American Resilience

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American Resilience Model Portfolio

Monthly Portfolio Review: February 2024

Publication date: March 1, 2024

Current portfolio holdings

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Executive summary

Welcome to the American Resilience Model Portfolio!
With the publication of this first report, we are officially initiating the portfolio.
For each position, we provide a summary description of the business and an explanation of the investment thesis.
We then go into a general discussion of the investment approach that drives our American Resilience strategy.
At the end of this report (and all future Monthly Portfolio Reviews), we provide updated tables and charts with important information related to valuation, performance and company earnings expectations.

Business descriptions and investment theses

Air Products & Chemicals (APD)

Description: Air Products & Chemicals manufactures and distributes atmospheric gases. The company produces and sells gas products around the world to customers in the refining, chemicals, metals, electronics, manufacturing, healthcare and food industries. The company also sells air separation equipment to customers in the energy and commodity sectors.

Thesis: Air Products is among a handful of global leaders in the highly specialized and consolidated industrial gas market. Serving customers in the energy, chemicals, electronics, metals and manufacturing industries, APD operates in over 50 countries with some 1,800 miles of industrial gas pipelines. The industrial gas business is characterized by localized economics and long-term contracts. APD is now the world leader in blue and green hydrogen production, with visibility on a number of mega projects. Over the past decade, APD has delivered double digit EPS and dividend growth on a compounded basis.

Roper Technologies (ROP)

Description: Headquartered in Sarasota, Florida, Roper Technologies, Inc. is a diversified technology company that provides software and technology enabled products to various niche markets. Roper’s customers operate in a wide range of industries including healthcare, transportation, government contracting, food, utilities, and oil and gas.

Thesis: Roper offers a highly differentiated business model focused on highly cash generative, mature software companies that are entrenched leaders in specialized areas. Over the past two decades, Roper’s acquisition algorithm, which revolves around valuation sensitivity and decentralized management, has led to significant share price appreciation and outperformance. This formula should continue to support mid-teens free cash flow per growth with minimal equity dilution.

S&P Global (SPGI)

Description: S&P Global Inc. provides an array of information related services to customers in the financial, automotive and other industries. The Market Intelligence segment provides financial data and analytics and solutions across multiple asset classes. The Ratings segment delivers credit ratings, research and other investment-related services. The company also provides solutions related to commodities, vehicle manufacturing and engineering. The company was founded in 1917 and is headquartered in New York City.

Thesis: S&P Global is a well-entrenched information services provider with pricing power and solid platform to continue to extend into diverse areas. S&P Global is the market leader in ratings, which is effectively a duopoly with Moody’s, and should benefit from a recovery in credit issuance. In addition to organic growth prospects and a defensive business model built around recurring revenue streams, S&P Global is adept at creating value through both acquisitions and divestitures.

Stryker (SYK)

Description: Founded in 1941 in Kalamazoo, MI, Stryker Corporation is a medical technology company operating in several segments. MedSurg and Neurotechnology includes surgical equipment and navigation systems, endoscopic systems, workflow solutions and other products. Orthopaedics and Spine includes hip and knee replacements as well as cervical, thoracolumbar and interbody systems.

Thesis: Stryker is a leader in the med tech industry that has delivered for investors in almost every conceivable way. In addition to being an engine of organic innovation, the company is adept at M&A and integrating leading technologies into its development and distribution platform. Driven by an aging global population and rising affluence, Stryker’s diverse medical end markets, involving advanced procedures, are generally growing at mid to high single digit rates. Stryker has consistently grown earnings and dividends at double digit rates and justifiably expects this pattern to continue, which validates its premium valuation.

Texas Instruments (TXN)

Description: Founded in 1930, Texas Instruments designs, manufactures, tests and sells analog and embedded semiconductors with a catalog of more than 80,000 products. Analog semiconductors convert real-world signals like sound, temperature and pressure into digital data. Embedded processors handle application-specific tasks such as optimizing power, performance and cost.

Thesis: Texas Instruments is among the few global leaders in the analog chip space, an attractive niche that is both structurally growing due to technological innovation and difficult to penetrate due to the breadth of intellectual property required. The company also stands out historically from a culture, governance and capital allocation perspective. Texas Instruments is focused on reinforcing its competitive advantages and growing free cash flow per share, reflecting a disciplined management approach that has translated into significant outperformance over multiple decades.

