7 questions for assessing business quality
We spend a lot time analysing individual companies and the industries they operate in. There are two time horizons investors are focused on predominantly. Firstly, there is the short term, which is trying to assess the earnings trajectory over the next half yearly or yearly reporting season.
In a perfect world, all stocks we invest in continue to revise up earnings, which in today’s investing climate is the overriding theme. Earnings momentum. It is extremely powerful given the amount of quant funds (and money) following these upgrade/downgrade cycles, which in itself becomes a self-fulfilling prophecy. i.e. if investors know there is a lot of money following such strategies, then perhaps they should too.
Of course the other time horizon in investing is the medium to long term where investors take a structural view of an industry they want to be exposed to and will patiently wait as cash-flow growth ultimately delivers higher returns to shareholders through capital and dividend growth. The two investing horizons are not necessarily mutually exclusive but we are in an environment where momentum (and low interest rates) has taken the growth complex (high-growth stocks) to, in some cases, extreme valuation bounds.
We are not averse to investing a portion of our capital in high-growth stocks, but we still need to be very cognisant of some valuation framework to arrive at a logical conclusion and not just invest in QAAP stocks (quality at any price). That is not our style.
The table above (click on it to enlarge it) illustrates how we value a range of high growth stocks, using predominantly the WAAAX (Wisetech, Afterpay, Altium, Appen and Xero) stocks as they are so topical, but also the Chinese-listed tech stocks as a means of comparison.
Both on a PE multiple basis, and a long-term DCF (cash flow) basis, the Asian names appear significantly cheaper than the Australian-listed names. We view a PE as not necessarily reflective of a business's ability to grow over the medium term, so for high-growth stocks it is not necessarily of much use.
Our fundamental (long-term) questions is this. How sustainable is this business model? Below we set out a range of questions that we use to seek out the best quality businesses in Australia, the key issue being how confident we are that this business will be in the same (or a stronger) position in the next 5 years. In fact, as share prices of these companies have been so inflated, we have internally started using 10-year DCF models to justify the current share prices.
This in a sense is more problematic, as we are then making assumptions that each business is a viable going concern 10 years from now. In an age of disruption and fast implementation of new technology, 10 years is a long time in tech world.
So to put this in perspective, the right-hand column highlights how much of the business valuation is captured post the explicit forecast period. For all these companies, there is still a significant component of their valuation that is determined by making an assumption on what the business looks like in 10 years time. For each company we assume a terminal growth rate of 4% (above inflation) and a WACC (weighted average cost of capital) of 9%. Given where interest rates are our internal discussion always debates the appropriate WACC to use, but we apply this 9% consistently across this universe.
As a summary, the more value we can see in the explicit forecast period (the first 10 years) the more comfortable we feel in the valuation. So from the above, Baidu, the leading Chinese search engine - which has 23% of it’s market cap in cash on the balance sheet - is clearly the best value (as distinct from the best business). The Asian names, are in aggregate, significantly cheaper. Of the Australian names, we find Xero and Altium as the best value (from a cash flow basis), and interestingly, also from a business quality basis.
The above framework is how we assess each company we have on our watchlist. We actually rank each question out of 10 but have simplified the framework shown here. We assess the Business Quality, Financial Quality and Management Quality using a range of questions as illustrated above. This then provides us with a ranking system for each stock in a particular sector or thematic that we then overlay with an appropriate valuation to determine the appropriate stocks for the portfolio.
So these are the seven (relatively generic) questions we ask ourselves when looking at each company. This is clearly an exercise in subjective analysis as each answer is considered with the industry structure as we currently view it. When looking at these tech names, they obviously operate in different industries so comparing like for like is a subjective exercise. We do find it to be a useful thought process as we consider the investment thesis of each company though, outside the short-term thinking of whether or not the earnings will exceed or disappoint consensus numbers.
When looking at the answers above, we demonstrate a preference for Xero relative to the other tech companies, largely as a result of both comfort with the technology (we use and recommend it) and the large runway over the 5-10 year view for Xero to start raising prices. This will be a powerful driver of future cash flow growth with an incredibly strong franchise (we don’t think it will impact customer engagement).
The other companies we have either less confidence (Afterpay) or less understanding (Altium) of how pricing plays out over the medium term. All these companies can grow organically above 5% to a greater or lesser degree while the control of input costs for technology companies is largely controlling development spend and labor costs, which are largely driven by internal drivers. We focus on this as a way of understanding the ability to grow (and protect) margins.
The question about whether these assets are easy to replicate is often the most challenging. If we are wrong about Afterpay (and the share price is suggesting we are), it will be largely as a result of us viewing pay day lending as a highly competitive industry with many competing products and some aggressive pricing. If Afterpay (with first mover advantage) has been able to build a viable ecosystem of retailers, then it itself (and its online portal) can become a very powerful distribution channel for these retailers. This is what we are trying to come to terms with on Afterpay, notwithstanding the fact it looks (to our forecasts) heroically expensive. But we have been proven wrong many times before.
For what its worth (it formed part of a presentation we gave recently) below we have illustrated the companies (large caps) that we view as having the best quality businesses in Australia. This doesn’t mean we will hold them all, we still overlay a valuation framework to much of our thinking. There are others, but we couldn’t fit them all on the page!
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Rob recently founded Chester Asset Management after 7 years at SG Hiscock where he was PM of the SGH Australia Plus product that delivered in excess of 10% outperformance per annum over 3.5 years.