When quality counts

Sustainable Investment Labels help investors find products that have a specific sustainability goal. The Premier Miton Global Sustainable Growth Fund and Global Sustainable Optimum Income Fund hold the FCA ‘Sustainability Focus’ label. Information on the sustainability characteristics of the funds can be found in the Sustainability Factsheet located on the product page of the Premier Miton website premiermiton.com.

The last few years have presented many challenges for investing with an active approach and sustainability focus. However, we remain consistent in our approach, attempting to purchase shares in undervalued businesses that we think can grow and maintain their returns over the long-term.

Our recently adopted “Sustainability Focus” label on the Premier Miton Global Sustainable Growth Fund and Global Sustainable Optimum Income Fund recognises our approach to investing in environmentally and/or socially sustainable companies. In this note we discuss why, in an increasingly volatile economic and political environment, a focus on returns and the underlying business fundamentals remains valid.

Uncertainty is not new, nor is it welcome, but it can create opportunities

Whilst it is tempting to think of the current macroeconomic and geopolitical backdrop as unique, the fact is, history is filled with uncertainty. It is easy to read financial history as though it were a novel; we know how the story unfolded, and it seems like a predictable sequence of events. But pick any point in time and there were reasons to fear the future, and uncertainty about the prospects for the financial markets.

It is also true that through it all, equities have had a remarkable ability to bounce back from adversity and reward investors that take a long-term approach. Imagine a potential investor in 1930 conversing with someone from the future and being told that over the coming decades there would be another catastrophic world war, the global hegemony would lose its empire, and the reserve currency would collapse; the world would split in two for decades under shadow of a Cold War that would threaten nuclear annihilation. What is the correct action for our would-be investor? Invest in the face of such turmoil, or hold off to wait and see? If they had invested $10,000 in the S&P 500 Index (an index for which historical data is available) it would have grown to $10.4m by the end of the century, but it would have been a bumpy ride and attempting to time the market, trading in and out of stocks, would have been fraught with danger.

We feel that the key to investing in the face of uncertainty is the same now as it has been in the past: take a long-term approach and focus on the underlying fundamentals of a business, rather than trying to pinpoint exact turning points in overall markets and geopolitical driven investor sentiment. To do this, we emphasise paying extra attention to businesses' operating returns; an approach that contrasts with many investors.

The importance of returns

Within equity markets, analysts tend to focus most on a company's earnings per share (EPS), which equates to the money a business retains from its revenue after paying for all of its costs, including interest payments and taxation, divided by the number of shares in the company. It represents the money that belongs to equity holders, and we agree that it is an important metric.

Focusing exclusively on EPS, however, has its flaws, because whilst profits are important, to truly understand a business and the quality of its operations, we must also understand how much capital was used to generate those profits.

There are several ways of measuring returns. Each has its strengths and weaknesses, but fundamentally they aim to do the same thing: look at a company's ability to generate profits in relation to its capital requirements.

If we go back to EPS; a company CEO's ultimate job is to allocate capital efficiently from the profits it generates for its shareholders. Priority number one is usually to retain a portion of the earnings and reinvest that money back into the business to grow profits. Another option is to seek growth inorganically by purchasing other businesses. There is then the option to pay down debt. Any remaining cash can be considered excess capital and returned to shareholders via dividends or share buybacks.

The ultimate business is one that can generate attractive returns on capital and has opportunity to grow the business. If, for example, a company generates a return of 30% and is able to reinvest half of its profits at that same rate of return, then the company's profits will grow 15%. A business that is capable of compounding at such a rate will generate handsome rewards for shareholders, especially when taking into account the additional return provided by dividends and share buybacks from the capital that the CEO chooses not to reinvest.

Simply focusing on EPS, as many investors do, means that one might miss the signs that a business is beginning to struggle, because it is perfectly possible to grow EPS whilst a business is experiencing diminishing returns, and diminishing returns is not something a shareholder should ignore.