Union Pacific (UNP)

Description: Headquartered in Omaha, Nebraska, Union Pacific Corporation operates the Union Pacific Railroad, which provides rail service in 23 states in the western United States, a territory covering approximately two-thirds of the country. The railroad operates in the Bulk, Industrial and Premium segments and serves some of the fastest growing population centers, with critical links to Canada and Mexico.

Thesis: The consolidated U.S. railroad industry consists of a handful of players that effectively have regional monopolies and are essential parts of the national and international supply chains. Replacement cost economics make reproduction of these assets extremely prohibitive. Union Pacific will benefit long-term from its exposure to more promising regional markets and the increasing relevance of rail service as a lower cost, lower pollution alternative to trucking.

Visa (V)

Description: Founded in 1958, Visa provides digital payment services. The company’s products and services include debit cards, credit cards, prepaid products, commercial payment solutions and automated teller machines. Visa manages a complex global network that connects consumers, merchants, financial institutions, strategic partners and government entities.

Thesis: As the largest retail electronic payments network in the world, Visa is an entrenched player in a structurally growing market as electronic payments displace cash globally. The company is able to leverage its central position in the payments ecosystem to develop adjacent businesses around consulting, analytics, fraud management, security, merchant solutions and processing. With a long-term track record of earnings growth and value creation, Visa benefits from inflation through its claim to a small but recurring slice of nominal consumer spending.

Arch Capital Group (ACGL)

Description: Arch Capital Group is a leading global insurance solutions provider. The company’s Insurance segment focuses on specialty product lines, including property, casualty and professional liability. The Reinsurance segment underwrites reinsurance and offers specialty products lines in casualty, marine, aviation and catastrophe. The Mortgage segment provides mortgage insurance and reinsurance.

Thesis: Arch Capital Group has generated an impressive long-term track record of higher and less volatile margins versus peers as a result of its focus on diverse specialty areas, conservative and flexible approach to underwriting, and skillful management of catastrophe risk. Over the past 20 years, Arch has proven itself to be a premier underwriting franchise that continues to grow book value per share at a mid-teens rate, which has translated into significant long-term outperformance for shareholders.

Costco Wholesale (COST)

Description: Costco Wholesale Corporation operates membership warehouses and e-commerce websites that offer members low prices on a limited selection of nationally-branded and private-label products in a wide range of categories. The company has nearly 900 locations around the world, including 600 in the United States. Over 70 million households are members.

Thesis: Costco is one of the largest and most successful retailers in the world with an innovative business model that enables the company to deliver exceptional value to its highly loyal customer base. Costco customers, a mix of individual small businesses and consumers with an above average income profile, pay annual membership dues that represent about half the company’s operating profit. Renewal rates exceed 90%. While Costco tends to be awarded a premium valuation, it should continue to enjoy a long runway of organic and square footage growth.

GXO Logistics (GXO)

Description: Headquartered in Greenwich, CT, GXO Logistics is a global contract logistics company that operates in some 27 countries. The company has nearly 1,000 warehouses and approximately 200 million square feet of warehouse space. Its customers include approximately 25% of all Fortune 100 companies. GXO Logistics was spun out of XPO, Inc. in 2021.

Thesis: As the largest pure-play contract logistics provider in the world with an advanced, tech-enabled footprint, GXO Logistics is well-positioned to capitalize on a number of structural tailwinds in the logistics industry that can support sustained double digit growth, through both organic growth and M&A. These include outsourcing, as businesses look to highly automated third parties to handle complex logistics requirements; e-commerce, with rapidly rising penetration of retail spending; and customer investment in supply chain resilience.

Thermo Fisher Scientific (TMO)

Description: Thermo Fisher Scientific sells a wide range of products and services to healthcare and other end markets. The Life Sciences Solutions segment offers a portfolio of reagents, instruments and consumables used in biological and medical research. The Analytical Instruments, Specialty Diagnostics and Lab Products and Services segments serve various applications in the laboratory and field.

Thesis: Thermo Fisher has an exceptional long-term track record as a supplier of essential and innovative products and services for life sciences activities and other industrial purposes. Serving end markets that grow at mid-single digit rates, Thermo Fisher aspires to high single digit revenue growth, driven by organic growth as well as its proven acquisition platform. Over the past decade, the company has applied this formula to grow earnings at mid-teens rates, which we regard as sustainable.

