L&G ISPY Cyber Security ETF

Unlocking growth

Rachel Winter

Associate Investment Director

Rachel sums up the key takeaways for investors from a busy Spring in global markets. Share prices hit some positive milestones last quarter. US equities reached new all-time highs, European equities returned to pre-pandemic levels and the FTSE 100 index climbed steadily. Meanwhile, the OECD upped its forecasts for global growth again in 2021 to 5.8%, citing better than expected progress in the rollout of COVID-19 vaccines. Here in the UK, the level of household wealth has climbed to a record level, on the back of rising house prices and stock markets.

Increasing inflation

However, the associated rapid pick-up in demand has also led to a rise in inflation. Recent readings in the UK, US and Europe have all surpassed consensus expectations. Here, the number for May came in at 2.1%, exceeding the Bank of England’s target for the first time in two years. In the US, the equivalent reading was 5%, the highest since 2008. The key question for investors is whether we are seeing a temporary inflation spike, as economies rebound from very depressed levels, or the start of a more sustained rise in prices. UK and US government bond yields offered a possible clue – they have not risen during the quarter, implying that bond market inflation expectations remained broadly unchanged at the time of writing.

Staying safe

Following three high-profile hacks that have all been attributed to Russian criminal gangs, cyber security remains in the spotlight. The targets were the IT infrastructure behind Ireland’s healthcare system, the world’s largest meat processor JBS, and the huge US Colonial Pipeline. Having successfully hacked the latter, a group of cyber criminals demanded and received a ransom payment of $4.4m in Bitcoin. These recent examples highlight why firms must consistently strive to ensure they have adequate cyber security in place – a report published by Gartner in May predicted that global spending will top $150 billion this year. It highlighted cloud security as the fastest growing area within this space, reflecting increased usage of the cloud as more and more people work remotely. Related investments have duly performed well, for example the L&G ISPY Cyber Security ETF.

Creaking crypto

Meanwhile, although the regulator here (the FCA) does not oversee cryptocurrencies, which considerably reduces their attractiveness as investments, the volatility of this asset class over the last quarter is worth noting. Bitcoin, for example, dropped substantially from its March peak, and for some pretty clear reasons. Firstly, China banned cryptocurrency exchanges and initial coin offerings. Then “Technoking” Elon Musk announced that Tesla would no longer accept payment in Bitcoin, owing to environmental concerns about the mining process. He subsequently revised his position by saying that the firm will accept payment in the cryptocurrency, provided it has been mined using sustainable power. Further, global authorities have been discussing how best to tax this new asset class and make anyone profiting from it aware of their potential liability to capital gains tax. Finally, the US FBI revealed that it has recaptured most of the ransom that was paid to the hackers of the Colonial Pipeline, sowing doubt about the security of Bitcoin in the process.

Supporting sustainability

Cryptocurrency mining concerns aside, investors’ growing enthusiasm for sustainability was demonstrated when shareholders in ExxonMobil voted against three board candidates put forward by the company. Instead, they expressed a preference for others nominated by activist hedge fund, Engine No. 1. The fund has been critical of Exxon’s lack of action on climate change and wants the new directors to steer the company down a greener path. The firm has lagged peers when it comes to reducing its dependency on fossil fuels and has been the worst performer of the “big five” oil majors (the others being Royal Dutch Shell, BP, Total and Chevron) over the last five years. Fossil fuels were also high on the agenda at the latest G7 summit in Cornwall, where leaders from the developed nations agreed to help developing countries to reduce their dependence on coal.

Dissecting data

Looking ahead, we wait to see how far consumer behaviour will shift as social restrictions are lifted. Companies involved in online retail, digital payments and remote working technologies have all thrived during lockdown as people shopped online and worked from home. However, it is not yet clear to what extent these new habits will stick. Online retail sales, for example, accounted for just under 20% of the UK’s overall sales total for February 2020, ahead of the first lockdown. By February 2021 that proportion had risen to 36%, but in April it dropped back to 30% as consumers took advantage of physical stores reopening. Investors should keep a close eye on this sort of data as our freedoms are restored. ●

As firms emerge from the pandemic and resume payouts to shareholders, Stephen examines the case for returning capital and weighs up dividends against share buybacks as the mechanism for doing so. One of the primary purposes for which companies are created is to generate an acceptable return on capital (“equity”) for shareholders in the form of earnings. The key question then becomes, what should happen once they do? There are two basic choices open to the directors – earnings can be retained and reinvested, or given back in the form of a dividend or a share buyback. This is amongst the most important capital allocation decisions regularly made by company management teams, and a key determinant of long-term shareholder value creation. With dividend payments resuming and buybacks on the rise, here is a snapshot of their relative merits.

