Short-term reactionary behaviour is to be expected within every earnings season, and February 2019 was no exception. But opportunities that went misinterpreted or unappreciated by the herd await patient investors willing to block out the noise and really take a look at a company’s fundamentals and growth prospects. Here, we try to identify high quality results that may have been victim to market myopia.
Read on for the experts’ views on seven such stock ideas from Steve Johnson at Forager, Chris Prunty at QVG Capital, Matt Williams of Airlie Funds Management, Mark Arnold at Hyperion Asset Management, Natalie Tam at Aberdeen Standard Investments, Arden Jennings at Ausbil, Weimin Xie at MX Capital and Sinclair Currie from Novaport.
Flying kangaroo has muscle to flex
Matt Williams, Airlie Funds Management
The Qantas (QAN) result, while prima facie looked “ho-hum” – profits were down – demonstrated the incredible strength of its franchise. Battling higher fuel costs increases that on their own would have led to a halving of profit, the company was able to pass all the fuel cost increase to customers.
Since the end of the capacity war with competitor Virgin (VAH) five years ago, Qantas has experienced a golden run. The shares are up from $1 to $5.60, the balance sheet is strong, dividends have been re-instated, and more than 25% of the shares on issue have been bought back – a remarkable turnaround.
Can it continue? We think it can (subject to the usual caveats regarding consumer demand, oil price, competitor behaviour) for the following reasons:
- The pincer movement Qantas has put on Virgin with Qantas mainline and Jetstar encircling both the premium and corporate markets, and the budget and leisure customer allows Qantas to achieve +60% market share but +90% profit share.
- The remaking of international routes and alliances should make blowout losses in this division a thing of the past.
- The strength of the loyalty program (more than 10 million members), which consistently delivers about 25% of Qantas total profit.
A lot of things can go wrong in an airline business. But as we study the industry globally, we are hard pressed to find a company that has the unique advantages enjoyed by Qantas.
Qantas is valued as if it is no better than most global comparable airlines with a price-earnings ratio of 9 times. If returns can be maintained, we believe Qantas could justify a PE ratio of 12 times, putting it on a similar valuation to premium-rated airlines such as Southwest Airlines of the US and Ryan Air in Europe.
Johns Lyng Group: The master of disaster
Weimin Xie, MX Capital
Johns Lyng Group (JLG) has reported a solid result in February. The company provides emergency building work and restoration services for insurers. The stock was under pressure for the better part of 2018 as the cyclical element of the earnings were in decline thanks to the softening housing cycle.
Entering FY19, the company’s core insurer work revenue has continued to grow strongly at a double-digit growth rate while the profit for the cyclical component declined to zero.
On top of attractive business characteristics such as being capital-light, with 100% cash conversion and a substantial net cash position, the company will be a major beneficiary from the rebuild after the recent Townsville flood, which is not in the current earnings guidance.
The market is underappreciating JLG in two respects. Firstly, the business-as-usual revenue of the company is likely to keep growing at a relatively high rate for a long period without any need for capital investment.
The company is also exploring opportunities to expand in the US through selective acquisition. This will add the blue-sky potential for the business. Most importantly, the growth of the business is independent of the equity market or macroeconomic environment.
Secondly, the company is a major beneficiary of extreme weather events, which are increasing in frequency.
Look at fundamentals and don’t overreact
Natalie Tam, Aberdeen Standard Investments
Cochlear (COH) was sold down (after it reported earnings) because sales were impacted by a competitor launching a new product that can be used when a patient is in an MRI machine.
While this did miss expectations and will remain a short-term issue, we think the market overreacted. Cyclical changes in market share are commonplace each time a new technology is launched. Cochlear has its own pipeline of new products which will be released in time, and sales should swing back in their favour.
Cochlear’s Service Division posted a particularly strong result, with revenue up 21%. The division now represents 30% of total sales revenue. The fundamentals of the business remain strong. Cochlear has a very clear strategy and the balance sheet to implement it.
We are watching for opportunities in sectors that are under pressure, such as the residential property market, where stocks have been beaten down as expectations are slashed and sentiment sours. But inevitably, the cycle will turn and when it does, the upswing will be substantial.
“Nailing it” in education; Myer worth another look
Chris Prunty, QVG Capital
I thought IDP Education (IEL) nailed their result. They delivered the trifecta of an earnings beat, clean accounts, with earnings backed by strong cash flow and a very strong operating outlook.
At 54x FY19 and 42x FY20 earnings it’s hard to say the market underappreciates it, but we sure did! At these levels we haven’t quite got our heads around the valuation, but the multiple suggests the market sees a long runway for growth.
Having just said we want to avoid cheap domestic cyclicals I think Myer’s (MYR) recent result is worth a second look. The result showed they’re not going broke anytime soon. The company produced $140m of free cash flow in the first half, which takes a lot of pressure off their balance sheet. This ought to give them enough time to reduce their store footprint and rent bill while ramping up online sales.
Broker consensus is still bearish on Myer and short interest is over 10% because there have been so many failed attempts to turn it around in the past. The opportunity here is to take a view on whether “this time is different” and whether new management under John King have what it takes to stabilise the business. Early signs are promising.
It’s hard to argue against the current consensus positioning of “defensive growth good,” “domestic cyclicals bad” given current growth expectations and interest rate settings. The data and central bank musings would suggest rates will be lower for longer in Australia, while the probability of rate rises would seem higher in the US.
