With a wealth of European equity manager talent, Threadneedle’s David Dudding employs a get rich slowly strategy that will find many advocates in the institutional market. After starting his career as a financial journalist, Dudding switched into fund management in 1999 on Threadneedle’s graduate scheme and remains a one-company man – an increasingly rare commodity in today’s industry.
Initially making his name in small caps, he took on the flagship European Select portfolio in July 2008 and has delivered consistent performance over the subsequent period, top decile in the peer group over three and five years.
Key to this is a strong European team, which has continued to grow in recent years – adding three more analysts since 2011 – despite the challenging backdrop in this part of the world.
The European landscape
Threadneedle’s investment philosophy has three pillars, an active approach to take advantage of market inefficiencies, appropriate allocation of risk and combining macro and micro to produce what the group calls its perspective advantage.
This latter element is key in Europe, where – although there are signs of subdued recovery – Dudding says it is hard to be positive on growth for at least the next five to 10 years. “Europe has its macro and demographic challenges but for us, the continent is full of world-leading companies,” he adds.
“A further key factor is the global reach of many businesses, with companies often forced to grow outside their borders. With just 18 million people in Holland for example, Dutch businesses have a major incentive to seek customers in growth areas of the world and this model means many European corporates are not purely dependent on their home economy.”
The power of pricing
European Select is a focused fund with the number of holdings typically near the lower end of the 45 to 55 range and Dudding’s stockpicking is very much done through a lens of pricing power.
He says this ability to set prices in an industry – or least not having to compete on price – is a key attribute for his holdings and a major driver of overall returns.
Looking around Europe, Dudding notes a telecom versus cable stock story in several countries as the best example of pricing power at work.
“In Germany for example, Kabel Deutschland has strongly outperformed Deutsche Telekom in recent years and the same goes for Iliad versus France Telecom and KPN versus Ziggo in the Netherlands,” he adds.
“Key to this cable over telco call is pricing power, with the former benefitting from lower costs, superior technology among the small, newer players and lack of legacy infrastructure. Mobile is also a highly competitive market while fixed line is far more concentrated.
“We are getting to a point where few people care about their phone tariff, forcing companies to keep on slashing price. Competing on price like this is a red flag for us and we have therefore been zero weighted in telco names and held all the cable companies outlined plus further Belgian and Portuguese businesses. This highlights the value of strong analysts and the benefits of a focused approach, with the telco sector still among the biggest in the European index.”
Dudding sees pricing power as the first measure of a good business model, with a fragmented supplier base – so no one can overcharge for inputs – and a diverse customer base typically creating higher market share.
Taking advantages of barriers
Next up in his wish list is barriers to entry, with advantages in areas such as brand, scale and regulation meaning returns are less likely to be competed away and therefore producing a sustainably high return on capital.
Last up for a strong business are structural growth drivers, including exposure to overseas markets with superior demographics for example, outsourcing trends within a certain industry or increased productivity.
Making use of the the fantastic five
With pricing power so integral to Dudding’s stockpicking, analysing this element of a business is key and the team uses Porter’s Five Forces to find stocks meeting its criteria.
In short, this system considers five factors – supplier power, barriers to entry, degree of rivalry, thread of substitution and buying power – to ascertain overall pricing power. “Companies with pricing power and barriers to entry can broadly sustain high returns of capital but the market tends to underestimate their ability to maintain these levels and therefore under-prices them,” he adds. “Seeking sustainable returns on capital means we tend to focus on quality businesses, with most of our favoured names producing consistent returns rather than the price surging at any particular point. That means we would typically lag a strongly rallying market.”
Long-term positions
As pricing power is a fairly long-term attribute, turnover on the fund is low, with Dud- ding often selling if a company hits a share price target or if the management starts making poor decisions or altering successful strategies.
He is fairly agnostic on capital management as long as it adds value, noting a company like Bayer that would benefit from a period of acquisitions after a good period to strengthen its portfolio.
“We prefer dividends to share buybacks, as the former are more visible and reward all shareholders equally,” he says. As examples of a solid business model, Dudding highlights Nestle and Kone, admitting he spends a large portion of his working life talking about coffee and lifts. With Finnish company Kone for example, the company is benefiting from huge demographic shifts, with around 250,000 people moving to cities across Asia every two days and that level of growth expected to continue for the next two decades.
“In simple terms, that means more lifts and escalators will be needed and this remains a consolidated industry, with a 20% market share for Kone,” says Dudding.
“The company makes most of its money from maintaining its products after the initial sale, meaning it has a large installed customer base, and invoices for this at the start of the year, providing a visible and recurring revenue stream.
“Finally, Kone also has barriers to entry as we cannot see Chinese companies trying to crack this market for example, with neither a technology edge to speak of nor local presence in markets around the world for the maintenance side.”
Nestle also boasts a similar profile, with Dudding highlighting the group’s Nespresso brand.
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