Direct Equity Team: A Note from Bishopsgate

“You Can't Predict. You Can Prepare.”  Howard Marks

As we have been communicating with our supportive financial advisers more regularly recently, we decided to revive the ‘Note from Bishopsgate’ format to allow our thoughts to be sent on to clients more easily. This note will focus on a recent decision to trim Cisco Systems Inc across portfolios.

For years, Cisco had been branded a dull business often overlooked by investors. We purchased Cisco in the initial selloff in March 2020 at the onset of the COVID pandemic, when it traded on circa 12x earnings.

For years, Cisco has been transitioning its business to towards software from purely hardware. Software is higher margin, often with recurring revenues through a subscription model. Cisco is roughly 50% software and 50% hardware currently. At the time of the pandemic, this revenue split was of little interest to investors, the market rewarded higher margin software businesses with much higher ratings. How times can change…

With the advent of generative AI in 2022, the market is pricing many of these software names as if they are in existential crisis. Meanwhile, boring Cisco has been awarded a rating of 28x earnings. With the amount of capital expenditure expected on the data centre rollout, suddenly companies that manufacture hardware like switches and routers for data centres became interesting again.

We topped up our Cisco position to 3.5% across portfolios in 2024, the business continued to perform well; it was highly profitable, paying an attractive dividend yield, and earned good returns on capital. We also were somewhat bemused; with the forecasted capital expenditures on data centres, it seemed likely that Cisco would benefit from this injection of investment, although this was not reflected in the share price at the time. Cisco has now seen a step change in its earnings growth expectations, and the market has re-rated the shares as a result.

We have trimmed our Cisco position from 5.2% on average across portfolios to 3%. We believe Cisco is a high-quality business that we would be happy to own for the long term. Successful investing hinges on being able to identify a good company and then assess to what degree the market valuation reflects that quality. At 28x earnings, significant growth is required from Cisco’s business to maintain that rating, that growth is dependent on the AI data centre build out story. When we topped up Cisco, we believed the potential upside far outweighed the potential downside. Given the current rating, we believe the range of potential outcomes is more balanced, prompting a reduction in portfolios.

We started this note with a quote from Howard Marks. We can’t accurately predict a company’s earnings growth. We can assess a likely range of outcomes and monitor position sizes accordingly, “You can’t predict, you can prepare”.

This article was prepared by Tom Waters, one of our Investment Managers.