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Rosemary Banyard, manager of the VT Downing Unique Opportunities Fund (DUO), recalls Warren Buffett’s emphasis on owning outstanding businesses with strong economic moats as long-term holdings. She explains why companies with superior returns on equity and minimal debt typically possess durable moats, making them market leaders and highly cash generative. Key factors for long-term success include disciplined, long-term management teams with significant ownership or incentives, an unconstrained investment mandate, and resilience from fund managers and investors. Rosemary explains how she follows this approach, maintaining low turnover and transaction costs, and importantly having the patience and the ability to wait for compounding returns to materialise.
In his 1988 letter to shareholders, Warren Buffett famously said that “when we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever.” He cited Coca Cola as an example, which he still holds today. Thanks to the free education lessons available from Berkshire Hathaway’s annual shareholder letters, we learn that his definition of outstanding businesses is those that possess strong economic moats that keep out the competition and enable the achievement of superior returns on equity over the long term.
Unique businesses
Our experience is that companies which regularly achieve superior returns on equity without excessive levels of debt tend to possess identifiable and durable moats. This makes them hard to displace and, therefore, often unique, or at least market leaders in their field. These businesses are typically highly cash-generative, giving management teams great optionality over capital allocation.
Some managements choose to distribute surplus capital as special dividends, particularly if expansion opportunities are limited or they don’t require much capital. Others carry out share buy-backs. In the present depressed UK stock market, 345 companies announced share buy-backs in the year to April 2024. Potentially more valuable for the long-term investor are those businesses which have the discipline of reinvesting their surplus cash at good rates of return, as it can create the flywheel of the upward long-term compounding of returns, a virtuous circle if executed well.
Rewards from long-term compounding
In order to reap the full rewards of long-term compounding, we would argue that you need at least three factors to be present. First is the need to choose companies possessing a management team with a long-term mindset and a disciplined approach to capital allocation. In practice, this generally requires either skin in the game in the form of significant outright share ownership (not options) or, failing that, a long-term share incentive scheme which includes explicit targets for return on capital. Significant shareholdings bring with them the owner’s eye and an alignment with other shareholders. Share incentives which reference the capital used to achieve profits protect shareholders from foolish acquisitions and limit the curse of the adjusted earnings per share target, where too often the earnings adjust out all the bad news as exceptional items. It is not a coincidence that the weighted average holding by directors in the VT Downing Unique Opportunities Fund (DUO) is 9%, and we own 11 companies where directors own over 3% of the equity. A further four companies have explicit long-term incentive targets linked to returns on capital in one form or another, making up half the fund altogether.
From a small-cap listing to the FTSE 100
A second prerequisite for maximising the returns from long-term compounders is an unconstrained investment mandate. The full rewards can only be reaped if a fund is allowed to own companies as they move through the whole market capitalisation spectrum. A holding in a Mid 250 fund will generally have to be sold upon its promotion to the FTSE 100 index. However, with DUO, when Diploma was promoted to the FTSE 100 index in September 2023, we were delighted to continue to own it, and the share price has since risen by a third.
Small companies which reinvest surplus capital at attractive returns can grow into large companies provided their total addressable market is big enough. Examples of this strategy working in my investing lifetime have been Dechra Pharmaceuticals (veterinary pharmaceuticals) and Diploma (specialist distribution). In both cases, I owned them as far back as 2005 when they were still in the FTSE Small Cap index and saw them move over time into the Mid 250 Index. Both companies were later promoted to the FTSE 100 Index. Renishaw (precision engineering) is another example of a company I owned in 2005 and still held a decade later. It started and ended this decade in the Mid 250 index, but its market value rose by 2.5 times in this period without any share issuance.
The merits of a long-term mindset
The third factor needed is resilience and patience from the fund manager and their underlying investors. Taking the example of Diploma, the shares fell from £21 to £13 (-38%) in the Covid sell-off in early 2020, and from £34 to £22 (-35%) between January and April 2022 when interest rate expectations rose. Mental resilience is needed not to panic out in these situations. It helps to have a clear understanding of the business model and the durable moats.
A long-term investing mindset and an unconstrained mandate should result in low trading costs compared to the typical fund. Turnover at DUO is in the 10-12% range per annum, implying an average holding period of approaching ten years. Transaction costs in the financial year to end June 2023 were 0.06% of average NAV, of which 0.04% was stamp duty. The average fund turnover in our peer group, the IA UK All Companies sector, has been reported as 80% per annum, suggesting a gambling rather than an investing mindset. While funds do have to declare their transaction costs in their annual report, they are not usually prominent and not included in the Ongoing Charges Figure, which they should be in our view, to assist a proper comparison.
More broadly, compounding is a simple concept in principle but a difficult mindset to maintain in an industry that rewards short-term action over long-term results. Resisting the urge to (over)react may go against human nature. The late great Charlie Munger put it best: “It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait.” With the VT Downing Unique Opportunities Fund, we choose to embrace the patient approach to support long-term growth.
Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Important notice: this document has been prepared for professional investors and has been approved as a financial promotion in line with Section 21 of the FSMA by Downing LLP (“Downing”). Capital is at risk and investors should note that their investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a reliable indicator of future performance. Any subscription to the fund should be made on the basis of the relevant product literature available from Downing or from the ACD, Valu-Trac; and your attention is drawn to the charges and risk factors contained therein. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 6th Floor, St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
