Owning Microsoft over Nvidia, and backing Diageo to recover

Sebastian Lyon, manager of Troy Trojan Fund and Personal Assets Ord (LSE:PNL), an investment trust, explains why he owns two of the Magnificent Seven technology stocks, Microsoft Corp (NASDAQ:MSFT) and Alphabet Inc Class A (NASDAQ:GOOGL), but is steering clear of NVIDIA Corp (NASDAQ:NVDA) as he wants to keep a lid on risk.

Lyon also discloses two new holdings, and two stocks that have been sold.

An out-of-form company that Lyon continues to back is Diageo (LSE:DGE), which he's held for 18 years. He's backing a share price recovery, although notes that this could take time. He explains why he remains a long-term fan of the stock, which, he says, continues to enjoy plenty of pricing power.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider interview. I'm Kyle Caldwell, and today in the studio I have with me Sebastian Lyon, manager of the Trojan Fund and Personal Assets, an investment trust. Sebastian, thanks for coming in today.

Sebastian Lyon, manager of Trojan Fund and Personal Assets: Kyle, thanks very much. It's a pleasure to be here.

Kyle Caldwell: So, Sebastian, Troy Asset Management is known for its cautious investment approach. How are you approaching the so-called Magnificent Seven stocks that have dominated stock market returns since the start of last year?

Sebastian Lyon: Well, we've been in an extraordinary time from the point of view of growing assets and protecting assets, which is obviously our aim, when we've effectively been in a boom - I think that's pretty uncontroversial - a generative AI-driven boom, an investment boom. A lot of these companies, the Magnificent Seven, have been investing for that prospective boom, which will happen further down the line.

We hold Microsoft and Alphabet. We bought Microsoft back in 2010 and it's been an amazing investment for us, and we bought Alphabet in 2019. So, we do have an exposure to that area.

Clearly there's been a huge concentration of return, and the size and scale of these businesses affects the markets on a daily basis. I think something like 30% of the US stock market is derived from those seven stocks today, and when you have concentration like that, generally speaking, you should be wary. That's not necessarily a good sign of a healthy stock market.

Now that has been driven not entirely by pure speculative reasons. It has been driven by huge profitability and huge growth in earnings, particularly, for example, with Microsoft, with the growth of its cloud business on Azure. And that's going to benefit from AI as time goes on as well. We think there are genuine benefits to generative AI in the future. The problem is that when you have these booms, there are hiatuses where there's a question over when it's going to deliver.

And markets extrapolate and they get excited. Then you have periods of pullback and then you have the subsequent growth from that investment. And we're possibly going into a period like that at some stage in the future. And that's what we would be concerned about. A little bit like the dot-com boom. But I think there are differences.

It's very easy to make comparisons, but in the dot-com boom, if you remember the huge optimism, then the pessimism that the growth didn't come through and then, ultimately, the Amazons and the Googles, etc, produced huge growth subsequently after that.

My fear is that we may go into one of the hiatus periods at some point in the future, but at the moment clearly they're driving investor returns.

Having said that, it's not just about the Mag Seven, and while we have had great returns from Alphabet and Microsoft this year, we have also had good returns [from what are perceived as] quite pedestrian businesses such as Unilever (LSE:ULVR), which has done very well for us, and which two years ago everybody hated, and American Express Co (NYSE:AXP) as well. So, it's not just been about those seven.

Clearly, the S&P 500 returns and the MSCI returns, the global returns, have been affected by the dominance of those businesses.

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Kyle Caldwell: The two big US technology companies that you've owned, Microsoft and Alphabet. Have you been taking profits given the share prices went up a lot in response to hype over artificial intelligence?

Sebastian Lyon: We're always going to be careful about not allowing ourselves to get overexcited, not allowing ourselves to run things too hard. It's very tempting as an investor, and I know there are many investors who feel [that you should] run your winners. You do want to run your winners, and cut your weeds, to some extent, but there is a danger of running your winners too hard.

And especially if valuations are increasing materially. And we have seen a very material increase, particularly in the valuation of Microsoft over Alphabet, still in low 20 times multiples and still executing incredibly well and generating very good growth. But with Microsoft, we have trimmed it a little bit this year. So, we have been managing that risk and being careful not to get too overexcited.

Kyle Caldwell: A stock you don't own, which has performed remarkably well since the start last year, is Nvidia. Is it a stock that you looked at all? Why don't you own it?

Sebastian Lyon: We looked at it very briefly, and I think that this comes back to our whole investment process of how we go about generating great returns with equities. What we want, and as I describe it, it possibly sounds a little generic, are qualitative businesses and we want to be paying sensible value and to not have a great deal of cyclicality, because cyclicality can really kill performance, leverage can kill performance, but cyclicality can kill performance as well.

