Can Australian quality cut through Covid?

The market underestimates the ability of high-quality firms to sustain returns, leading to stock mis-pricing. Investors could look to Australia to take advantage.

Q How does quality investing work?

A We believe it is the inherent strengths of companies that drive stock prices, yet many high-quality firms are priced inefficiently because the market systematically underestimates their ability to sustain their returns. These businesses boast stronger balance sheets, higher margins and higher return on assets and return on equity. This affords them more resilient earnings streams to navigate uncertainties and capitalise on opportunities to create value. Specifically, we would argue that mid-sized companies have greater flexibility than large blue-chip firms to disrupt their industries. Comparatively they are nimble, with a lack of bureaucracy allowing for quicker decision-making. Smaller companies, too, operate in markets with room to grow. They are often under-researched and have a wider dispersion of returns, meaning there is more opportunity to capitalise on mis-pricings and generate above-market returns.

Q How can investors determine quality?

A We would recommend they focus on five pillars in their company research: Industry structure: to determine if a company can deliver strong returns sustainably, they should consider whether the industry it operates in is growing or declining, the strength of the firm’s competitive position and whether it will be a disruptor or be disrupted. Business strategy: investors should ensure companies have a clear, consistent strategy – comprising milestones and a track record of execution – and that they (the investors) are aligned to the long-term direction of the business as a shareholder. Management: investors should examine the track record of a company’s management team to determine whether they can execute on their strategy. We prefer conservative management teams with a proven record of delivering consistent growth in earnings and returns. Financials: investors should study a company’s cash flows through different business cycles and the strength and transparency of its balance sheet. They should look to see evidence of industry-leading margins and returns, or at least a pathway to them. ESG: only by knowing a company’s ESG credentials can investors understand its ability to adapt and prosper in a changing business environment. They should identify where ESG risks could be material financially and look to ensure companies have plans in place to mitigate these. As an investor we score each company on a scale of 1-5 for each of these pillars, with 1 the best and 5 the worst. A company must score a minimum of 3 overall for us to invest.

Q How can investors determine value?

A They should take a forward-looking view of a business to determine the accuracy of its market valuation. They can use valuation multiples and other metrics to understand what is priced in to the market valuation already; and evaluate the underlying strengths and future potential of a company themselves. This is done through first-hand research to gain insights into the quality of a company’s assets to determine if they are priced correctly. Investors should consider the ability of assets – both fixed assets and intangibles such as customer relationships – to generate returns; the quality of a company’s cash generation and predictability of its earnings over the long term; and the sustainability of a company’s competitive advantage that enables it to maintain a higher return on invested capital for longer. The type of business and industry it operates in will determine which valuation metrics are most appropriate to use. A volatile market is the best time to buy quality businesses whose prices have diverged from their earnings potential. Investors need to be opportunistic in that sense.

Q How can investors gain information on companies?

A Using a professional fund manager with global scale can provide a competitive advantage and afford deeper insights into Australian companies. To cite an example, one Australia-based auto parts manufacturer that we invest in has a manufacturing facility in Thailand. The information we gleaned from our team in Bangkok speaking to the company’s management team in the local language was more insightful than we would have got from an Australian manager flying in for a site visit. As another example, one Australian cloud-based accounting software firm generates almost 40% of its revenue offshore. When we first looked at this stock, Australia’s tech sector was very immature in relation to the US. So we liaised with colleagues in the US to understand how investors there gauge value in the tech sector. We learned that they were using price-to-sales as a valuation metric, which no-one was using in Australia at that time. That’s how we understood the stock was mispriced in the local market.

Q How has the coronavirus pandemic impacted your local stock market?

A Australia’s stock market has fallen into three camps. 1) Companies whose performance has lagged and are unlikely to recapture their pre-Covid performance level. Typically these are firms with large asset bases in industries facing structural challenges, such as airlines. 2) Businesses adversely impacted by the pandemic that we expect to return to their pre-Covid performance level over time. In the travel industry, for example, we expect the leisure segment to pick up strongly, although we think business travel will take longer to recover, in part due to the adoption of technology to facilitate meetings. 3) Companies that are long-term beneficiaries of the pandemic, such as those operating in online services, the cloud and logistics – and the providers of technologies that facilitate these trends. Investors might look to position their portfolios with a balance of defensive companies with stable earnings; businesses leveraged to the reopening of economies; and companies in line to benefit from long-term growth. But they should consider their holdings in companies where Covid-19 has had a potentially long-term impact on the business. Changes in media consumption, for example, have altered the outlook for that industry.

Q How has the market held up during Covid-19 relative to the rest of the world?

Australia boasts some leading global businesses selling products with universal appeal in areas such as health care and technology.

A Australia is better placed than many markets worldwide given sound domestic management of the pandemic. The strength of Australia’s fiscal position also allows authorities to continue to stimulate the economy. The Federal Budget last year was directed at supporting businesses in areas such as investment, hiring, lending and loss provision. It also included infrastructure funding and brought forward income tax cuts to boost disposable household incomes. We are confident that this coordination between monetary and fiscal authorities and bank regulators will mitigate downside risks to economic growth and help to alleviate concerns about the efficacy of monetary policy during this near-zero interest-rate environment. This should support the earnings of Australian companies and underlines the appeal of the local stock market for investors. Australia boasts some leading global businesses selling products with universal appeal in areas such as health care and technology.

Q Why should investors pay attention to environment, social and governance factors?

A We believe ESG is critical for sound investment decision-making, from idea generation to portfolio construction. We believe strongly that ESG analysis should be integrated into the investment process, which means considering risks and opportunities surrounding ESG factors during research on companies. A company may look cheap, but if it is polluting rivers it will likely be subject to a government fine, could suffer reputational damage and even be shut down. Factoring ESG into company analysis means incorporating the full spectrum of information available to assess the sustainability of a company’s business model. It helps investors to learn how a business operates and assesses risk. As such it allows them to develop a more rounded understanding of a company and its management. This puts them in a better position to understand whether the risk of investing is priced appropriately. Firms able to showcase how they safeguard customer data, prioritise environmental sustainability, foster a good staff culture and maintain standards among their supply chain will resonate with customers. That will drive profitability, and consequently investor interest. Ultimately, we believe selecting companies with strong ESG standards improves the chances of investing in long-term winners and avoiding loss-making corporate failures and scandals.

Q What are the broader implications of ESG investing?

A We think ESG and responsible investing will become even more important as the global coronavirus pandemic forces people to rethink their priorities when pursuing economic growth. As governments worldwide pledge trillions of dollars to support businesses and save jobs, this will present investors with opportunities to make a substantial commitment towards a more sustainable future for their portfolios and the planet. One of the ways investors can look to create value is by identifying and engaging with companies willing to raise their ESG standards. By engaging, they can help companies to make lasting changes in areas such as workforce diversity, investment in human capital, provision of a living wage and flexible working. In Australia, we want to see institutional investors focus attention on human rights and management of supply chains and push for diversity and inclusion among investee companies.

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Risk warning

Risk Warning

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.