagement.

2 MEASURING A COMPANY S TRUE VALUE: Quality is a highly subjective and notoriously difficult investment style to pin down. Common traits are companies that are well-managed, with strong balance sheets and stable earnings. They may also have large competitive moats, progressive dividend policies or be in the growth phase of their lifecycle. But there are still many intangibles: what constitutes good management? Is capital used efficiently, or frittered away on vanity projects? Are decisions motivated by meeting the next quarter s guidance, or ensuring the company builds for the future? Value creation, a subset of quality, takes us closer to the idea of true quality. The term has been adopted by companies and investors alike, referencing both the sustainable growth of a business and its potential to generate shareholder value over time. In essence though, if a company can continue to create consistent returns on investment over and above its cost of capital, the share price will take care of itself. In attempting discovery of a stock s fundamental value, many market participants focus on its price-to-earnings (p/e) ratio, or its tangible return (dividend, earnings or free cash flow) as a shorthand for whether it is expensive or cheap relative to the market. While intuitive and allowing quick comparison across a range of sectors and regions, multiples are blunt instruments which overlook capital intensity (the level of capital required to generate a unit of cash) and capital allocation (how any excess cash is put to work by management). Both these factors are very relevant drivers of valuation, but often overlooked. A better focus is on cash, or more specifically, discounted cash flow (DCF) and the value creation equivalence: enterprise value (EV)/invested capital = ROIC/ weighted average cost of capital (WACC). ROIC a company s net operating profit after tax (NOPAT) divided by its operating assets is, we believe, the most comprehensive measure of financial return. By comparison, return on assets (ROA), can be skewed by excess cash on a company s balance sheet, while return on equity (ROE) is unreliable when comparing two companies with different capital structures. Investors may sometimes hunt for quality attributes among defensive stocks, such as utilities or consumer staples, in the hope it can help them stand up to any market storms. However, in general, this tends to mean accepting lower returns. Assessing companies on how they create value provides a more robust measure of their sustainable-growth potential and ability for through-cycle returns. CREATING A VIRTUOUS CIRCLE Value creation is a virtuous circle. Cash-generative companies with sustainable capital allocation strategies create a positive feedback loop, enabling them to promote consistent growth over the long-term. For investors, this means a superior pool of stocks, made up of companies which can create value on a sustainable basis. In allocating capital, there are four main options for management teams: Invest in the business and grow organically through capex, usually by expanding capacity Invest in other businesses and grow inorganically through acquisitions (M&A) Pay down debt this might be high on the agenda for companies with too much leverage Reward shareholders either through ordinary or special dividends, or share repurchases. The alternative to the above is allowing cash to pile up on the balance sheet. This can be beneficial, the company keeping its powder dry for future acquisitions or projects. However, if allowed to accrue for too long it can lead to an inefficient balance sheet, potentially raising the company s cost of capital or making it an M&A target. VALUE CREATION, A SUBSET OF QUALITY, TAKES US CLOSER TO THE IDEA OF TRUE QUALITY. IN ESSENCE, IF A COMPANY CAN CONTINUE TO CREATE CONSISTENT RETURNS ON INVESTMENT OVER AND ABOVE ITS COST OF CAPITAL, THE SHARE PRICE WILL TAKE CARE OF ITSELF. 2

3 ANALYSING THE RETURNS OF THE VALUE CREATORS In this simplified example, we can demonstrate how two theoretically identical companies, operating in the same sector and with the same business prospects at the outset, can have vastly different outcomes, based on their approach to capital allocation: Company X generates free cash flow (FCF) equivalent to 1% of its annual sales, with a FCF margin of 1%, is growing sales at 2% per annum but is operating at near-full capacity. Its management runs the business for income, therefore 1% of FCF is allocated to rewarding shareholders through dividend payments. Nothing is allocated to expansionary capex. In our example, over five years, due to serious capacity constraints, the company s growth rate declines by 2 percentage points (pp) every year. In that time, its generous dividend policy means shareholders gain US$1 per annum. However, this dividend is not sustainable and by year 1 declines to US$9 in line with sales. Despite its sector growing at 2% per annum, Company X experiences falling sales. Shareholders initially attracted by generous dividends are faced with a declining (and ultimately unsustainable) income stream, falling to only US$54 per annum in year 2. Company Y, by contrast, has an identical FCF margin but