Retaining profits

“Retained earnings” are those that have been kept in a company, thereby increasing its equity (and net assets). However, although boosting this number for its own sake may suit ambitious directors, it is not necessarily the best course of action for a firm’s shareholders. That is because, as investors, they should always require a minimum return on their investment in a firm for a given level of risk. So, in principle, earnings should be retained only if they can be reinvested at, or above, that required rate. There are some circumstances in which companies may hang on to their earnings, despite delivering sub-par returns – to satisfy regulatory requirements for example – but otherwise any “surplus” equity should be promptly returned. But how?

Paying back

Stephen Timoney

Senior Analyst

Dividing the spoils

Cash dividends distribute equity through a simple disbursement of some, or all, of a company’s cash to shareholders. Share buybacks can achieve the same distribution of equity, but not solely in the form of cash. Instead, they involve a company acquiring its own shares, usually by buying them in the open market. These become “Treasury Shares” (in issue, but no longer outstanding), or are otherwise cancelled. Either way, the number included in the distribution of dividends and the calculation of earnings per share is reduced. Conceptually, share buybacks can be thought of as using cash to ‘buy out’ one or more business partners, thus increasing the equity value attributable to the remaining ones. They therefore result in increased per-share ownership for non-sellers, while generating cash for sellers.

The popularity of each mechanism varies by regional market. In the US, for example, share repurchases surpassed cash dividends to become the dominant form of corporate payout in the late 1990s. Unsurprisingly, buyback activity slowed amid the uncertainty caused by the pandemic, as companies hoarded cash to protect their balance sheets. Nonetheless, the longer-term upward trend has resumed more recently with US companies announcing $484bn in share buybacks in the first four months of this year, the highest such total in at least two decades, according to Goldman Sachs. Notable amongst them was Berkshire Hathaway’s $18bn repurchase of its own stock.

In the UK, by contrast, dividends remain the preferred option. COVID-19 took a heavy toll, as around twothirds of companies cut or cancelled dividends between the second and fourth quarters of 2020. In that context, the recovery to date has been muted and, in contrast to the outlook for US buybacks, it will likely be several years before UK dividend payouts reach pre-pandemic levels.

Battering buybacks

A common criticism of equity distributions to shareholders, of any sort, is that they divert money from investment in plant and equipment, or research and development, thereby stymying overall economic growth. Overwhelmingly – and illogically – such criticism seems to be focused on share buybacks to the exclusion of dividends. In the US, the antibuyback viewpoint gained strong political momentum in the run-up to the presidential primary elections, with Senators Chuck Schumer of New York and Bernie Sanders of Vermont calling for a limit on them unless companies also raise worker pay, boost staff benefits and invest capital. Even Republican Senator Marco Rubio, of Florida, jumped on the bandwagon with a call for higher taxes on share buybacks. This barrage of criticism is, however, counterproductive. Leaving aside short-term tax considerations, the decision to retain earnings, or to distribute them by way of a dividend or share buyback, is fundamentally linked to a firm’s year-to-year investment opportunities. And, in the long-term, to the stage it

has reached in its corporate lifecycle. High-growth start-ups, for example, often have many attractive investment opportunities and will tend to retain earnings as a result. It makes little sense for such companies to return equity when it can be reinvested for the benefit of shareholders at high rates of return. Mature companies, by contrast, typically have established market positions with more limited options for growth. Their best course of action is often to return cash to shareholders, rather than commit capital to value-destructive investments or acquisitions. Regardless of their stage in the corporate lifecycle, however, all companies may find their investment opportunities constrained by the wider economic backdrop. Despite the political finger-wagging, buybacks may be a symptom, rather than a cause, of economic malaise. If so, politicians should not be forcing companies, in effect, to make bad capital allocation decisions.

Lining up

Once a firm has decided independently to return capital to shareholders, the issue becomes how best to do it – through buybacks or dividends. Both have their pros and cons. According to the proverb, a bird in the hand is worth two in the bush. As such, dividends are a tangible distribution of equity to shareholders whose value, once received, is not subject to change. Share buybacks, on the other hand, are a less certain proposition. Since the required transaction reduces the number of shares in a company, key ratios, such as earnings per share, get an automatic boost. However, provided a theoretical ‘fair price’ is paid for the shares, any gain in earnings is offset by a loss of cash for nonselling shareholders (and vice versa for selling shareholders), making it a break-even transaction.

But what if a fair price is not paid? Buying back shares when they are cheap adds value for non-selling shareholders, at the expense of those who sell. Conversely, share buybacks at a premium add value for selling shareholders, to the detriment of nonsellers. As such, it’s a zero-sum game. Unfortunately, history shows that most share buybacks take place close to the top of market cycles, when rich valuations abound, and investment opportunities are few. To compound this problem corporate managers, like many other investors, appear to be reluctant buyers at market bottoms. Buybacks, then, are more akin to the proverbial “two in the bush”: they can add value if they are carried out at attractive valuations, but they can also destroy it if they are executed poorly.