Vulcan Materials (VMC)

Description: Vulcan Materials is the largest producer of construction aggregates in the United States, including crushed stone, sand and gravel. Vulcan also manufactures and distributes downstream construction materials like asphalt and concrete. The company is a key supplier to infrastructure, residential and commercial end markets.

Thesis: Vulcan Materials is one of a handful of listed companies in the world that offer investors meaningful exposure to the American construction aggregates market. Vulcan's footprint of quarries and production facilities benefits from superior structural growth opportunity with its sunbelt orientation. Due to geological scarcity and environmental regulations, Vulcan has and likely will continue to benefit from organic pricing power even during periods of declining demand.

Williams Companies (WMB)

Description: Based in Tulsa, Oklahoma, the Williams Companies is an energy infrastructure company that explores, produces, transports, sells and processes natural gas and petroleum products. Williams handles approximately 30% of U.S. natural gas production and owns and operates more than 30,000 miles of pipeline in 25 states.

Thesis: Williams’ portfolio of pipeline assets is an indispensable element of America’s energy infrastructure, including the Transco pipeline extending from south Texas to New York City which delivers approximately 15% of the nation’s natural gas. Williams has a cash flow profile that is protected on the downside by predominantly fee-based contracts unaffected by commodity prices, with visibility over the next 5-10 years on dozens of potential pipeline expansion opportunities to the transmission network. The business offers generous capital returns, prudent balance sheet management and a platform for accretive growth.

Investing for resilience

A corporation is simply a form of organization used by human beings to achieve desired ends. – Supreme Court Justice Samuel Alito, Burwell vs. Hobby Lobby Stores, 2014

Samuel Alito

A business is nothing more than a collection of people, trying to earn profits through some combination of physical, intellectual and financial property.

There is a strong tendency, however, for people to analyze businesses in very impersonal terms, as though they were machines or physical objects. This is especially true in finance, which has developed using economic frameworks that borrow heavily from fields like statistics and even physics. Businesses are often treated like billiard balls colliding, rather than living, breathing arrangements among human beings.

This tendency is reinforced by the character traits of the sort of people who are usually drawn to professional investing and investment research. The investment world is awash in mathematical data, so it is no surprise that it attracts quantitatively oriented individuals who have a strong preference for hard numbers over subjective impressions.

In certain realms of finance, like fixed income and derivatives, the bias towards an almost purely mathematical approach is clearly warranted. But when it comes to stock picking, the quantitative impulse arguably goes too far at the expense of qualitative factors that deserve more emphasis.

If you enroll in an MBA program, or pursue the Chartered Financial Analyst program, one of the main things they want you to learn in the context of equity investing is “discounted cash flow” or DCF analysis. The idea is to project out many years, if not decades, of cash flows and then discount them back at an appropriate rate to arrive at a precise valuation for a business.

DCF analysis is theoretically sound, and the attempt to forecast future revenues, profits, capital expenditures and so forth can be a useful intellectual exercise. But to a large extent, DCF modeling is a fool’s errand. Unlike bonds, where you have great visibility into future cash flows as a result of strict contractual obligations, predicting what a company’s financial statements are going to look like in ten years is a lot closer to guesswork than a scientific undertaking.

Many if not most of the best investors in the world understand that successful stock picking is based on obtaining a firm grasp of the key fundamental characteristics of a business, rather than complicated mathematical calculations. Buffet and Munger repeatedly bash DCF analysis as offering false precision. Jean-Marie Eveillard always spoke about concentrating on the three or four most important features of a business, rather than financial minutiae or unreliable long-term forecasts.

When hiring analysts, Seth Klarman, one of the all-time greatest value investors, said he looks for “ideational fluency,” by which he means creative thinking, rather than mathematical prowess per se. Say what you might about his politics, George Soros, who began his adult life as an academic philosopher, has been one of the most successful investors of all time.

Ex-philosopher George Soros

We once heard a multi-billionaire hedge fund manager we know say he only hires liberal arts majors. Full disclosure: the founders of 76research were respectively history and politics majors, so we may have some bias here ourselves.

Investor and writer Robert Hagstrom has actually written an interesting book on this topic called Investing: The Last Liberal Art. He makes the case that a range of disciplines can and should be brought to bear to enhance the “mental models” that we apply in the process of deploying capital. Of particular interest to us is his chapter on biology, in which he discusses how the legendary economist Joseph Schumpeter believed “economic phenomena more closely resembled biological processes than the standard mechanized theory.”