reinvests heavily in the business, allocating 9% of capital to expansionary capex, paying out the remaining 1% of annual FCF in dividends. Company Y s expanding capacity enables it to take market share away from Company X. As a result, sales growth accelerates by 2pp per year. In Year 5, shareholders receive a dividend of US$24, but it is sustainable and growing, so that by Year 2 Company Y s dividend is greater than Company X s and it has an expanding, well-invested business. Value creation: the positive impact of well-allocated capital (all figures in US dollars) Company X Company Y (54) Year 2 Growth -6% Sales: 541 FCF: 54 Year Growth +2% Sales: 1, FCF: 1 Year 1-5 average annual expansionary capex Year 5 dividend (1) Year 5 Growth % Sales: 1, FCF: 1 (77) Year 2 Growth +1% Sales: 3,853 FCF: 385 Year Growth +2% Sales: 1, FCF: 1 Year 1-5 average annual expansionary capex (97) Year 5 dividend (24) Year 5 Growth +4% Sales: 1,217 FCF: 122 (257) (116) (74) Year 15 Growth -4% Sales: 737 FCF: 74 Year 1 Growth -2% Sales: 94 FCF: 9 (9) (48) Year 15 Growth +8% Sales: 2,392 FCF: 239 (165) Year 1 Growth +6% Sales: 1,628 FCF: 163 (33) Dividends/share buybacks Average annual expansionary capex Source: Martin Currie. The data supplied is used for illustrative purposes only. These examples are representative and do not reflect existing companies. While Company X appears, on the face of it, to be an appealing investment, for an investor with a long-term time horizon it is Company Y which has truly created value, generating through-cycle returns as a result of sustainable capital allocation. GLOBAL LONG-TERM UNCONSTRAINED 3

4 HOW THE MARKET MISPRICES VALUE CREATION We can delve deeper into how value creation persists over time by analysing the levels of ROIC among companies in the MSCI ACWI over a 1-year period. Of the firms with a high ROIC (greater than 2%) in 27, around half remained at this level in 216 (see Chart 1). It is this persistence of high returns that mean-reversion mindsets fail to recognise. Chart 1: Destination of ROIC over a 1-year period ROIC >2% ROIC 1-2% ROIC <1% ROIC >2%: 46.5% ROIC 1-2%: 28.4% ROIC <1%: 25.1% ROIC >2%: 14.1% ROIC 1-2%: 42.9% ROIC <1%: 42.9% ROIC >2%: 8.9% ROIC 1-2%: 21.8% ROIC <1%: 69.4% Source: Martin Currie and FactSet as at 31 December 216. Data calculated on 28 November 217. Banks, insurance and companies with negative invested capital excluded. SHAREHOLDER OR STAKEHOLDER? Rising short-termism in markets suggests that a business longevity has become less of a priority for many investors. The average holding period for stocks has reportedly dropped dramatically from around four years in the 196s, to a matter of months by the beginning of 217. This decrease suggests a broader shift in investor mentality, where shareholders are more willing to pull the trigger early if stocks do not appear to be performing as expected. In the most extreme circumstances, a shareholder s role is more speculator than investor; in other words, finding a business which demonstrates long-term value creation is deemed of lesser importance than making short-term gains. We believe, by adopting the mentality of stakeholder/owner rather than shareholder investors are able to access the benefits, not just of the accumulative power of compounding over an extended holding period, but also of avoiding the destructive erosion of capital from transaction costs. This is where the market s short termism is an opportunity for long-term investors, as it fails to assign appropriate value to companies displaying intelligent capital allocation, and therefore able to compound high returns sustainably. While typically all stocks are priced to fade over time by the market, we do not believe this should be the case for true value creators. When you adopt an investment horizon of greater than five years, there is strong potential for high-roic stocks to be mispriced. THIS IS WHERE THE MARKET S SHORT TERMISM IS AN OPPORTUNITY FOR LONG-TERM INVESTORS, AS IT FAILS TO ASSIGN APPROPRIATE VALUE TO COMPANIES DISPLAYING INTELLIGENT CAPITAL ALLOCATION, AND THEREFORE ABLE TO COMPOUND HIGH RETURNS SUSTAINABLY. 4

5 VALUE CREATION AND EARNINGS YIELD AN EX POST ASSESSMENT To demonstrate the value creative power of companies with high and sustainable ROIC and how that value compounds year on year, we address the Enterprise Value Added (EVA ) over the course of 1 years. In Chart 2, using our Global Long- Term Unconstrained (GLTU) portfolio as a guide, we have selected the median value-creating stock s ROIC and notionally invested US$1 at that return for every calendar year over the course of a decade, doing the same for the market (using the MSCI ACWI). There is a stark difference between the two; over the period the portfolio has turned US$1 into US$576, versus the market s US$148. In Chart 3, we overlay the earnings yield (earnings/price) for the same 1-year period, again for the median value creator and the market. We fix the stock price (p) at the 26 level in both cases and vary earnings (e) by the actual earnings growth achieved ex post each year. The earnings yield of the portfolio increases from 5.