Why Evenlode remains bullish on the unloved consumer

Whether interest rates in the developed world do rise by any significant degree in the next year or two remains to be seen.

Hugh Yarrow

But the prospect of rising rates has led to a rise in bond yields in recent months, and a narrative has formed in the investment community that stable dividend paying sectors such as utility and consumer branded goods (‘bond proxies’ as they have become known) should be avoided. Due to our sole focus on capitallight business models, Evenlode does not invest in utility stocks. However, we do have a significant exposure to consumer branded goods companies, which make up a third of our portfolio.

In light of the bond proxy argument, it is worth reiterating we think our holdings in this sector remain attractively valued and offer good risk-adjusted total returns for the patient investor. We like companies that are able to grow at a healthy rate while routinely converting earnings into free cash flow.

There will always be year-by-year fluctuations in working capital and investment requirements, but over time this characteristic of high cash conversion is a key driver of longterm shareholder value creation. Repeat purchase consumer goods businesses exemplify these capitallight qualities thanks to their strong brands and consumer loyalty. Below are the five largest holdings we currently have from this sector, and the average percentage of earnings each has been able to convert into free cash flow over the last fifteen years. (see table below left)

This rate of cash conversion makes every pound of earnings extremely attractive, particularly when compared to asset-heavy business models such as resources, utilities, telecoms or heavy manufacturing companies where cash is routinely absorbed by capitalised investment for growth. The five companies mentioned

below trade on an average Price-toEarnings (P/E) multiple in the high teens. But thanks to strong cash conversion, this converts to a free cash flow yield of nearly 5%. This cash flow gives healthy support to an average dividend yield of 3.5%. A look back at dividend growth over the last fifteen years for these holdings is a reminder of the solid cash compounding abilities these business models possess. (see table below right) They have seen their global markets slow somewhat in the last couple of years and currency has had an impact, but fundamental performance has remained resilient, as has dividend growth. Even for Diageo, which has had the toughest two years operationally of any of the companies on the list, dividends continue to increase at a healthy rate and the outlook for free cash flow is improving as headwinds begin to abate.

In our view, the long-term prospects for steady revenue growth and operational leverage remain compelling for these globally diverse businesses.