Be an investor not a speculator Claremont Global June 2022 The current market sell-off has many market participants running for cover and waiting till the "uncertainty clears." Issues concerning the market are well-known - central bank tightening, high inflation, the Ukraine conflict, supply chain shortages and increasing concerns of a recession in 2023. And in current markets, I am reminded of the timeless words of Benjamin Graham (the father of security analysis and Warren Buffet's mentor) who made the clear distinction between investment and speculation. In his seminal work "The Intelligent Investor" on the very first page he makes the following observation: "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting this definition are speculative."  Defining an adequate return When reading this quote the key word is adequate. Note that Graham makes no mention of market timing or predicting a bottom - a practice much loved by sell-side strategists. So what is considered an adequate return? Over the 100 years to December the S&P 500 has given an annual return of 8% p.a. Equity returns are simply a function of: earnings growth dividend yield, and price to earnings (PE) expansion / compression. The S&P 500 path to adequate Let's break down these constituents: Earnings growth: looking at 2007 as our starting base (i.e. peak of that cycle) and using consensus earnings in FY22 - earnings per share (EPS) growth was on average close to 6 per cent per annum over the 15-year period. We think this number is a reasonable proxy of our long-term estimate for future earnings growth. Dividends: the current dividend yield is 1.6 per cent. PE expansion/compression: this is the hardest to forecast and requires an accurate forecast of future investor psychology and interest rates. Over the last 15 years the market multiple has averaged 16 times and the current multiple is 17.4x. Assuming a reversion to 16x over 10 years would detract 0.8% p.a. from an investor's return. Source: FactSet If we add these three constituents together it leads to a return of 6.8% per cent - somewhat short of the long-term equity return of 8 per cent. And while this may not be quite "adequate", it is still a reasonable return compared to what's currently on offer in a savings account - although hopefully news here is improving and central bankers will offer some comfort to hard-pressed pensioners! This assumes one invests in the market through an index fund, where for the purposes of this article I have ignored passive fees. And as an active manager trying to beat the market - we have always targeted a long-term return of 8-12 per cent per annum.  This is why last year we were cautioning clients that we expected future returns to be at the bottom end of our targeted range, given the elevated valuation of the market. However, the recent market sell-off has us feeling far more constructive and on the front foot with clients. Let's now look at this by breaking down into the same three constituents. The Claremont path to adequate Earnings growth: we believe our companies could deliver earnings growth over the long term in the low double digits. Dividends: the current yield on the fund roughly equates to our active manager fees. PE expansion/compression: our fund holdings now trade 1 per cent below their 10-year average and 13 per cent below the five-year average. We would argue that it is not unreasonable to expect PE multiples to have a neutral impact on future returns over the long-term. So, if we put this all together - we are much more confident of hitting the right side of that 8-12 per cent per annum equation than we were a few months ago. We know we have little ability to call the bottom, however at current prices we believe we have a reasonable probability of achieving an adequate return. The art of patience To conclude with Ben Graham and one of my favourite quotes on market fluctuations in Chapter 8 of the Intelligent Investor: "The speculator's primary interest is in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices." The sell-off this year has already seen us add two companies to the portfolio - companies we have been following for years while we waited patiently for an entry point. And now with 13 names in the portfolio and a cap of 15 - we have room for two more. Whilst no one likes a falling share market, it opens up a wider opportunity set for us and the ability to acquire truly great businesses at prices that ensure a fair risk-adjusted return. We intend to do just that. Author: Bob Desmond, CFA, Head of Claremont Global & Portfolio Manager Funds operated by this manager: Claremont Global Fund