% in 26, to 13.8% in 216. The value creator has flipped from being more expensive than the market at the start of the period to less expensive since 211. The widening gap is due to the vastly superior earnings power of the value creators. Chart 2: EVA over 1 years Chart 3: EVA & Earnings Yield over 1 years % US$ US$ % % % 12% 1% 8% 6% 4% 2% % GLTU MSCI ACWI GLTU earnings yield GLTU EVA ACWI earnings yield ACWI EVA Source: Martin Currie and FactSet over periods to 31 December 216. Data calculated on 3 September 217. EVA based on MSCI ACWI index and a representative Martin Currie Global Long-Term Unconstrained portfolio, using the median stock for every calendar year. Earnings yield defined as E/P where the numerator, E, is the EPS of the median earnings yield stock in 26 inflated every year through 216 by the median EPS growth; and the denominator, P, is the share price of the median earnings yield stock in 26 held constant throughout the period. In Chart 3, the value creator s earnings yield (right-hand scale) closely follows its enterprise value added (EVA ) over the 1 years, implying a relationship between earnings yield and the value created. In contrast the market s earnings yield has risen more steeply than its underlying value creation. This suggests (i) the market has become more expensive relative to the portfolio and (ii) the market s valuation is not backed up by the cumulative value it has created. HIGH-ROIC STOCKS JUSTIFY HIGHER VALUATIONS We can extend this analysis to look at how the market underestimates the persistence of value creation. Expanding on its 199 book Valuation McKinsey has established the arithmetic relationship between ROIC and p/e. * Essentially, by combining the principles of the Dividend Discount Model and the Sustainable Growth Model, at a given level of market growth, the higher a stock s ROIC, the higher its justified p/e ratio due to the lower re-investment required to achieve a given level of growth. *Source: All P/Es are not created equal. Nidhi Chadda, Robert S. McNish and Werner Rehm, McKinsey & Company, Spring 24. Further reading: Valuation, Tim Koller, Marc Goedhart, David Wessels, McKinsey & Company GLOBAL LONG-TERM UNCONSTRAINED 5

6 Knowing the p/e ratio and ROIC of the market, in Chart 4 we have calculated the market-implied growth, which comes out at 4.%. The market (blue dot) sits on the justified p/e curve, while the portfolio, again using GLTU as a proxy for value creators (green dot), with a ROIC of 24.2% and a p/e of 23.5x sits just below it. Assuming the 4% growth rate applies to both market and portfolio, the portfolio is modestly undervalued relative to the market. This approach validates the notion that the portfolio merits a higher p/e ratio. The companies in the portfolio have materially higher ROICs, meaning they have lower re-investment requirements to grow at a given rate than the market, therefore have more free cash available to shareholders. Chart 4: Analysing high-roic stocks against the market-implied growth rate p/e ratio ROIC (%) Market implied growth rate 4.% MSCI ACWI GLTU Source: Martin Currie and FactSet as at 3 June 217. Representative Martin Currie Global Long-Term Unconstrained portfolio shown. Median ROIC and p/e shown. ROIC excludes the two financial stocks held in the portfolio. Assumes a WACC of 7.5%. CASH CONVERSION However, these assumptions rest on the market and portfolio having identical levels of growth. In fact, we believe these value creating stocks are able to grow faster than the market. As we can see in Chart 5, looking at sales growth and earnings per share (EPS), taking the last seven years and consensus forecasts for the next three, there is evidence that value creators are growing earnings faster than the market. Even more compelling, is that, based on FCF per share growth, the portfolio has vastly superior cash conversion. Chart 5: Superior Cash Conversion of Earnings Sales growth EPS growth FCF per share growth Sales growth (indexed) EPS growth (indexed) FCFPS growth (indexed) GLTU Index Source; FactSet and Martin Currie over periods to 31 December 216. Data calculated as at 3 June 217. Representative Martin Currie Global Long-Term Unconstrained portfolio shown, using seven years of sales, EPS and FCF per share data, and three years of consensus forecasts. Please note that this strategy is unconstrained by any benchmark. For illustrative purposes, we compare the strategy to the MSCI ACWI. All data is calculated in US$ numbers use estimated data. However, genuine value creators are rare. Crucially, of the companies in Chart 1 with a lower ROIC in 27 (under 1% at the start of the period, 69.4% had remained at this low level, with only 8.9% moving up to the top bracket. The ability to create value is clearly difficult to master. The test therefore for investors, is to identify these companies where high ROIC (that is, value-creating firms) can be sustained over the long term. 6