Timing trouble

From a pure capital allocation point of view, however, share buybacks offer much more flexibility than dividends. Ideally, companies would time them to coincide with a lack of investment opportunities and low share valuations. What is more, once started, there is no obligation for a repurchase programme to be completed within a certain time frame. Dividends, by contrast, may be discretionary but they can bind management. As investors become accustomed to receiving regular payouts, and may even come to rely on them, any reductions, suspensions or eliminations can trigger drastic share price declines. This means that once regular dividend payments are established, management is effectively obliged to keep making de facto ‘interest payments on equity’, even when there are better ways that they could be deploying cash. Share buybacks also offer a tax advantage over dividends because the eventual profit is treated as a capital gain. This means that investors are in control of when they decide to sell their stock to take a gain, allowing them to postpone taxes in perpetuity by delaying, or set capital losses off against them as they are realised. Moreover, in countries such as the UK, capital gains are taxed at a lower rate than income.

A darker side of share buybacks is that, while they only benefit shareholders when carried out at attractive valuations, company managers can exploit the mathematics to their advantage, regardless of market conditions. By tying their compensation packages to growth in earnings per share, the less scrupulous ones may be incentivised to buy back shares regardless of their valuation, perhaps at the expense of other attractive investment opportunities. Thankfully, many companies try to mitigate this risk by either adjusting for the inflationary impact of buybacks in calculating pay packets, or aligning them to other, more shareholderfriendly measures, such as total return. Nonetheless, investors should be on their guard.

Closing out

In summary then, dividends and share buybacks respectively present advantages and carry certain disadvantages. Therefore, what ultimately should matter most to investors is not so much the chosen mechanism by which equity is distributed by a company, but rather whether such distributions stack up in the context of the prevailing investment environment. Management teams that judge this correctly will create the most long-term value for their shareholders. ●

This quarter, Andrew takes two deep dives into our thematic approach to stock selection.

The Killik & Co investment process is built on harnessing thematic ideas. It is an approach that requires us to identify economic, political and social trends that can offer above-market growth over time. By contrast, other investing styles may be geared towards short-term factors relating to the economic cycle, such as GDP growth and employment levels. These may manifest over just a few quarters or even months, whereas the secular themes we seek to capture via our investment strategy can run for many years. This kind of approach is intellectually demanding, in that we must be prepared to peer further into the future than a typical investor. That, in turn, comes with a greater level of uncertainty and even margin for error – it is much easier to predict what the world will look like over the next week, rather than five years. However, we seek to counter this headwind by taking a thoughtful and conservative approach to our projections. Further, we believe that the long-term outperformance that comes from correctly identifying winning themes far outweighs any potential downside.

Seeking stability

Naturally, we are not alone in our thinking. In 2021 there seems to be a theme for everything, and an associated investment vehicle to match, whether the underlying thread is cryptocurrencies, rising levels of global obesity, or even the space economy. However, whilst not wanting to totally dismiss them, we nonetheless feel that investors should not underestimate the risks of investing into what are, in some cases, nascent industries where the underlying companies have no clear path to profitability. Instead, our approach is built on looking for themes that have a relatively high level of predictably. We therefore spend time on “Big Picture” thinking combined with detailed research and analysis, a strong pairing that makes a substantial contribution to our investment performance over time. Once we have found a theme that we like, we then look for businesses that stand to benefit from secular tailwinds that should provide lasting opportunities for growth in revenue, earnings, and free cash flow. We keep the old investing adage in mind that, “a rising tide lifts all boats” even if the tide in our case is not the overall economy or a specific pocket of it, but a broad theme that we want to tilt towards. The businesses that we select must therefore be able to plan and invest for the long-term, whilst demonstrating the means to withstand any short-term volatility in their endmarkets or regions. As such, we are focused on high quality companies that can offer significant scale, balance sheet flexibility, strong brands, and robust growth opportunities. As we enter the final stage of our re-emergence from the pandemic, here are two examples of key global challenges that demonstrate how the thinking outlined above, positions us to deliver superior risk-adjusted investment performance.

Thinking thematically

Andrew Duncan

Senior Equity Analyst

Staying healthy

The first is our Future Healthcare theme. The cornerstones of our investment case are several seemingly unstoppable global forces, which include a rising population (the UN predicts an extra 700 million people on the planet by 2030) and increasing need for, and access to, healthcare in emerging markets. This will create a wall of demand as not only are people living longer, but they are also becoming less healthy. That combination implies a higher incidence of chronic conditions, such as diabetes and heart disease which, in turn, are expected to place a greater strain on an already overburdened global system (in 2017, it was estimated that over one in seven dollars of spending in the US went towards treating diabetes alone). These drivers strongly suggest to us that global healthcare spending will continue to rise consistently over the next decade and beyond. Given the inherent uncertainty in developing new therapies or medical devices, it is often difficult to accurately predict which companies in this space will be able to deliver the next round of solutions. However, what we are convinced of is that all healthcare companies, both existing giants and emerging upstarts, will have to spend significant amounts of money as part of an important global effort. But rather than taking what we would see as undue levels of risk in buying companies facing uncertain success around their future products, we prefer to ride the existing wave of research and development (R&D) spending in the healthcare