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Legally Bond: finding underappreciated resilience

Theo Golden, Investment Analyst

Key Points

  • Credit investors might be quick to dismiss unique business models
  • In doing so, they could be missing out on opportunities – we recognise this and so take a different approach
  • Rather than rushing to judgement, we believe that by looking closely at fundamentals we can deliver attractive returns

All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.

The idea of judging a book by its cover is cautioned against in countless fables and works of popular fiction. When Elle Woods arrived at Harvard Law School, for example, everyone dismissed her. The glamorous lead character of the 2001 box-office hit Legally Blonde was judged as superficial by people who could not understand her and thus underestimated her talent.

Confronted with unusual business models, fixed income investors could fall into the same trap: jumping to conclusions about a company without considering it on its own merit. It can be easy to dismiss companies without giving them a fair chance. However, when we step back with an open mind and take time to explore the fundamentals, we can find some resilient business models and attractive opportunities.

Burford Capital and Veritext are two great examples. Their services contribute to the smooth running of the American legal system, giving them cash flows divorced from the ups and downs of the economic cycle.

Burford Capital is a litigation financing firm that funds cases for companies and law firms in return for a share of the eventual proceeds. It was initially dismissed by credit investors due to its novel business model which did not fit standard valuation approaches or sectors. But those investors overlooked a business with substantial scale, data-driven expertise and a human capital edge. Moreover, they missed a leading company revolutionising a sleepy industry and developing a new asset class with double-digit annual growth.

Strong demand allowed Burford to attract high-quality clients and use its legal expertise to pick winning cases. The company’s track record speaks for itself. It wins 91 per cent of the cases it funds, achieving, on average, an 88 per cent return on invested capital. Importantly for fixed income investors, this has led to substantial growth in cash flow.

At its core, this is a durable business model with cash flow generation uncorrelated to the business cycle. Burford’s management compares a case to a conveyor belt: once it has started it will progress regardless of what interest rates do. Indeed, the business model is arguably countercyclical, as economic downturns are correlated to bad decision making, which often drives an increase in litigation.

With its solid cash flow and appropriate leverage, the company represented a compelling investment idea for our credit portfolios yielding high single digits. Having invested in bonds of Burford Capital since March 2021, we looked for more exciting opportunities in what could be dismissed as a ‘boring’ sector.

That’s how we found Veritext, a niche business that brings scale and efficiency into a staid corner of the North American legal system. In the pre-trial phase, all legal testimony must be taken under oath by an ‘officiant’, recorded and transcribed. This service is often provided by tiny ‘mom and pop’ court reporting agencies. In that environment, Veritext’s strategy of acquiring competitors allowed the company to offer size and simplicity to its clients, and to embed itself into the infrastructure of the US legal system – all the while offering a 9 per cent yield.

Similarly to Burford Capital, Veritext’s business model defies the business cycle. This is demonstrated by its achievement of double-digit revenue growth during the global financial crisis. However, like many service companies, Veritext is exposed to disruptive technologies like AI. As long-term bond investors, we are looking for sustainable income, not short-term yield, so we need to ensure the company is innovating to keep pace with evolving technology.

Veritext’s management team has a good track record of anticipating change. The investment it made during the last decade in remote and digital testimony technology proved to be particularly beneficial in the face of restrictions imposed during the Covid-19 pandemic. Now, Veritext is already future-proofing its business model, developing its AI capabilities to help with transcribing depositions.

In current markets with uncertainty over economic growth, it is increasingly important to find companies that can generate solid cash flows whatever path the economy takes. Our investment process allows us to dedicate time to understanding niche business models with underappreciated sources of resilience, which should help us to meet this challenge.

Like attending Harvard, looking beyond established business models isn’t easy. But just as Elle defied stereotypes in Legally Blonde and proved the doubters wrong, we believe that our open-minded approach to investing in companies that break the mould will deliver durable income for our clients.

Actual Investors
look to the future. 

Not the past.

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Author

Theo Golden

Investment Analyst

Theo joined Baillie Gifford in 2021 as an Investment Analyst as a part of the Multi Asset Team. Previously, they worked as a financial journalist at Bloomberg, Business Insider and Mergermarket. They graduated from Durham University in 2020 with BA(Hons) in Music.

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