7 THE CHALLENGE: FINDING THE TRUE VALUE CREATORS Screening for 1 consecutive years of value creation (high- ROIC) stocks eliminates around 85% of the companies in the MSCI ACWI. However, as we take a long-term time horizon, pinpointing the businesses with the potential for sustainable value creation goes further than a simple quality screen and therefore requires more than quantitative analysis. Making a qualitative judgement on a business potential demands a fundamental active approach, in-depth research and extensive company engagement. From this we gain a greater depth of knowledge on corporate ethos and the rationale behind all material company decisions. No two value creators are made alike. As Chart 6 shows, companies can be highly capital intensive, such as a railway operator, or a semiconductor manufacturer, which are both required to spend large amounts of capex every year. On the other hand, some companies displaying high ROIC are very asset light, such as software providers or IT services companies. There are industries where we consider it unlikely to find value creators, most notably banks and energy stocks. However, all levels of asset intensity are valid, as long as we believe there is a consistent ROIC over WACC. * Chart 6: No two value creators are made alike decomposition of ROIC Net operating profit after tax x 2.x 4.x 6.x Asset turns ROIC: 1% 2% 3% 4% Source: Martin Currie and FactSet over periods to 31 December 216. Data calculated on 31 October 217. Representative Global Long-Term Unconstrained portfolio stocks shown excluding two financial stocks, as well as one stock for scale purposes. In order to find these companies, we look for both sustainable growth and good stewardship of capital: GOOD CAPITAL ALLOCATION We have demonstrated the power of sustainable capital allocation, so first and foremost, for us, is a company s ability to reinvest in the business. We would expect firms which are genuine value creators to have a far lower debt-toequity ratio than the market clearly companies which are over-leveraged are forced to spend cash on reducing their debt, rather than put it back into the business. Among these cash-generative companies, it is essential we have a thorough understanding of their capital allocation decisions and in our engagement there are a number of key signposts we look for which constitute good practice. We would expect many value creators to allocate the highest proportion of spending on capex, essentially reinvesting in the business so it will still be fit for purpose in 1 or 2 years time. Value-creating technology companies, or those with low capex requirements would be likely to focus their attention on capitalised operational expenditure such as R&D, or software development. We would be concerned by an aggressive use of share buybacks and overpayment on dividends. These would suggest two things: firstly, that the company has no more room left to grow, and secondly, it could be a sign the firm is leveraging up its balance sheet. LONG-TERM STRATEGY (NOT SHORT-TERM TACTICS) We look for evidence that a company is guided by a genuine focus on long-term sustainability as opposed to a predominance of so-called quarterly capitalism, where management is fixated on short-term numbers. A key area to look at here is M&A activity: we would prefer a company to grow by organic means, but also look for the rationale behind any deals smaller M&A, as an accretive way of growing the business, could be a sign of a company which has its long-term future firmly in focus. A potential red flag would be if the M&A has the appearance of empire building and growing the size of the company at all costs. This would suggest potentially unsustainable growth rates, beyond the company s continued reach or capability. APPROPRIATE MANAGEMENT INCENTIVES How a company incentivises its management speaks volumes about its potential for sustainable value creation and we want to see remuneration structures which are sufficiently balanced between long-term capital allocation and short-term performance. We look for compensation packages which include metrics such as ROIC, EVA or FCF, to ensure that management is aligned with the long-term future of the business. For example, looking again at M&A, a management team which is incentivised to focus solely on growing the company will not be penalised for over paying. On the contrary, it is likely to be rewarded, as the stock will now have a higher EPS and, on paper at least, will look like a better prospect for investors. Management which is incentivised to provide robust stewardship of shareholder capital, is less prone to disproportionate outlays on M&A, paying over the odds for assets. *For financial stocks, which have very little invested capital, we use ROE to assess their value-creation ability. GLOBAL LONG-TERM UNCONSTRAINED 7

