Direct Equity Team: A Note from Bishopsgate
S&P GLOBAL INC
“The first rule of compounding: Never interrupt it unnecessarily.” – Charlie Munger.
The DEP Team seek to preserve and grow our clients' capital by owning exceptional businesses for the long term, and buying them at sensible prices. Opportunities to do both at once are rare. However, the recent market preoccupation with all things AI has left some of the world's highest-quality companies trading at valuations not seen for years. In this update, the team profile one resulting addition to the portfolio; S&P Global Inc. The leader in credit ratings, benchmark indices and market intelligence for over 110-years has been added to portfolios because we are confident to hold it for the next decade.
In the DEP team, we believe the purpose of investing is to preserve and grow our clients’ hard-earned savings long into the future. This starting point leads us to have a long-term mindset. It focuses us on the compound annual growth potential of our businesses. We do not trade around short-term price fluctuations. We are not trying to find the next big thing. We simply do not believe these strategies have prudent rates of success. Warren Buffett is known for saying that if you couldn’t own a stock for ten years, you probably shouldn’t own it at all. This is a viewpoint we try to emulate with all our purchasing decisions.
Building enough confidence to hold a company for ten years is a challenge, and one learns quickly that of all publicly listed companies, there are few that have the necessary characteristics. Firstly, we look at the longevity of the business, we like companies that have been in existence for long periods of time because we can see how they handled difficult economic or competitive circumstances as well as different management teams. We like companies with a competitive advantage, that enables them to earn attractive profit margins for shareholders and resist competition. Typical gauges of a competitive advantage include consistent market share over time and earning high profits compared to the capital invested in the business.
The well known investor, Howard Marks, like to point out that generating satisfactory investment returns depends not only on finding good companies, but in buying good companies well. If shares trade expensively relative to corporate earnings, history suggests shareholders are likely to receive a lower return on their investment. The recent de-rating across quality businesses that are not directly related to the AI boom has presented us with opportunities to add some very high-quality names to our portfolios at reasonable valuations. One such example, is S&P Global Inc.
Amid the US railroad boom in the 1860s, Henry Varnum Poor published “The History of the Railroads and Canals of the United States”. It was the first attempt to inform investors with market data on the growing US railroad industry, and it was the origin of S&P Global Inc as we know it today. Standard Statistics Bureau was founded in 1906 to provide information on non-railroad industrials. Poor’s published its first credit rating in 1916 and Standard followed suit in 1922. The two companies merged in 1941 to create Standard & Poor’s. At its core, S&P remains a market intelligence and credit ratings business with over 110 years of experience in these segments. It has survived two world wars, and 23 recessions since Poor’s first credit rating in 1916, including the Great Depression in 1929 and the Financial Crisis in 2008.
We look for businesses with pricing power and enduring competitive advantages. With a track record of over a century of innovation in its market segments, it is difficult to argue with the competitive dominance of S&P Global Inc. Even the most optimistic of analysts would not have assumed the growth it has achieved over the last 100 years; yet it clearly shows the business has pricing power and it still retains high market share, high returns on capital, and high operating margins today.
If a business wants to open a new shop as part of its growth strategy, but lacks the funds to do so, it may decide to fund the investment with debt. An established business typically does this by issuing a bond; a commitment to pay back the original loan amount plus interest. This bond can be traded on a secondary market over the course of its life. If the bond is unrated, investors must rely on their own assessment of the company’s creditworthiness. If the bond has a reputable third-party rating, investors can be more confident in their assessment and will reward the company by lowering their required return from the bond. This means companies with ratings can raise debt at a cheaper cost than those without. Reputation of the third-party rating agency is essential, if a company is going to pay for a rating, it needs to be one that is respected by a broad set of investors. This is why S&P and Moody’s combined have about 80% of the credit ratings market share. They have been in the business so long, and are so well known, it is very difficult for new entrants to penetrate the market.
If that wasn’t enough of a reason to hold S&P, it also provides investors with market intelligence and earns a royalty fee from the use of industry standard benchmark indices such as the S&P 500 and the Dow Jones. To put this into context, the 3 largest US ETFs have about $2.8 trillion in AUM tracking the S&P 500. To change the index provider would be a huge risk for the likes of BlackRock or Vanguard who provide the ETFs and it would be a monumental upheaval of what has become an industry norm over decades. These are highly profitable segments, with exceptionally high barriers to entry, ensuring S&P’s profits are well defended.
We managed to buy S&P Global on a multiple of circa 22x expected earnings, a multiple not seen for the shares for over 10 years. For a business that has grown so consistently, with so little change in its competitors over decades, we believe this was an acceptable rating to justify our purchase. If we could not sell the shares for the next decade, we are highly confident that in 10 years’ time businesses will still desire credit ratings to raise debt, active and passive investors alike will still benchmark returns against the S&P 500, and investors will still require market intelligence to enhance their decision making. Given the long-term track record of the business over more than 110 years, we have high conviction that S&P Global will continue to hold a dominant market position for a further 10.
This article was prepared by Tom Waters, one of our Investment Managers.
