Perpetual Investments' Deputy Head of Equities, Vince Pezzullo is clear about the stocks he wants to invest in. He and his team like companies which provide structural advantages, are well positioned for future growth and are trading at reasonable valuations. And he wants cyclical companies that rise and fall with the business cycle.
“We believe many cyclical companies are trading at steep discounts to mid-cycle valuation despite being high quality, well managed market leaders in a good financial position,” Pezzullo said at Perpetual’s AGM and Investment Manager Update in Sydney on Thursday.
Key to this process is the use of four filters:
- Quality of business – this test looks at the industry in which the company operates, its market share and barriers to entry, its products and their positioning and any issues such as social and environmental impacts.
- Conservative debt – involves strict balance sheet scrutiny to avoid overleveraged companies.
- Sound management – based on an assessment of the track record of a company’s management.
- Recurring earnings – looking for companies that have at least a three-year track record of generating earnings and cash flows.
While Perpetual only considers investment in companies offshore when these offer better value than Australian companies and there is a high degree of conviction in the investment case for the stock, Pezzullo identified three in his presentation. Each was presented next to an Australian counterpart, a similar company that is not in the portfolio.
“We can leverage the resources of the entire Perpetual Investments team to identify investment opportunities. For example, investing in the IPO for La Francaise Des Jeux SAEM (PAR: FDJ) when it listed on the Paris Stock Exchange.”
Three against three
FDJ, France’s national lottery operator, has been preferred over Tabcorp (ASX: TAH) because it holds an attractive 25-year monopoly license to operate the French lotteries. Whilst sports-betting is a high growth division for FDJ, 85% of group earnings are derived from the lotteries business.
“Analysis of FDJ’s lotteries business, shows a similar profile to Tabcorp’s with consistent growth in total ticket sales over a long period of time translating to earnings growth and strong cash flow conversion which we expect to continue moving forward,” said Pezzullo.
Pezzullo has also picked Ferguson (LON: FERG), a distributor of pump, plumbing and heating products — predominantly to the US — over Australia’s Reece (ASX: REH), despite being big fans of the local business. Ferguson’s UK business is due to be demerged later this year, leaving the company solely exposed to North America.
“There are several reasons we like the company's medium-term prospects. It has a great business model, largely in the US and has a good balance sheet that allows for growth and acquisition including through inorganic means,” said Pezzullo
Finally, Pezzullo took a new position in Auto Trader (LON: AUTO) in March, the UK’s equivalent of carsales.com (ASX: CAR). This is a good example of a stock the Perpetual equities team had considered to be a quality company that was be over-valued during the bull market. As a result of market volatility, the manager has been able to take advantage of the company trading at a discounted valuation.
Sky’s the limit
Pezzullo also took the time to caution investors against “value traps”, while offering an example from his own experience. Value investing involves identifying stocks that the market appears to have undervalued and are trading at a discount relative to the company’s underlying or ‘intrinsic’ value.
“The goal in value investing is for the share price of the stock to ultimately align with or trade above the stock’s intrinsic value,” he said. “While a company trading at a discount can appear attractive, the share price can sometimes end up becoming cheaper. This is known as a ‘value trap’.”
Perpetual first invested in SKY Network Television (ASX: SKT) in 2015 as the stock de-rated from a premium valuation. The business had solid revenue streams from licenced content, including rugby in NZ, and had been well managed while consistently extracting value from its capital expenditure cycle, which they had just completed.
“However, a failed merger with Vodafone and other management decisions changed our perception of the outlook,” said Pezzullo. “Our extensive research seeks to avoid value traps through ongoing evaluations of the company.”
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