Winning the war on talent Claremont Global May 2022 As global fund managers, one of the most important areas of focus for many of the companies we research is around talent acquisition and retention. This issue goes beyond not just ensuring the brightest minds remain on the books but also extends towards becoming an employer of choice in an increasingly competitive market. This is made all the more difficult due to the growing expectations laid down or justly expected by a labour pool that is, as we stand today, heavily in demand. As a result, it is becoming more and more intrinsic to a company's position within their respected industry to ensure their organisation is, in fact, an attractive proposition for any prospective candidate. A winning talent management strategy therefore should be viewed as a robust advantage, that may prove to be just as critical to the company's long-term success as the competitive moat around the business itself. Employee retention - an 'old school' metric or one to cast a sharp eye over? One metric that can get often overlooked is that of the retention rates of company staff. Whether it relates to a technology business, a retailer, or a consulting firm, the cost of replacing any given employee is greatly underappreciated. According to estimates out of the Work Institute's 2017 Report, the replacement cost for an employer averages roughly 33% of an employee's annual salary for their exit. A company we believe is industry standard when it comes to placing a stringent focus on retaining its talent and expertise is the paintings and coatings business, Sherwin-Williams (SHW-US), which operate close to 5,000 stores around the US. While providing competitive compensation and benefits for its staff, the company prides itself on the discipline of its execution and is known to train staff "like the military". Store managers usually start as graduates but are often treated as business owners. This may sound like a talent strategy from a bygone era, however, this tried-and-tested method from a 155-year-old company creates an exceptionally low staff turnover of 7-8%, or 5-6% for store managers and sales reps. We begin to appreciate how impressive this number is when measured against the US Bureau of Labour Statistics' annual turnover figures across both retail and wholesale channels. Annual US employee turnover by sales channel Source: US Bureau of Labour Statistics This incredibly low churn creates real loyalty from the company's professional customers, who take comfort in the fact that the staff member they are dealing with on a daily basis is, in fact, an expert in what they sell. "The managers of the big brands have a very clear responsibility. It's attracting and keeping talented people in order to sustain and build the trustworthiness of that brand. There is no clearer objective in the economy. Your economic success depends on expanding and building your economies of trustworthiness." - Robert Reich The company also pushes the notion of upward mobility (everyone knows the CEO started in the stores), providing a tangible path to move into management positions, and areas of increased responsibility, if they remain at the business over the long term. The growing importance of scale The aptly termed "war on talent" could not currently be any more evident than in the technology and digital industries. The sheer pace at which the world has evolved in partnership with an accelerated digital transition through the pandemic has pushed demand for top-quality personnel to an extreme level. One of the key dynamics we have noticed is the unmatched strength at which the large technology firms are able to exert when looking to attract talent out of a thinning top-end labour market. These larger technology players are able to offer potential candidates extremely competitive pay and benefits packages, heavy investment in training and strong career progression opportunities ― in addition to offering a meaningful company mission and purpose that may strike a chord with those looking to make a tangible difference in how we live our everyday lives. As we can see in the chart below, many of Sherwin-Williams' competing players are struggling to compete for top-end talent due to the likes of the "hyper-scalers" sucking up this talent at unprecedented rates. The company's older and arguably less-savvy competitors are suffering "brain drain" if desired work experiences, compensation and benefits, or career progression opportunities are not fulfilled. US software engineer and software developer hires   Source: BainAura talent platform, Bain For context, while many companies were furloughing staff amid the pandemic's economic fallout, Microsoft (MSFT-US) saw its employee base rise 18,000 or 11%, with Alphabet's (GOOGLE-US) base also rising net 16,000 employees or 13%. This has developed into a seriously large competitive advantage for the large technology firms and, as current shareholders of both companies, provides us with comfort that they will be able to continually drive innovation and product development with the pools of talent they have in their corner. "What's most impressive is that your team (Google) has built the world's first self-replicating talent machine. You've created a system that not only hires remarkable people, but also scales with the company and gets better with every generation." - Paul Otellini, Former President and CEO, Intel An alternative strategy This system of managing and curating talent extends beyond simply retaining existing personnel and hiring new staff. The strategy of careful, diligent M&A to bring in experts that not only have the skills to drive sustained innovation and product development but actually want to work for the broader organisation, is one that cannot be overlooked. We see this dynamic present itself in areas such as medical and analytical instruments, where it can be more efficient to bring in a team of scientists or technicians through bolt-on acquisitions into the umbrella organisation, rather than invest in years of internal R&D and