Should the rate expectations change here it would be because wages, inflation and growth had picked up. If this were to happen, cheap underperforming stocks in the retail, media and housing sectors would show signs of earnings recovery and get a double win from the earnings kick and multiple expansion. I think this scenario is unlikely in the short term but is one worth thinking about.
In the meantime, perhaps the best way to be is to own a section of defensive growth stocks that will benefit from low rates and scarcity value, and resources and mining services which will benefit should the much-touted Chinese stimulus bite in the second half of the calendar year.
Runway for growth may be no laughing matter …
I spoke about Enero Group (EGG) at last year’s Livewire Live event and we all had a good chuckle about my decade-long dramas with the stock.
Well, Enero reported earnings growth of 90% for the first half of the year thanks to a 33% revenue increase. Some of that was due to acquisitions, but the organic revenue growth was 15%, a great result for a business that looked to be in terminal decline a few years ago.
One good result doesn’t make for a growth stock but this company trades at 10x earnings and pays a decent fully-franked dividend, so I’d definitely classify it as underappreciated.
In addition to liking it because the numbers are good, I’m particularly pleased for the CFO and CEO. They’ve worked tirelessly to turn this business around and it’s great to see them enjoying some success.
Enero owns the world’s leading tech public relations company, Hotwire Communications. PR is the one growing part of the marketing agency landscape. Tech PR is the fastest growing piece of that, and Hotwire is winning more than its fair share of work.
That’s driving much of Enero’s growth and, where the market is seeing a one-off spike in profits, I think it’s something that can grow significantly further yet.
Citadel survives siege on strong earnings outlook
Arden Jennings, Ausbil Investment Management
Citadel Group Group (CGL) sold off as much as -27% on results day in the wake of earnings that missed analyst estimates and the announcement that founder and director, Miles Jakeman, was abruptly leaving the business. The earnings miss was driven by a weaker top line and softer-than-expected gross margins.
While disappointing, this weakness was largely a function of a much faster-than-expected transition in revenue mix from lower-margin and less predictable services work, to higher-margin recurring SaaS revenue.
In our opinion, Citadel continues to represent an attractive buying opportunity with improved earnings quality, underpinned by a healthy contract pipeline and margin improvement as the business transitions to increasingly SaaS revenue.
We used this as an opportunity to increase our position, and subsequently, shares rebounded by 23% off the results day low as investors realised that the business retains a strong earnings outlook.
Winning their way in the US of A
Sinclair Currie, Novaport
Credit Corp (CCP) delivered a result which was high-quality yet underappreciated by the market. What struck us as positives from the result was the significant progress being made in its US operations as well as continued growth potential within the Australian lending business.
Credit Corp’s core business is the acquisition of aged debts and then arranging repayment plans to recover these, and the company has extensive database and analytic capabilities which support its market-leading position in Australia.
The company continues to drive attractive returns from its core Australian operations, yet the result also demonstrated the significant growth opportunities available via investment in new initiatives.
We believe the market underappreciates the strategy and planning which underlies Credit Corp’s growth ambitions. The company opened a presence in the US market years ago, investing significant time and money in establishing a solid platform before pursuing growth.
With this platform now built Credit Corp is scaling up its US operations and is seeing good success winning share in a market which is multiples larger than Australia.
A final thought: wheat will separate from the chaff
Mark Arnold, Hyperion Asset Management
We are long-term investors, which means we look for long-term quality, rather than short-term results. We don’t look at short-term, high-quality or low-quality results because they don’t always reflect underlying fundamentals.
We screen out short-term market noise to make a rational assessment of whether a business has the underlying fundamentals – sustainable earnings, strong management, a large and growing market – which will allow it to perform over the long term.
In some cases, quality businesses are overlooked by the market because investors can be swept up in market sentiment and forget to look at what’s really going on. For example, some very average businesses and speculative stocks have been able to perform over the past few years on the back of low-cost debt and short-term consumer demand, which resulted from the very accommodative monetary policy of many central banks.
Our view is that these average businesses will struggle in the longer term – as they will no longer be able to hide their shortcomings. On the other hand, quality businesses may have been underappreciated because investors were not able to sufficiently differentiate them from average businesses.
I would argue that the market regularly underappreciates quality businesses, because investors get caught up in market sentiment, and fall victim to the herd mentality where investors do what the group is doing, regardless of whether the actions are rational or irrational. In times of heightened market volatility, this is particularly prevalent.
There is no question that investors, even experienced investors, do not always understand or see the differences between short-term opportunities and long-term fundamentals. The only way to overcome the temptation to react irrationally to market sentiment is to follow a robust, research-based investment process, one which helps investors to identify growth-oriented companies with strong long-term fundamentals, and to screen out average businesses or speculative stocks.
Most market participants are obsessed with short-term alpha (outperformance) and share-based returns as opposed to fundamental quality. In our view, trying to predict short-term share price movements by buying and selling in the short term is extremely difficult to do well consistently.
Without an understanding of the underlying economics of a business, it is impossible to assess intrinsic value.
7 stocks for uncertain times
Growth stocks like Afterpay, Appen and Nearmap that are making waves offshore have been dominating the leader board. Meanwhile, domestic cyclicals have been struggling as deteriorating economic conditions weigh them down.
How are investors supposed to invest in this dichotomy, in which growth stocks with overseas success look ever more expensive - while the local cyclicals look cheap, but keep getting cheaper..?
We put this thorny issue to our panel of professionals in part of one of this exclusive, which you can access here.