"What do you think you see, Linus?"
"Well, those clouds up there look like the map of the British Honduras on the Caribbean... That cloud up there looks a little like the profile of Thomas Eakins, the famous painter and sculptor... And that group of clouds over there gives me the impression of the stoning of Stephen... I can see the apostle Paul standing there to one side..."
"Uh huh... That's very good... What do you see in the clouds, Charlie Brown?"
"Well, I was going to say I saw a ducky and a horsie, but I changed my mind!"
- Charles M. Schulz, The Complete Peanuts, Vol. 5: 1959-1960
There are two ways to make money. Quickly with a high risk of losing your initial investment or taking a longer term compounding of return approach with a focus on downside protection. When I was a young lad I favoured the former. One week into my apprenticeship wiser older heads politely steered me to the latter.
To identify long term compounding stocks you need to focus on the beneficiaries of long term structural growth trends. We are look to identify companies that can generate long term attractive returns on invested capital, have consistent free cash flow generation and are supported by long term structural growth trends.
Accenture and Microsoft are two examples of companies that have the compounding characteristics that we believe will deliver long term attractive real returns. The companies are both riding the wave of the 'disruption' theme, supporting the transition required by companies to survive in a continuously evolving technological landscape. One of the key areas that both companies are benefiting from is the increasing adoption of cloud technology, which provides computing power as a service that is accessed over the internet.
What is in the cloud
Preparing documents is a simple example of cloud computing. Previously, documents created in programs such as Microsoft's Word and Excel would be stored on the hard drive of your PC, taking up space and slowing down your machine. Now, users sign into Office 365 when installing the program and documents are stored in the cloud by default. The document can be accessed from any connected device, anywhere in the world, any time you like.
Adoption of cloud computing is accelerating for a number of reasons. The first is that the service is provided by someone else and managed on your behalf. Gone is the hassle of backing up files, and the fear that the program may not recover all your work in the event of an error. The documents themselves will be kept free of corruption by viruses or malware. Microsoft kindly does all that for you.
Secondly, cloud services are available on-demand and have enabled new revenue models. Using this service eliminates the need to buy, install and maintain computer systems and reduces the operational, business and security risk – simply subscribe and upgrade, as and when required, to the latest version with minimal capital outlay.
Thirdly, the cloud allows you to retain control. Just like the quote from Peanuts, the cloud can be, or contain, anything it wants. The public cloud enables an organisation to hire the data processing and storing capacity of a third party, giving the ability to scale at minimal cost. Often, business applications are too sensitive to be hosted in a public cloud, so secure network connections can be created to ensure the security of such information whilst still retaining the benefits of the cloud - the so called private cloud.
Accenture, the world's largest consulting firm, describe themselves as working at the intersection of business and technology to help clients improve their performance, creating sustainable value for their stakeholders.
Providing a broad range of services and solutions in strategy, consulting, digital, technology and operations, and serving clients in 120 countries covering specialised skills across 40 industries, Accenture's offering is so diversified it is not reliant on any single end market or customer. Clients use the provider to enter new markets, increase revenue in existing markets, improve operational performance, and deliver new products to market.
Historically, Accenture's services would have been sought on an ad-hoc basis. However, given the need of companies to keep pace with a constantly changing world, it is increasingly viewed as a 'partner' by the clients it services, and is continuously involved in advising and servicing their client's changing needs. As relationships with clients expand and become further entrenched, this translates to greater visibility of their earnings growth and increased certainty of free cash flow generation.
The company is financially secure with over USD 4bn cash and negligible debt. For the year ended 31 August 2017 (the most recent annual result) the company generated just over USD 4.4bn free cash. Beyond the needs of the business, excess free cash flow is returned to shareholders via a combination of share buy backs and dividends; the dividend has grown by an average of 11% over the last 5 years.
Microsoft immediately brings to mind the Windows operating system Office software. However the business is extremely diverse, spanning products such as tablets (Surface), game consoles (Xbox); it also owns Skype, as well as LinkedIn. The company's cloud computing platform, Azure, is one of the leaders in that burgeoning market.
Cloud computing growth is in its infancy with the key providers and beneficiaries being Amazon (AWS) and increasingly Microsoft (Azure). The penetration of the cloud is still only at modest levels which should increase significantly as enterprises, across all industries, adopt this service. Microsoft should be a key beneficiary of this adoption given the existing usage of Microsoft software and services by cloud adopters. Eventually, the concerns that many firms may have about Amazon competing against their own business may swing the preference to partnering with Azure rather than Amazon's cloud business, AWS.
Microsoft's business is also diversified by both end market and geography, and is exposed to high growth areas. It has a track record of generating free cash flow that is reinvested back into future growth areas, allows acquisitions to bolster the service offering and is used to buy back shares as well as pay a consistently rising dividend. The company has an extremely strong balance sheet allowing it to weather a downturn, as well as benefit from any opportunities such an event inevitably provides.
At Aberdeen Standard Capital, we seek to identify those companies that will benefit from shifting trends as well as avoid those where change will be detrimental. Experience has taught us that companies that have strong balance sheets; generate cash flow in excess of their operational requirements; and invest in their business as well as distribute to shareholders, tend to generate stronger and sustainable returns. As a result, they merit a long-term position in portfolios regardless of shorter-term sentiment. The wise old heads would approve!
John Hair, Chief Investment Officer, Aberdeen Standard Capital
First published in Paraplanner Magazine May 2018.