training in order to develop specific products or technologies. We have been most impressed by this method of talent management through another one of our portfolio holdings, Agilent Technologies (A-US). Their large team of highly skilled field scientists is one of the most underappreciated assets of their business and the retention of this talent is critically important to the sustainability of their business model. This was shown over the course of the pandemic when they did not move to reduce staff, nor did they cut base pay or hours, as a response to the temporary disruptions across the business. According to Agilent's CEO Mike McMullen, this has led to attrition rates that sit at much lower levels than peers in the market. However, a key piece in the evolution of their team of scientists is the onboarding of R&D teams through focused acquisitions of appropriate target companies, subsequently integrating them into the larger Agilent ecosystem. This can be witnessed through one of their most recent acquisitions in BioTek, a leading cell analysis business, of which then-owners, the Alpert family, sought to sell their company to Agilent as they appreciated the prevailing culture and long-term synergies across their respective R&D teams. "The cultural alignment, the consistency and commitment to the same sort of core values really do matter." - Mike McMullen, Agilent CEO, Goldman Sachs Healthcare Conference, Jan-21 Agilent's stringent focus on an engineering-led culture allows them to present themselves as an attractive suitor to smaller, niche businesses with bands of top-end scientists and experts in their fields that do not necessarily want to be swept into a corporate behemoth. This enables them to not only bolster the talent pool across the organisation but retain them over the long term, which will, in turn, materialise into tangible value creation for shareholders through sustained innovation and product development. Intrinsic to longevity Talent management can no longer be dismissed as simply an HR problem. It is becoming so critical in today's world that if a company mismanages its workforce, a loss of competitive advantage and profitability will present itself as the most likely outcome. The subsequent costs of recruiting, training, loss of expertise, potentially fractured relationships with customers, wage inflation, and cultural tearing all need to be placed in heavy consideration when curating a talent management strategy. We ensure that the businesses we invest in and research at Claremont Global have sound strategies in place to manage their pool of talent, ensuring that they not only retain the best people but also attract top-flight talent in the market to drive sustained innovation and product development well into the future. Authors and consultants, Rob Silzer & Ben Dowell, capture this phenomenon perfectly: "Talent management is more than just a competitive advantage; it is a fundamental requirement for business success." - Silzer & Dowell, Strategy-Driven Talent Management: A Leadership Imperative. Author: Luke Davrain, CFA, Investment Analyst Funds operated by this manager: Claremont Global Fund

Why 15 stocks are all you need Claremont Global May 2022 With a mandate of owning 10-15 stocks, I am often asked: "How do I sleep at night given the concentration risk?" This has been a familiar refrain for most of the 25 years I have been managing client capital and where I have always run concentrated portfolios with 10-25 stocks. The thinking suggests that with a concentrated portfolio, you are running excess risk and one would be better served having a more "diversified" portfolio. My answer is always the same - it all depends on how you define risk. If you define risk as the chance of underperforming an index or benchmark in the short term - then I would agree this is "risky". This is the classic fund manager's "career risk" - the chance of underperforming a benchmark and putting your job on the line or losing client FUM. In the words of John Maynard Keynes: "It is better for reputation to fail conventionally than to succeed unconventionally". But to earn returns that are better than the market, it is really quite simple - you have to own portfolios that are different from the market. Robert Hagstrom in his excellent book The Essential Buffett - timeless principles for the New Economy ran a 10-year study from 1987-96 where he had a computer randomly assemble 3,000 portfolios from 1,200 companies and broke the results down as follows: It is interesting to note the 15-stock portfolio achieved an average return not much different to the 250-stock portfolio but with a much wider range of outcomes (i.e. much higher career risk!). However, the chances of beating the market were also more than 13 times higher. In addition, Lorie & Fisher showed in their 49-year study of NYSE-traded stocks between 1926-65 that 90 per cent of stock risk can be diversified with a 16-stock portfolio. But we define risk as the possibility of permanently impairing client capital or not achieving a satisfactory return for the risk taken. And we target a long-term return of eight to twelve per cent per annum over a five to seven-year period. We believe a permanent impairment to capital is most likely to arise in the following ways: Buying heavily leveraged businesses Many management teams are very