This article is a consolidated and edited version of the podcast.

Steve Lipper: Can you remind listeners how you select stocks?

Mark Rayner: We see ourselves as quality investors, so we want to own a portfolio of really the very best companies we can find. For us, that means two things: firstly, we like conservative, well-capitalized balance sheets. For us, good companies should have good balance sheets. Secondly, and probably more importantly, we think the best indication of quality is a company with consistently high profitability. Now the definition of profitability is absolutely key—it’s not operating margin.

A lot of sell side analysts and investors call profitability operating margin. For us, profitability has to be linked to the assets, so the key measure of profitability and the key measure of quality is return on invested capital, which is what we invest in.

SL: How do you go about identifying those high-quality companies?

MR: We start with a very large opportunity set of thousands of companies, and we try to distill that down to a portfolio of maybe 60/65 names. We do that by first screening for market cap to get rid of the really low liquidity stocks. We screen for the balance sheets as we generally want at least a third of the balance sheet to be shareholders' funds. We prefer equity to debt in the balance sheet.

We also screen for return on invested capital and look at a five-year mean return on operating assets of at least 20%. We then run it through two more filters. The first one we call the customer test, which is a rigorous set of questions that we look at that focuses on three things: does the company provide a customer benefit that we truly understand, does the customer has little incentive or ability to be price aggressive, and are the customer relationships naturally enduring?

Then we start looking at the competitive position. We run it through Enterprise Quality Scoring, and only those companies that score 70 or more out of 100 are the only included in our database of investible companies. We're not screening for value at this stage—we're building the database for really good businesses. Valuation starts coming in when we start building the portfolio.

SL: Quality investing is perhaps less well-known than value and growth investing. Can you contrast quality investing versus value and growth?

MR: We call what we do QARP: Quality at a Reasonable Price. The reasonable price means that like value investors, we like to pay low multiples for companies. So that's great if we can buy a really high-quality company on a low multiple. We love growth, but we like even more return on invested capital. For us, it's like an iron law. If you want to invest in value creating companies, you must invest in companies where their return on invested capital is above their cost of capital. We're investing in the engine of value creation, and if we have our stock picking right, that should be a perpetual engine that allows us to stick with our companies a lot longer, run our winners, and make fewer decisions. We spend more time on each decision, but we make fewer of them because we want to harness the power of compounding.

SL: Geography is frequently an expectation and a conversation that investors in international and global portfolios have. What role does geography plays in the investment process?

MR: We're very much bottom-up stock pickers. We invest in companies, not countries. I would slightly caution against looking at the Fund by a country of incorporation because it doesn't always paint a completely accurate picture. A very good example of that is a U.K. company called Victrex. It makes very high-performance plastic used in the aerospace, automobile industry, and more. Less than 2% of their revenues are won in the U.K., but in terms of the Fund purposes, that's called a U.K. company.

There are certain geographies we like. Experience has told us, for example, that Northern Europe is a very fruitful hunting ground for us, with countries such as Switzerland, the U.K., Germany, Holland, Sweden, and Iceland. We like Japan, as well as Australia and Canada, which many people may think of as being large cap, natural resource type economies. If you go down two or three levels, you can find some super little software commercial services companies in Australia and Canada.

There are certain areas where we don't invest, such as Russia for corporate governance reasons. We have a somewhat lower exposure to emerging markets. We're more developed market investors, not out of any intention—it's just where we find the good companies. We go where we find the good companies, and they tend to be more prevalent in the developed markets.

SL: Can you give us some examples of where you see investors are overlooking?

MR: I've been in this business for over 30 years now, and I would say it's probably one of the most thematic markets that I've seen in that time—probably similar to where we were in the Dotcom boom 20 years ago.

Themes that the market has been playing over the last six to nine months include pandemic lifestyle changes. With more remote working, there's an array of technology stocks that have done very well. With staying at home, pet ownership companies have done very well. The investing has been very thematic, so that's left behind some companies that aren’t playing into those themes that we think offer very attractive investment opportunities going forward. An example is a U.K. company we own called Restore. They do records management, which is about 70% of their profits. Any company or corporation that's created a customer or internal paper document has a choice of either storing it in a filing cabinet in the office or in deep filing in their basement. Or, they can give it to a company like Restore.

Restore will take it off site, put it in a box, charge you about a pound a year per box. That box stays there for 20 years typically, and that's such a recurring, repeat, and very cash generative business. Restore uses those cash flows to grow into related businesses like shredding, office relocation, IT hardware recycling, and more. Restore unfortunately has the word office in its business description, so it’s not playing into the current themes of remote working. We can buy that great business where the records management is already back operating at 95% of pre-COVID levels at very attractive valuations.

SL: Can you give us another example? I believe you've done some things with the intellectual property firms, as well.

MR: There's a very interesting company we own in Australia called IPH. The stock is trading at around 52-week lows because it hasn't picked up one of those themes I was mentioned, but it's terrific company. If you're a U.S. business and want to register a patent in Australia or Southeast Asia, you'd go to a company like IPH. IPH makes sure you're not contravening any local patents. It would redesign it for local law, and then it would manage the patent to over its life, which will last 20 years, all the time raising small invoices typically have about $1,000.

If you have thousands of these patents you administer, you have a portfolio of mini annuity streams that are very asset light and have high margin. IPH has 100% return on invested capital, strong balance sheets, consolidating its market, growing historically in last five years 20% per annum, but trades with a dividend yield of around about 4.5/5% because it's not playing into those themes. We think it's waiting to be rediscovered.

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