Nvidia has historically been a phenomenal business and a huge success, particularly in the last 18 months. But it's also had periods of huge cyclicality. It had a 90% drawdown during the dot-com bust. It had something like an 88% to 85% drawdown, share price fall, during the financial crisis. Even recently, in 2022, I think it was down 70% from peak to trough.

Clearly, it's been phenomenal now. But the reason for that is that it does have an IT hardware, compared to IT software such as Microsoft, does have huge cyclicality, and that's why for this mandate [it's not right], this [mandate] is about getting our investors to sleep at night and being comfortable. Owning a company like Nvidia, I would view that as inappropriate.

The other point to make about the business is that I think 50% of its revenues are accounted for by three of its largest customers. So,  think about how many millions of customers a company like Microsoft has compared to the three customers that Nvidia has. The risk of those customers stepping back on that Capex change, if they're desperate to find another provider of chips rather than Nvidia. They would be very keen to diversify those purchasing if they could. So, I think those are the reasons why [we do not own] Nvidia.

There's FOMO with Nvidia, huge FOMO. I think in stock market terms, FOMO can be a very dangerous thing, the fear of missing out. I get the sense, there's real “Why don't you own Nvidia? Oh, we own Nvidia.”

We live in our own area and we stick to what we know. And we know what's right for the portfolio in terms of equities. And we have a fairly strong view as to what we feel isn't appropriate, particularly for the multi-asset mandate when we're trying to protect. We're not trying to make people 20%, 30% a year. We're trying to protect the value of their investment and grow it, hopefully by 7% or 8%, 9% a year.

Kyle Caldwell: You invest for the long term. So, you don't often make changes to the equity holdings in either the fund or the investment trust. Having said that, could you run through portfolio activity perhaps over the past year or so?

Sebastian Lyon: Over the last year, we've made four changes to the equity part of the portfolio. We sold two holdings, and we bought two holdings.

Last December, we sold Franco-Nevada Corp (NYSE:FNV), which is a gold streaming and royalty business, and we sold that very much frustratingly, really, because it had been a great investment for us since 2017. Your point about us investing for the long term, is that we would still hold it today, [but] there was one particular stock-specific risk, which was that it had exposure to one mine in Panama, which effectively was closed.

We saw that coming actually, and we sold it down in 2022 and in 2023. In fact, interestingly, if things had been going well for it, the share price would be much higher thanks to the gold price going up. But we realised that there were stock-specific reasons as to why it wasn't going to benefit from those increases in the gold price. And, actually, the share price has fallen since we sold it last December.

The other thing we sold, which is another long-standing holding, was Becton Dickinson & Co (NYSE:BDX), which is the world's largest syringe manufacturer. People always start shaking when I start talking about syringes. It was a business we had owned since 2010, and we thought it was going to be a beneficiary of a post-Covid world of people going back to hospital, having operations, that sort of thing.

It was a company that we were close to, and we felt that it wasn't executing as well and delivering as well as we felt it should do. Sometimes you've got to recognise that the company you bought 10 years ago, 15 years ago, for various reasons, whether it be M&A, whether it be changes of management, whether it be a different dynamic within the business, is that things do change. Businesses have an organic form to some extent, and therefore we've got to recognise when those changes happen. For us we just felt that change had happened and not necessarily positively, and we thought we could allocate our capital somewhat better than keeping Becton Dickinson. Again, we made money in it, but over the last few years it had been pretty dull. And we recognised as to why that was the case and we thought we would move on.

In terms of the two purchases we made in the summer, the first was Chubb Ltd (NYSE:CB), which is the world's largest property casualty insurance company. What we felt with that was that we were looking for businesses which were going to begin to benefit from a different interest rate environment.

Coming back to your earlier questions about changes in interest rates, insurance benefits from that because they have a float, because they're investing that float, they're investing effectively the premiums every year. So, in a higher interest rate environment, they're actually a beneficiary. So, it comes down to the top-down view and the bottom-up view of the fact that the business had a bit more of a tailwind than it had done hitherto.

We've owned insurance companies in the past, both Lloyd's insurance and Berkshire Hathaway. Insurance is a sector where, to some extent, you need to be careful. But nevertheless, we think it's excellently managed and the returns have been very good over the long term. It's on a relatively low valuation, 12, 11 times earnings. And so we've made a start, a holding in Chubb.