happy to layer on debt in the good times by "returning capital" to shareholders and achieving artificial EPS growth to satisfy short-term and poorly defined incentive targets. There is no better example of this than the actions of American Airlines in the five years to 2019. The company "returned" $13bn in buybacks - this was despite the fact there was no capital to return, as free cash flow over the period was a NEGATIVE $3.2bn! The ratio of debt to earnings before income, taxes, depreciation and amortisation (EBITDA) was 4.2-times in 2019 at the peak of the cycle. In our opinion this is highly irresponsible, given the industry already has a high degree of operational gearing, has a large amount of off-balance sheet debt in the form of leases and is vulnerable to rising oil prices. And then when tough times hit, these companies go cap-in-hand to the government and/or shareholders to repair balance sheets at very depressed equity prices, resulting in severe value destruction. By contrast, our portfolio has a weighted net debt/EBITDA of 0.7x. Excess leverage is just not a risk we are willing to run. Balance sheet strength is a given in our portfolio. We know that the future is always uncertain and rather than trying to forecast when the good times will end (folly in our opinion), we assume that recessions are a natural part of economic life and we prepare accordingly. The added benefit of this is that when recessions occur, our companies can play offence - buying quality assets or their own shares at favorable prices and maintaining or even increasing the dividend. We have companies in our portfolio that have consistently paid rising dividends for over 40 years. Buying businesses that rely on an accurate forecast of some hard-to-predict variable These variables can be interest rates, moves by the Federal Reserve, commodity prices, regulation, innovation and election results, amongst many others in a complex world. In 2016 I didn't know many people who predicted Trump would be elected ― and for those who did, how many predicted that markets would rally? Or in March of this year, who would have thought the market would be at an all-time high in December, when the global economic contraction has been the largest since the Great Depression? Another favourite of mine in recent years has been buying banks on the "yield steepening trade", only to then see rates collapse. Or the oil majors in 2014, who spent billions on exploration with a forecast of oil being above $100 a barrel, only to see oil collapse with the advent of shale oil. We deliberately avoid businesses that rely on us correctly forecasting commodity prices, interest rates, elections, drug discoveries, economic growth or political outcomes. Experience has taught us that very few people are able to do this on a consistent basis. Yogi Berra put it well: "Forecasts are hard, especially about the future". Buying inferior businesses with no competitive advantage Over time, competition does a pretty good job of taking away excess returns for most businesses. And over time, it is very hard for an investor to earn a return much different than the underlying economics of the business one owns. If an investor wants to earn an excess return, logic suggests that the best place to start is with owning businesses that themselves earn excess returns on shareholder capital. Superior returns on capital normally arise from some form of competitive advantage - be it a brand, network effect, scale, reputation, data, client relationships, IP or technology. But the allure of buying "cheap" businesses is often too much for some. Even Warren Buffett himself made this mistake when buying textile company Berkshire Hathaway at a steep discount to its underlying asset value. But as he said many years later, once he came to realize his mistake and finally exited the business: "Berkshire Hathaway's pricing power lasted the best part of a morning". Our preference is to own businesses that have been proven over many years and cycles. The average age of our businesses is over 70 years, with the oldest dating back to the end of the US Civil War. They have been tested through wars, product cycles, recessions, political upheaval, inflation and financial crises. The competitive advantage in our portfolio is evidenced by an operating margin of 27 per cent and a return on invested capital of 18 per cent - both over 2x the average listed business. It is interesting to note the average listed business earns a return of 9 per cent - not far from the level equities have actually achieved over the long term. "Over time it is hard for an investor to earn returns that are much higher than the underlying businesses' return on invested capital". Charlie Munger Aggressive management or those who allocate capital poorly Unfortunately, it is a fact of life that the people who end up running businesses are often no "shrinking violets". They are usually very confident in their ability and their normal starting point is to aggressively "grow the business". This can often involve straying away from their core competence into new areas, where their "skill" will translate into superior returns to shareholders. The worst situation occurs where management take on a lot of debt at the peak of the cycle, pay an inflated price for an asset, heap goodwill on the balance sheet, only to