Introducing Xafinity, plus our view on the market

Steve Clayton - Fund Manager

19 February 2018

When the stock market makes the headlines, it rarely makes for comfortable reading. So perhaps it should have been no surprise that January’s headlines about soaring stock markets around the globe, were closely followed by February’s reports of record falls on Wall Street and beyond.

The precise causes of the current market correction are unclear. Wall Street worries over inflation could be the cause, or perhaps valuation is the driver? Maybe it was the imploding volatility tracking ETFs which bet on continued quiet in markets?

We are though quite clearly at a pivot point in the financial markets, where central banks begin the long row back from the era of cheap money. “Normalising” interest rates and liquidity will inevitably change flows within and between economies, asset classes and nations.

So uncertainties will be plentiful whilst the changes are made. Central bankers are acutely aware that they must not poison the patient whilst they adjust the medication. Interest rates will rise, but it doesn’t seem likely that they will rise a lot. The USA has the lead role in the process, with the UK following and Europe still to decide when to tag along. As always, politics clouds the glass and frankly, looks likely to continue doing so.

So when we look into the crystal ball, we see interest rates rising a bit, surrounded by a lot of fog. How should one react to a foggy, minor change? Looked at that way, in our view the answer is not to do very much at all.

What matters in the long run

Our preference has always been for businesses less dependent on the economic cycle. Strong balance sheets and robust cash flows are so important. If you have cash in the bank, it matters little if interest rates rise. If your business model is designed to generate cash through thick and thin, then you can concentrate on serving and winning customers each and every day.

Repeat revenues are another protection; customers that keep coming back makes for a stronger business. And if those customers value your products and services sufficiently to pay you a fat profit margin, all the better. Companies with these features offer great growth prospects.

Markets will rise and fall whenever investors sense shifts in the sand. But in the long run, companies’ success in growing their businesses determines their value, regardless of the markets’ fickle fads.

We can’t pretend to know precisely where the markets will head next. But we can keep looking for great businesses that can prosper over the long run. And in recent weeks we believe we have found another one.

Introducing Xafinity

We’ve been building a position in Xafinity and have now completed the position. Like our existing investment, Sanne Group, Xafinity is a business that operates in the world of fund administration. Whereas Sanne Group is focused on Alternative investment funds, such as private equity and hedge funds, Xafinity operates in the defined benefit pension fund space, where it is one of the UK’s leading operators.

You could be forgiven for wondering why we are investing in a business that serves a sector that is rapidly disappearing; almost every other day it seems, someone announces the closure of their defined benefit scheme. Fair point, but in practice, whilst schemes may be closing to new members and pulling the shutters down on future accruals, the schemes themselves remain very much alive.

Ever rising sums will be paid out to retirees

Ever rising sums will be paid out to retirees for decades to come. Xafinity expect the payments out of DB pension funds will typically peak in the late 2030s. Schemes will need to be administered until then and far beyond with the last schemes set to finally close around the turn of the century.

The market for servicing pension schemes is dominated by three big players, who control most of the market. Xafinity is in the second tier and recently announced the acquisition of another operator, Punter Southall. It’s a business Xafinity’s management know well, for they began their careers there so we expect them to integrate it well.

The deal creates cost synergies and the scope to deploy Xafinity’s Radar technology across a wider clientele. Radar allows clients to get a real-time view of their scheme’s financial position, a big step forward from the traditional three-yearly actuarial valuation.

A clear challenger to the big players

With funds tending to switch Administrators infrequently, Xafinity has strong recurring revenues. If they can succeed in exploiting Radar and their other competitive offerings then they should be able to gain and retain market share. The merger with Punter Southall puts them into the position of being a clear challenger to the big players.

There is a Competition and Markets Authority investigation underway in the Pensions sector. This is expected to focus on the potential conflicts that can exist between the larger investment consultancy firms, investment managers and the advice provided to clients.

Xafinity do not have a fiduciary management aspect to their work and do not expect to be adversely affected. Indeed, to the extent that action is taken to reduce the Big 3’s grip on the sector, the CMA investigation could be a catalyst for new business opportunities.

Fund administration is a capital-light activity and we expect the group to have strong cash flows in the years ahead. Dividend paying potential should be strong, without any guarantees, and the group has little need to retain cash. With much of the consideration for the Punter Southall businesses coming from the sale of new shares, debt levels remain modest in relation to the enlarged group’s scale. At the current 185p level (18th Jan 2018) the stock yields a prospective 3.2% on consensus forecasts.

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