8 A DEEPER DIVE Central to our assessment is a detailed analysis of financial statements, in order to assess the quality of a company s earnings and the true health of its balance sheet. Our proprietary accounting diagnostic review (ADR) is an essential tool in drawing out issues that may not be immediately obvious. The ADR is also a vital part of engagement as it leads to more searching questions behind company decision making. Ultimately, if a company does not disclose the necessary information for the ADR, it will not be held in the portfolio. As signatories since 29 of the Principles of Responsible Investment (PRI), analysis of ESG factors is also integrated into every stage of the investment process. Significant emphasis on stewardship provides us with a better understanding of the mechanisms of a company s decision-making process. For example, we assess: governance risks, including board structure and independence; social risks, such as health and safety, cybersecurity or low wages in the supply chain; and how the company reports on material environmental factors, such as carbon emissions and mitigation. Risks to a business model of, for example, the introduction of a global framework for carbon pricing, is worth considering in any long-term investment thesis. CONCLUSION Even allowing for interest rate normalisation in the US, muted global growth is set to be a factor in markets for some time to come. This, we believe, plays to the strengths of value creators, which we would expect to outperform the wider market in all scenarios, other than where the market is rising sharply and volatility is high. Of paramount importance is the persistence of value creation and investors can take advantage of the market s mispricing of companies which display disciplined allocation of capital over a longer period of time. Screening for stocks with a long track record of value creation gives an advantaged starting point, but building conviction requires deeper analysis of capital allocation, accounting diagnostics and a firm understanding of ESG. In this way we can identify the companies planning for the future not just the next quarter. OF PARAMOUNT IMPORTANCE IS THE PERSISTENCE OF VALUE CREATION AND INVESTORS CAN TAKE ADVANTAGE OF THE MARKET S MISPRICING OF COMPANIES WHICH DISPLAY DISCIPLINED ALLOCATION OF CAPITAL OVER A LONGER PERIOD OF TIME. 8

9 IMPORTANT INFORMATION This information is issued and approved by Martin Currie Investment Management Limited ( MCIM ). It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested. The document may not be distributed to third parties and is intended only for the recipient. The document does not form the basis of, nor should it be relied upon in connection with, any subsequent contract or agreement. It does not constitute, and may not be used for the purpose of, an offer or invitation to subscribe for or otherwise acquire shares in any of the products mentioned. The information contained has been compiled with considerable care to ensure its accuracy. However, no representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained in this document for its own use. It is provided to you only incidentally and any opinions expressed are subject to change without notice. The opinions contained in this document are those of the named manager. They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Data calculated for the representative Global Long- Term Unconstrained strategy account. Some of the information provided in this document has been compiled using data from a representative account. The account has been chosen on the basis that it is the longest-running account for the strategy. This account is an existing account managed by Martin Currie, within the strategy referred to in the document. This data has been provided as an illustration only, the figures should not be relied upon as an indication of future performance. The data provided for this account may be different to other accounts following the same strategy. The information should not be considered as comprehensive and additional information and disclosure should be sought ahead of any planned investment. Risk warnings investors should also be aware of the following risk factors which may be applicable to the strategy: Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment. Emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. Accordingly, investment in emerging markets is generally characterised by higher levels of risk than investment in fully developed markets. This strategy holds a limited number of investments. If one of these investments falls in value, this can have a greater impact on the portfolio s value than if it held a larger number of investments. For Investors in the US, the information contained within this document is for Institutional Investors only who meet the definition of Accredited Investor as defined in Rule 51 of the United States Securities Act of 1933, as amended ( The 1933 Act ) and the definition of Qualified Purchasers as defined in section 2 (a) (51) (A) of the United States Investment Company Act of 194, as amended ( the 194 Act ). It is not for intended for use by members of the general public. Any distribution of this material in Australia is by Martin Currie Australia ( MCA ). Martin Currie Australia is a division of Legg Mason Asset Management Australia Limited (ABN ). Legg Mason Asset Management Australia Limited holds an Australian Financial Services Licence (AFSL No. AFSL24827) issued pursuant to the Corporations Act 21. Martin Currie Investment Management Limited, registered in Scotland (no SC6617) Martin Currie Inc, incorporated in New York and having a UK branch registered in Scotland (no SF3), Saltire Court, 2 Castle Terrace, Edinburgh EH1 2ES Tel: (44) Fax: (44) Both companies are authorised and regulated by the Financial Conduct Authority. Please note that calls to the above number may be recorded.