We find it very helpful to think about investments through this sort of biological lens. Companies are ultimately more like a pack of animals, trying to survive and thrive in the wild, than billiard balls bouncing around a nearly frictionless pool table. When you buy into a company by investing in its shares, you are in essence making a bet that a very specific tribe of people will prosper well into the future.

What is investing for resilience?

Investing for resilience is all about finding companies that will prevail in the long-term evolutionary battle. A resilient business is one that does not just perform well in a specific environment but evolves and successfully adapts as conditions change. For long-term investors, resilience is an essential characteristic.

Truly resilient businesses have a blend of attributes that are difficult to quantify. There is no silver bullet financial metric, or combination of them, that one can screen for to identify businesses that will display resilience long into the future. The search process is more organic and requires consideration of a wide range of factors and, often times, subjective judgment in lieu of calculation.

5 Key Sources of Resilience

To determine our universe of resilient businesses, we focus on five main areas of inquiry: Competitive advantage; Structural backdrop; Optionality; Leverage; and Leadership.

Competitive advantage

Identifying businesses with sustainable competitive advantages is arguably the most important task of any fundamental investor. The Great White shark as we know it has been around some 70 million years. Its genetic ancestors were around for several hundred million years before that. The only known predators of the species are the killer whale and humans.

Investors should look for businesses that, like the Great White, are supremely well adapted to the ecosystems in which they operate. Buffet likes to frame this kind of structural advantage as a competitive “moat.”

…[W]hat we’re trying to find is a business that, for one reason or another — it can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it. – Warren Buffett, Berkshire Hathaway Annual Meeting, 1995

Resilient businesses are able to earn excess returns on capital, and survive economic shocks, because they have one or more inherent qualities that give them an edge over competitors and potential competitors. These advantages vary from company to company and industry to industry, and they are not always as durable as people think as a result of technological disruption and other changes.

Like Darwin in the Galapagos trying to understand why some species win and some lose, investigating the nature, trajectory and longevity of competitive advantage is the primary task of a resilience-seeking investor.

Charles Darwin

Structural backdrop

A species may dominate a particular ecosystem, but if the ecosystem fails, the species fails with it. So in addition to understanding how well a business can fend off competitive threats, it is essential to understand the overall environment in which a business operates. A business can only be as resilient as the industry in which it competes.

Investors looking for resilient businesses therefore need to pay close attention to the underlying structural drivers, which ideally point to a growing rather than shrinking pie for all competitors, whether they are advantaged or not. The ideal combination is of course a competitively advantaged business playing in an area with a solid long-term outlook.

Optionality

While certain industries can be fairly stable, technological and social change are a constant in the modern economy. Resilient businesses need to be able to adapt to survive but also to grow in new directions to take advantage of these changes and leverage off their dominance in one phase to recreate it in another. Resilient companies have an ability to innovate new products and services or grow through acquisitions.

The option value of future growth areas is hard to determine and therefore often overlooked, but over time has a tendency to become the most important variable of investment performance. So many of the most successful technology companies today derive a huge portion of their current value from cloud businesses, which are a relatively recent development.

Investors a decade ago might have been aware of the potential for the cloud to grow into something big, but it would have likely been a minor consideration in most instances.

Amazon.com delivered a compounded total return of more than 22% per year over the 20-year period ending year-end 2023. This was largely as result of its unique ability as a platform to extend into new product categories and business lines, such as the cloud.

Leverage

A company’s leverage profile can be likened to its immune system. Companies collapse when they are swallowed up by their liabilities. Excessive debt is often the first consideration, but leverage can be dangerous in many forms.

Operating leverage refers to a company’s fixed costs; these are often contractual obligations from which a company may not be able to escape even if there is a sharp reduction in revenue.

Often, the nature of a company’s financial debt is as important as the magnitude of it. Businesses fail when they can’t pay or refinance maturities as they come due, which means an understanding of the maturity schedule should be a high priority.

The type of financial liability can also matter. By all accounts, First Republic was a well-run bank, except for the catastrophic mistake management made with respect to the interest rate sensitivity of its balance sheet. Investors ultimately lost everything.

Resilience-oriented equity investors should always apply a credit lens to assess the vulnerability of a business to an external shock that may create a cash flow negative position that sends it into a death spiral.

Leadership

Businesses are not machines but organizations run by real people making real decisions on a day to day basis. One challenge of long-term investing is that management teams may come and go over time. It is tempting to focus on the assets of the business rather than the individuals exercising control over them, which can change, but the reality is the choices these individuals make can have a major impact.