reverse the deal many years later ― and more often under new management. A classic example of this is GE, who took a very good industrial business and then ventured into credit cards, property, insurance, media ... the list goes on. The end result was to take a AAA rated balance sheet and turn it into one that is now barely above junk status. Or closer to home - who can forget Woolworths ill-timed home improvement venture against the toughest of competitors, or even Bunnings themselves and their venture into the UK? Would it not have made sense to focus capital on the competitive advantage that made the company a market leader in the first place and then return excess capital to shareholders? And finally, my all-time favorite - the Vodafone purchase of Mannesmann at the peak of the TMT mania for $173bn, which saw Vodafone CEO Chris Gent earn a bonus of $16m for the "value" he created. In 2006, Vodafone quietly wrote the asset down by $28bn, but not before Sir Chris Gent received a knighthood for "services to the telecom industry." I wonder whether he should have received the highest German accolade "for services to the German pension fund industry." To quote Michael Porter, the doyen of competitive advantage: "The biggest impediment to strategy and competitive advantage is an overly reliant focus on growth". By contrast, we prefer our management teams to relentlessly focus on competitive advantage, customers, employees, communities and reinvest back in the business for the long term. And once this is done, to make sensible bolt-on acquisitions, pay dividends and buy back their stock when it is decent value. The last trait is very hard to find - there are very few management teams who treat buying their shares like they would any other acquisition. For most management teams, the logic is if I can borrow at, say 2 per cent, as long as I pay no more than 50x earnings - this enhances earnings per share. And unfortunately, most management teams will happily buy their stock in bull markets using cheap debt, only to stop this when their shares are cheap, as this is the "prudent" thing to do. Buying businesses at prices that are well above their fair value Even if one buys businesses that have superior economics, strong balance sheets and are well managed - even the most disciplined can be lured into paying inflated prices, especially in the upper reaches of a bull market. The narrative always follows a similar pattern that excess growth will last forever, interest rates will never rise, the company has changed (very few do), the company deserves a lower beta and the list goes on. When valuing companies, we do not change our discount rates, terminal growth assumptions, or market multiples, preferring to use "through the cycle" value inputs. Neither do we use a weighted average cost of capital (WACC) or beta to justify higher prices. Read any book by the doyen of valuation, Aswath Damodaran, and he will argue that if you are to drop your risk-free rate, you should also drop your terminal growth rate. This makes sense as a lower risk-free rate suggests a lower nominal gross domestic product (GDP) growth rate. Yet, in the upper reaches of a bull market, it is not uncommon to see lower risk-free rates and higher terminal growth rates to justify valuations! Conclusion So, to return to the original client question posed at the beginning of this article: "How do I sleep well at night with only 10-15 stocks?" The question assumes that I would sleep better if we owned more stocks. Well, to do that, we would have to add lesser quality names or those with lower expected returns. Would I sleep better then? It would decrease our research intensity, whilst potentially lowering the quality and/or the expected return of the portfolio. I could load up on "cheap" bank stocks but would now be exposing myself to balance sheet risk ― at 20x geared, these businesses can literally go to zero as we saw in the global financial crisis (GFC) ― as well as interest rate risk, economic risk and a large amount of regulatory risk (witness the halting of dividends in Europe recently). Or, I could load up on "cheap" oil stocks, but I would be up late at night poring over demand/supply dynamics, vaccine developments and economic data. These are areas where the future is difficult to define and instead of allowing me to sleep better, it would have the opposite effect! This is not our way. Instead, we prefer to construct a portfolio of 10-15 high quality businesses, whose earnings have a very good chance of growing well ahead of inflation over a long period of time ― and when the inevitable bad times come, we know we own time-tested business models, fortress balance sheets and seasoned management teams that will get us through to the other side. We may see share prices fall ― in some cases quite dramatically like the GFC or the March sell-off ― but for those with the fortitude to see it through, this is unlikely to be a permanent destruction of capital. This approach has served me well through hyperinflation in Zimbabwe, the TMT bubble, the GFC, the European debt crisis and more recently the COVID-19 pandemic. For one known to like his sleep, it allows me to sleep well. And more importantly, our clients too. Author: Bob Desmond, Head of Claremont Global & Portfolio Manager Funds operated by this manager: Claremont Global Fund