Julian Fosh

Why we have invested in IMI

Julian Fosh

Despite the extraordinary nature of social and economic conditions and heightened stockmarket volatility, we’ve made few changes to the UK Growth Fund in recent months. This is in keeping with our long-term time horizon and low turnover approach. However, we have been able to use the market sell-off to add a new position to the Fund at what we think will prove to be a very attractive price.

IMI is a specialist in the design, manufacture and servicing of highly engineered products that control the precise movement of fluids. These products are used in a wide range of end markets including energy, transport, life sciences and HVAC (heating, ventilation and air conditioning).

In our view, it possesses two of the three core intangible assets the Economic Advantage investment process seeks to identify in stocks: intellectual property (IP) and distribution network strength.

Its extensive IP includes knowledge in manufacturing valves used in some of the world’s harshest environments. Its strong distribution channels include operations in over 50 countries.

This theoretical Economic Advantage has consistently translated to excess financial returns, in the form of cash flow return on capital (CFROC) which is higher than the company’s cost of capital. This excess return provides economic evidence that intangible assets we’ve identified are providing barriers to competition. Our focus on efficient allocation of capital is mirrored by IMI’s own internal procedures – a measure of return on capital employed is one of its corporate KPIs.

Under our investment process, shares must trade at a discount relative to the market on at least one of five standard valuation metrics: price/earnings, enterprise value/sales, enterprise value/EBITDA, dividend yield and free cash flow yield.

We were able to buy IMI shares on a P/E ratio of 12.3x, a discount to the market’s 13.9 multiple at the time, while its 8.7% free cash flow yield was significantly better than the 5.0% market average.

As with most industrials, IMI will always be exposed to strength or weakness in its end markets. Currently, for example, the outlook for its mining and oil & gas industry sales is poor. However, we consider IMI to be a high-quality cyclical of the type we already hold in the Fund through stocks like Halma, Spirax-Sarco and Rotork. These businesses all have strong balance sheets and solvency and earn high returns on capital. While earnings may fluctuate in line business cycles for their key customers, this resilient profile provides investors with a reasonably high degree of confidence for future returns.

Buying IMI into the UK Growth Fund at this juncture means that it provides some cyclical upside to the post Covid-19 economic recovery. Recent updates from the company have illustrated its cyclicality. Organic revenues were 5% lower year-on-year in Q1 and the drop deepened to 9% in April as Covid-19’s global spread accelerated. This drop is primarily the effect of a steep decline in sales of precision engineering to automobile manufacturers, while its hydronics division also suffered reasonably heavily from the closure of many construction sites. Given the circumstances, IMI’s economic performance during the crisis has actually shown a pretty good level of resilience, with life sciences and energy among the areas to provide offsetting increases in demand for the company’s products. But we would still expect its shares to participate meaningfully in any rally underpinned by a normalisation of economic activity from today’s extraordinary circumstances.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Some of the Funds managed by the Economic Advantage team invest primarily in smaller companies and companies traded on the Alternative Investment Market.  These stocks may be less liquid and the price swings greater than those in, for example, larger companies. The performance of the GF UK Growth Fund may differ from the performance of the UK Growth Fund and will be lower than its corresponding Master Fund due to additional fees and expenses.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product.  Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, June 2, 2020, 9:26 AM