By Ben Peters, portfolio manager of the Evenlode Global Income fund
In the search for quality at reasonable valuations, the most compelling opportunities are often found in sectors where market indifference prevails. Several of our portfolio companies have seen their share prices decline despite continued growth in revenues, profits, and cashflows, strengthening underlying margins of safety.
But encouragingly, this disconnect has also driven a surge in share buybacks, which we view as a signal that valuations have diverged from fundamentals, and we are beginning to see a “floor” for some deeply unloved quality names.
Signal of confidence
Disruptive risks, such as AI, and cyclical winds have been driving investors to shun certain sectors and should not be easily dismissed. Reassuringly, companies are taking advantage of this phenomenon by stepping up large-scale repurchase programmes, which are highly accretive to shareholder returns at these valuation levels. This comes on top of organic reinvestment at high returns on capital and is funded by their growing streams of excess cashflow. We can see how this is playing out by looking at buyback yields.
When a company buys back its own shares and cancels them, it reduces the number of shares in issue and therefore increases per share free cashflow growth. If the shares are purchased at the current share price, the percentage reduction in share count is the buyback yield. Free cashflow per share growth is the combination of underlying free cashflow growth and this reduction in share count.
Therefore, when the company’s share price declines but free cashflow continues to grow, astute management can use the excess cashflow to buy back shares. The buyback yield is much larger than it would have been before the shares declined, increasing prospective shareholder returns. High return on capital, asset-light companies that generate lots of excess cashflow are perfectly placed to do this.
That companies have suffered large share price declines from their recent peaks is undesirable but offers a margin of safety if it contrasts with positive underlying performance. The market’s fear is creating an attractive ‘floor’ that can be illustrated if we assume no free cashflow growth or valuation multiple re-rating. This is a conservative but instructive view.
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Less conservatively one might look at analyst forecasts but these should be taken with a generous pinch of salt – their crystal ball is no better than ours – and the potential for disruption, whether from AI, geopolitics or the ordinary economic cycle, deserves to be taken seriously.
The broad point though is a near-immediate collapse in profitability implied by current market valuations is not what most analysts currently expect. Sentiment can change rapidly and if these companies continue to post positive fundamentals, their multiples will likely follow suit.
Overall, this is a simple analysis that has limits and excludes the depth of thought we apply to other areas like assessments of competitive advantage. In complex, noisy times it can be useful to strip things back and consider investing in simple terms.
At the fund level, our dividend yield stands at 3% and the buyback yield at 2%, and we expect free cashflow to grow at high single-digit rates over time – currently forecast at +9% per year. Together, these components imply double-digit total returns even in the absence of any valuation re-rating. A tailwind from expanding multiples would of course be welcome, but it is not a requirement for delivering attractive returns from here. Market prices are doing a great deal of the work.
Borrowing against the future
Set against this, the broader equity market tells a quite different story. Companies that have benefitted most visibly from the AI and defence boom are, in many cases, trading on free cashflow yields of just 2-3% or less with inferior microeconomics, already pricing in a great deal of good news. The market as a whole sits at a free cashflow yield of 3.3%, with free cashflow growth forecast in the mid-single digits. Its dividend yield is 1.8% and buyback yield is a further 1.3%.
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Applying the same simple framework, this implies single-digit total returns at best, and that is before accounting for the risk of multiple contraction from already elevated levels. A market that has levitated through war, tariff uncertainty and rate anxiety is one that has, we think, borrowed heavily against the future.
The divergence between these two sets of numbers represents a widening gap between a portfolio priced for pessimism and a market priced for optimism, and history suggests gaps of this nature tend to close – often meaningfully – in symmetry with their forceful creation by a momentum-driven market.
We remain focused on what we can control: the quality of the businesses we own, the prices we pay for them, and the patience to let fundamentals, rather than sentiment, drive long-term returns.