Everything has a cost

All companies have a cost of capital, which represents the opportunity cost of investing in the business. It is in effect a hurdle rate that must be surpassed for a business to make a true, economic profit. It is possible for a business to make a positive net income but fail to generate an economic profit. Consider a business, where at the start of 2023 the CEO decided to reinvest all profits to grow the business and the returns generated were 4%. The business could, the following year, announce to the market another profitable year, with EPS growth of 4%. The truth is, however, that the 4% return on that investment was in fact lower than could have been secured by investing in risk-free US government bonds, and the CEO would have been serving their shareholders better by returning capital and giving them the option of investing it elsewhere.

That business' cost of capital would in fact have been higher than the risk-free rate, because investors must be compensated for the additional risk of investing when there is a risk of failure. This additional cost, which is added to the risk-free rate and then combined with a cost of debt, to arrive at the cost of capital, is often referred to as the equity risk premium. Ultimately, a company's cost of capital is unknowable with exactitude, but must be estimated through inference.

The key takeaway is that for a company to be creating value for investors, it must be generating returns in excess of its cost of capital. If a CEO cannot reinvest profits to this requirement, then capital should be returned to shareholders. To reinvest at a return lower than the cost of capital is to destroy shareholder value.

Economic moats and the persistence of returns

When a public company is making an economic profit, it acts as a siren call to other businesses; the forces of capitalism will attract competition and, in due course, the returns on offer will be forced downward towards the cost of capital. Conversely, when returns are too low, businesses and their capital should exit the market and drive returns towards the cost of capital. This course of events is inevitable, and has been witnessed many times, unless there is a reason a business can fight off competition and maintain its advantage.

Warren Buffett famously used the metaphor of a castle surrounded by a moat to fend off aggressors; a successful business will have built an 'economic moat' that it uses to repel competition. There are many types of economic moats; for a pharmaceutical company, it could be the patent on a lucrative medicine; for an online classifieds business it may be the network effect built by bringing together buyers and sellers; and for a manufacturer it could be exclusive access to crucial resources. A business that has a moat can therefore gain immunity from the forces of capitalism and generate persistent economic returns.

Coming full circle and linking back to our previous comments about the risks of diminishing returns, such a phenomenon could be an indication that a business' moats are eroding. This could mean that the company's growth period is coming to an end. As investors, it crucial to understand if this is the case, because the company's share price will eventually reflect the new economic reality.

Prime examples would be Nokia and Kodak, both companies with exceptional returns and strong economic moats that collapsed when new competition, the smartphone and digital cameras respectively, disrupted their markets. A myopic focus on EPS could, in such circumstances, lead to trouble for investors. The risk is compounded  when, as is now often the case, management are incentivised to grow EPS; such a remuneration structure could encourage a CEO to reinvest capital at suboptimal rates.

Our approach

Whilst managing our portfolio of global equity holdings, we therefore pay serious attention to a company's returns, in addition to other important financial metrics like EPS. We also, crucially, try to understand the business' operating model and if a business possesses economic moats that will help it fight off competition. Below are examples of companies in which we have investments; Each have very different business models, but all exhibit economic moats and high returns.

Mercado Libre

• Market capitalisation: $107 bn
• Return on invested capital: 40.2%
• Economic moats: network effects, economies of scale, R&D and technological advancement

Mercado Libre is a Latin American e-commerce and fintech company that has managed to build a dominant market share and, unlike in other regions of the world, successfully maintained its lead over Amazon.

Mercado Libre benefits from significant network effects; consumers will shop on the platform that offers them the most products, at lower costs, with efficient delivery. Merchants will operate on the venue that provides them with the largest customer base. Over time, as the company’s scale increases, those network effects widen and act as a significant barrier to the entry of competition. It also allows Mercado Libre to spread its purchasing and logistics expenses over a wider user base, resulting in cost savings that can be passed onto customers in the form of lower prices, which in turn drives customer usage. This virtuous circle could enable the company to gain further market share.

