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Cash call

Hugh Yarrow got a solid grounding under managers including Carl Stick during six years at Rathbones and is now bringing this to bear on his own fund.

He left in 2009 to join his family business Wise Investments, launching Evenlode income – the private client firm’s debut direct equity offering – in October that year. According to Yarrow, Evenlode is the name of a river flowing from his Oxfordshire base into the Thames but he also likes the “investing alongside him” connotations of the brand.

“If all goes well, I would hope to be running this fund in 15 or 20 years and have all my own long-term savings tied up in the portfolio, so I clearly want a good return with limited downside,” he says.

Yarrow’s income process focuses on the concept of so-called cash compounder companies, which are those offering a high return on equity, with limited use of debt in the capital structure. He says: “These are typically growth businesses that compound value for investors at a high rate over the long term. They will usually be companies that offer a product or service that customers are willing to buy – and keep on buying – at prices not linked to the cost of production, such as with branded consumer goods for example.

“These firms will often also have intangible assets such as intellectual property or key skilled individuals and little in the way of fixed assets, which means a high return on capital.”

Such firms are typically well suited for an income portfolio, according to Yarrow, as they can offer sustainable dividend streams, not needing to reinvest excess cashflow into maintaining large tangible assets.

“This allows them to compound cashflows for share-holders over a long period of time and as most enjoy repeat purchases or subscription business, they are less suscep-tible to economic volatility.”

Based on this process, Yarrow’s fund will always be structurally over and under-weight certain parts of the market, heavy in areas such as food and drink producers, media and specialist engineers. He will typically be light in banks, based on too much debt in capital structure, as well as typical income stalwarts such as utilities and telecoms, which Yarrow sees as asset heavy and therefore offering lower returns on capital. Oil and gas also tends to be a low weighting, with these stocks maintaining big reserve bases that require substantial replenishment.

All this means Evenlode income will look very different to more traditional income fund, also finding yield opportunities down the market cap scale. Yarrow is also happy to use his 20 per cent flexibility to invest outside the UK – currently holding 15 per cent in the US, for example – although he stresses revenue exposure on the portfolio is more global than local via positions such as Unilever.

Yarrow and analyst Ben Peters screen the market for cash-compounding companies, which produces an overall universe of around 85 stocks. They trim this further to 30-40 holdings for the portfolio, based on attractive valuation, a growing dividend stream and a further measure called forward cash return. In basic terms, this shows a company’s quality-adjusted free cashflow and highlights stocks offering the best return on capital.

At launch, the fund moved heavily into small and mid-caps initially – with just 40 per cent in bigger companies – with performance driven by names such as Domino Printing and Weir Group.

Yarrow says: “As these stocks performed well, their forward cash return went down while the metric improved on market-lagging large caps.

“This has seen us shift the portfolio back towards bigger stocks and holdings in areas such as healthcare and consumer staples have been key to returns over this year, with 50 per cent of the portfolio across these two sectors.”

Looking at the macro picture, Yarrow – like most peers – highlights a major deleveraging period in the West and expects several years of sub-par economic growth and shorter economic cycles. He cites short-term deflationary pressure but sees inflation as a bigger concern over the coming years – claiming his favoured cash compounders can outperform against both backgrounds.

“In deflationary periods, these companies tend to have pricing power so can perform even as consumers have less discretionary income to spend. As for inflation, conventional wisdom is that asset-heavy businesses such as oil producers perform best but if you look at the figures, the share price of a stock such as Exxon Mobil was static through the high-inflation 1970s and we feel companies with a smaller asset base are better placed.”

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