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And then there's VeriSign Inc (NASDAQ:VRSN), which is a company that is probably less well known. It owns dotcom and dotnet. So, if you register an internet address with a dotcom or dotnet, effectively you pay Verisign a certain amount. It's about $10 a year, it's very small amount. Effectively, they hold the register of your domain name, and dotcom is by far and away the largest domain name in the world, while dotnet, I think, is the fourth largest.

So, effectively it's like an internet utility for want of a better description and they can put their prices up by about 5% a year. It was a company that sums up the way that we go about investing to some extent. We're looking at these things year in, year out. We were looking at it over a number of years.

The shares did very well during Covid. The shares re-rated very strongly. They were very expensive. Then, from 2022 through to 2023 and into this year, the shares became much more unpopular, and went from 40 times earnings to 20 times earnings. We thought at that sort of valuation, with the growth that we saw, that it looked pretty attractive to us, so we bought a new holding in Verisign.

Kyle Caldwell: You mentioned earlier that Unilever has been a strong performer, One of its peers that hasn't been performing as well of late is Diageo. Could you explain your latest views on the stock?

Sebastian Lyon: You're right, it's been disappointing. As one private client fund manager said to me once, clients will always focus on the one that's down rather than all the ones that are up! And that's definitely been the case with Diageo.

We've owned Diageo for 18 years, since 2006. Over that period, it's been a fantastic investment for us. It's generated returns of about 360% in sterling terms compared to the UK market of about half that, about 180%. So, it's been a very good long-term investment. So, that's one part of the story, and we've held it for that period. We have reduced it over time and increased it over time as well, but it has been a core holding within the portfolio.

Covid was for many businesses a very bizarre period for the economy. We had a period where people couldn't spend on services and so they spent on goods. Then we had the reopening, everybody spent on services, and nobody spent on goods. In the case of services, everybody went out [as they were] unable to party and suddenly, everybody in 2022, 2023 were able to go out, go to pubs and restaurants, etc. We had a huge boom in spirits, which is predominantly Diageo's business. And frankly, we are now seeing the other side of that.

We're seeing the downturn that has happened, as demand has fallen back, and normalised. Frankly, the comparators were very hard for Diageo in 2020, the late second half of 2023 and the first half of this year compared to the huge boom that we had in 2022 and the first half of 2023.

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Do I think the business is broken? No. We've got brands like Johnnie Walker, which have been around for, frankly, hundreds of years. People are going to be drinking Johnnie Walker in 10, 15, 20, 30 years’ time. They will have pricing power. So, I think this is a temporary thing.

You compared it interestingly to its peer within the UK market, Unilever. We had a lot of criticism about holding Unilever two, three years ago. We were adding to it back then. We have been adding to Diageo somewhat this year, gently, because possibly it's going to get worse before it gets better. And you just want to not be overly aggressive with your purchases if that's what you feel.

I don't think it's out of the woods yet, but I think it will get out of the woods. I don't think it's permanently impaired. I don't think we can have permanent capital loss from Diageo, and I think it will settle down and earnings will recover.

Ironically, we talk about not buying cyclicals. I mean, it's not a highly cyclical business, but I think it's probably more cyclical than people realised. I remember back in the early 1990s and late 1990s, that period, there was a boom in spirits in the early 1990s, particularly in Japan. And then Guinness had a pretty dull period through the mid-1990s as that boom effectively faded and the valuations of the companies came down and the earnings growth was relatively flat. Then gradually, ultimately, it picked up again.

Effectively, I think we're in a similar sort of period to that period. They will recover. When is the question. It may not be this year. Frankly, it may not be next year, but I think it will.

So, as long-term investors, we want to lean into that negativity. The valuation's come down a lot, it's not just been about earnings, it's been much more about the valuation of the stock. I think ultimately at the current valuation levels, you should make decent returns from here, there or thereabouts.

Kyle Caldwell: Finally, Sebastian, a question that we ask all the fund managers we interview. Do you have skin in the game?

Sebastian Lyon: Most definitely. Yes, I have skin in the game, Kyle. So, I've got a very material shareholding in Personal Assets, which is on the record. People can look at the report on accounts and see how big it is.

Generally speaking, I buy shares every year in Personal Assets, but I also have holdings in our in-house funds. So, in the Trojan funds and in global equity, etc, all our funds that we manage at Troy.

I've also got a very material stake at Troy Asset Management itself. So, I'm very aligned with our investors from that point of view. I'm aligned in every way.

Kyle Caldwell: Sebastian, thank you for your time today.

Sebastian Lyon: It's a pleasure Kyle. Thank you.

Kyle Caldwell: So, that's it for our latest Insider Interview. I hope you've enjoyed it. You can let us know what you think, you can comment, you can like, and do hit that subscribe button. Hopefully, I'll see you again next time.