More recently, Mercado Libre has built a fintech business that harnesses their vast dataset, built over decades, allowing them to provide credit to merchants and consumers upon whom they can have confidence in their ability to repay. They also provide payment processing solutions, both online and instore.

Bonesupport

• Market capitalisation: $2.1bn
• Return on invested capital: 28.8%
• Economic moats: patent protection and R&D

Bonesupport is a relatively small Swedish company that has developed a bone-void filler that elutes antibiotics. Bone void filler has, for some time, been used to treat bone injuries that occur through accidents or result from medical conditions, such as diabetes or osteoporosis. Bonesupport's key innovation is the inclusion of antibiotics within the bone-void filler; this dramatically lowers the risk of bone infections, which is a common complication of traditional bone-void filler treatment, and reduces the need to use systemic antibiotics, which helps efforts to combat antimicrobial resistance.

For healthcare systems, bone infections are extremely costly to treat, and the savings on offer by using Bonesupport's treatment has led to rapid adoption. In the US, where regulators have recently approved the treatment, growth is extremely strong. The company only recently turned profitable, having spent the preceding years funding R&D efforts to secure approvals. With revenues and returns having grown and limited capital requirements, the company comfortably meets the quality and growth criteria for inclusion in the portfolio.

Colgate-Palmolive

• Market capitalisation: $79.1bn
• Return on invested capital: 33.1%
• Economic moat: brand power

Most likely, you are a Colgate customer and well familiar with their products. Colgate is the most popular toothpaste brand in the world, and it owns several others, including Palmolive in personal care and Ajax in household cleaning. The brand power allows the company to charge a higher price than a competitor could for an equivalent product, which means better margins and greater returns. A competitor would need to spend large amounts of money and wait many years to displace the company's portfolio of brands, in our view; Colgate's first advertisement appeared in a New York newspaper in 1817. The products are non-discretionary (people still brush their teeth in the worst of recessions), which provides a relatively stable and predictable operating model.

Quality doesn’t come for free

By design, the Premier Miton Global Sustainable Growth portfolio has a significantly higher returns profile than the wider market. Over the long-term, such a fund should have a strong probability of outperforming, but this extra quality does not come for free. The underlying portfolio of the fund currently trades on a 12-month forward price to earnings multiple of 25.9x, compared to the FTSE All-World Index's 16.9x.

At first glance, it may seem reasonable to state that the fund is more expensive that the index. However, simply assuming that a company with shares trading on a low P/E is cheaper than one trading on a higher P/E misunderstands the fact that, all else being equal, a business with higher returns, higher expected earnings growth and lower capital costs should trade at a higher P/E multiple. It is perfectly possible for a company trading on 10.0x P/E to be expensive and another trading on 20.0x to be cheap. To interpret the numbers correctly, one must look deeper at the underlying fundamentals.

On a weighted average basis, the fund’s fundamentals can be seen in the below table, alongside the equivalent numbers for the FTSE All World Index. Whilst the portfolio trades at a premium, in P/E ratio terms, to the index, we believe that this is more than justified, when one examines the underlying returns, margins and growth provided by the investee businesses.

Source: Premier Miton Investors and Bloomberg as at 12.05.2025. Past performance is not a reliable indicator of future returns. Forecasts are not reliable indicators of the future.

Notes

Gross margin: Where a company does not state a gross margin, we have used the operating margin. This understates the overall number for the portfolio.

Return on equity: Numbers omitted where ROE cannot be computed, or it is not meaningful because of negative or small shareholders’ equity. This understates the overall number for the portfolio.

Net debt/EBIDTA: Calculation excludes four portfolio holdings (banking and insurance) because it is not a meaningful metric for such businesses.

Forward P/E ratio: Calculated as the 12-month blended expected earnings divided by the current price.