The human element extends to the board and overall corporate culture. Investors should pay heed to the ownership structure of the company, including the presence of founders or large strategic investors, to understand management incentives, particularly with regard to shareholder value creation.

3 Reasons to Build a Resilient Portfolio

There are three principal reasons why an investor should seek to identify and then build a long-term portfolio around a core of resilient businesses: (1) Tax-deferred compounding; (2) Fewer decisions to get right; (3) Stability and opportunity in a crisis.

Tax-deferred compounding

One of the compelling features of a buy and hold investment strategy is that you can avoid realizing capital gains on a frequent basis. So even if the average rate of return is the same relative to a shorter time horizon approach or a trading strategy, after-tax returns are likely to be better.

Potential tax advantages are amplified by the ability to coordinate capital gain realizations when offsetting losses are available, or until there is a low-income year, perhaps in retirement, or even death, when there is a step-up in basis. But only an investment that can work through multiple market cycles and phases is suitable for a long-term buy and hold approach.

Fewer decisions to get right

Investing is a time-consuming process that requires research, analysis and continuous monitoring. A high turnover approach, where one moves from one short-term opportunity to the next, not only consumes more time and creates more personal stress but has the added disadvantage of requiring the investor to be repeatedly correct in his or her assessments.

It is much preferable to find an investment that will ideally get you to a similar or better long-term outcome with less time, effort and pressure and lower risk of making a damaging mistake along the way.

Stability and opportunity in a crisis

Resilient businesses are, by definition, businesses that will make it through difficult times and perhaps even improve their long-term positioning as weaker competition withers. It makes sense to develop a strong familiarity or “circle of competence” (to borrow a Buffett phrase) with a universe of resilient businesses in order to take advantage of opportunities when they surface.

In periods of stress and market sell-offs, it is difficult to put money to work knowing sentiment may only worsen. But when an investor has a thorough understanding of a resilient business, this can provide the necessary confidence to put capital to work in difficult conditions marked by a great deal of macroeconomic uncertainty.

Severe market sell-offs often provide the best entry points into resilient businesses—you potentially get the benefit of a temporary but significant discount in the share price and then, even after prices normalize, you own a solid long-term investment that can continue to compound without having to realize taxable gains.

Valuation still matters

Once the universe of resilient businesses is defined, the final determination of what goes into the portfolio is driven by valuation or price (along with consideration of sector diversification).

With a longer time horizon, investors should logically have less sensitivity to entry price versus more short-term trading opportunities where, almost by definition, one is trying to capitalize on a perceived mispricing that will soon correct itself.

Amortized over a long period of time, a 10%, 20% or even 30% deviation from fair or “intrinsic” value could become immaterial relative to improvements in the profitability of the business that may lead to growth in intrinsic value.

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. - Warren Buffett, Berkshire Hathaway Annual Letter, 1989

Warren Buffett

While an investor might have more flexibility and willingness to accept a valuation premium for an exceptionally well-positioned business, the price one pays needs to be reasonable.

One major risk of investing in high quality businesses is that there is a high probability that you are not alone in your assessment. This could translate into a stock becoming dangerously expensive, especially if the factors driving the perception of quality prove to be transitory.

By drawing from a larger pool of resilient businesses, investors have the ability to maintain a primary focus on underlying business characteristics while applying a valuation lens to differentiate among them. Valuation discounts are not commonly made available for these types of investments but do occur, especially when certain sectors or themes temporarily fall out of favor.

The holdings of the 76research American Resilience Model Portfolio are the result of a process that begins with the identification of a larger pool of businesses that are expected to be long-term winners of the brutal natural selection process of global markets. Portfolio construction ends with a valuation exercise that is intended to discern the most attractively priced opportunities within this group that are currently available.

The 76research American Resilience Model Portfolio is designed to provide exposure to businesses that operate with competitive advantages in structurally attractive markets. The objective is to identify businesses that can survive and thrive across different macroeconomic environments and whatever geopolitical crises may unfold. The holdings are intended as long-term investments to drive portfolio compounding with minimal need to realize taxable gains. Emphasis is placed on critical markers of business quality such as barriers to entry, physical scarcity of assets, balance sheet strength, effective capital allocation and durable long-term demand drivers. These assessments are paired with careful consideration of valuation, risk and embedded expectations.