Achieving returns over a cycle typically means 6-7% p.a. organic earnings growth, 1-2% p.a. in dividends, and 2-4% from buying below value, says Stephen Arnold from Aoris Investment Management. But right now investors are presented with a rare opportunity. Stephen says they’re finding a select number of high quality companies that can grow their earnings at an above average rate and are trading at material discounts.

"We believe the discount to fair value across our portfolio is somewhat larger today, which adds to the revaluation component of our expected return."

With so much value on offer, I spoke with Stephen to get his view on what he's looking for in potential investee companies, how the extreme of a crisis can affect investor psychology, and he discusses some companies he thinks could come out stronger on the other side of the lockdowns.


Which market crash gave you the most valuable lessons when it comes to navigating the current crisis?

I started my investing career at Bankers Trust (BT) in January 1991, the day the first Gulf War began. In the 29 years since, I have seen many economic and financial crises, from the mild to the major, from the regional to the global. I spent my first year at BT in the credit department, which is a useful place for an equity analyst to get started as the risks in credit are very asymmetric – the best outcome is you get your money back.

In 1991, Japan was two years into its multi-year and very painful asset price deflation; in 1992, Australia’s commercial property vacancy rate was 20% and Westpac almost went under. 1997 saw the Asian and emerging market debt crisis. I was a technology analyst through the 1998–2001 IT bubble and subsequent crash, and a bank analyst through the GFC, both during my years living in London. The mid-2010s saw the European bank and sovereign debt crisis, which in reality never ended.

Each crisis is different. History may rhyme, but it doesn’t repeat, so we must be careful not to apply a prior framework too rigorously to the next event. There are general principles, though, which one can apply.

My three key learnings from those experiences were:

  1. Debt is at the heart of every boom and at the epicentre of every bust. As such, banks are almost always in the thick of the permanent wealth destruction that occurs over a crisis. For this reason, Aoris never owns banks.
  2. Be patient and don’t lose sight of what you own. As an investor you are part-owner of a business, not part-owner of the economy. The value of that business doesn’t rise and fall with the peaks and troughs of economic activity.
  3. You cannot predict (at least I can’t), but you can protect. It’s tempting to think you can see around corners, and crises are always obvious in hindsight, but predicting them and positioning a portfolio accordingly is not something I have seen done repeatedly well. My approach is to simply never own a ‘fair-weather’ business - one I wouldn’t be comfortable owning in a crisis.

Have the attributes you’re looking for in an investment changed since last year?

In short, no. We have simply doubled down on our existing criteria. Let’s start with what we are always looking for. We want to own businesses that we believe will become more valuable over time, where the risk of a disappointing outcome is low. We particularly favour businesses that have leadership positions in their market, where the size and scale that comes with being the leader carries distinct advantages. We want this competitive strength to be reflected in a track record of consistent market share gains, GDP+ rate of revenue growth and high profit margins. We like businesses with breadth across a number of end markets because of the economic resilience it provides. We look for all this to be complemented by management who think and act like long-term owners, and a conservative capital structure.

We have elevated our emphasis in four areas:

  1. Earnings strength – we want to ensure that we own businesses that remain profitable and cashflow-positive for the coming full year, even if their earnings decline sharply during the COVID-19 shutdown period.
  2. Capital strength – we seek conservative capital structures and want to avoid businesses where their ability to service and refinance debt may be called into question.
  3. Management strength and stability – our expectation is that companies with a team of relatively stable and long-tenured management will make better decisions during a highly unusual and stressful environment, than ones where there are many new faces.
  4. Competitive strength in breadth – we want to avoid businesses that may be the leader in their market in aggregate but have material parts, perhaps a division or geography, where they are competitively weak, as these may be areas the company loses market share during this period.

Through this crisis period, we expect our companies to take market share and emerge competitively stronger. For businesses to become more valuable over time, it is not necessary that their earnings only ever increase. What we don’t want to see is the external environment resulting in any of our businesses becoming materially less valuable.

Do you think it’s easier or harder now than it was in January to achieve 8–12% p.a. over the next 5–7 years?

In simple terms, it’s easier, because the companies we own are now cheaper. Ordinarily, our expectation is that the bulk of our 8–12% p.a. return over time will be achieved by the wealth creation of the businesses we own. We expect our investee companies to grow in capital value at a rate of 6–7% p.a. and to pay a dividend of 1–2% p.a., which sums to 7–9% p.a. before we consider value. We would usually expect the benefit of owning these companies at a discount of 10–15% to their intrinsic worth, to contribute an additional return of 2–4% p.a. We believe the discount to fair value is somewhat larger today, which adds to the revaluation component of our expected return.

They key is for the underlying value of the businesses we own not to be materially negatively impacted by the external, macro environment. For banks, energy companies, businesses in the travel industry, real estate companies, these businesses will in most cases exit the crisis worth less than they entered it. We believe that avoiding such companies, which we do all the time, will serve our investors well as the economic cycle unfolds.

I understand you generally shy away from consumer staples; why did Costco appeal to you?

Thinking first about supermarket retailers, these are businesses where life has become permanently tougher. Online retailing has changed the competitive landscape and consumer expectations, yet it is very hard for established supermarkets to create an online offering that is both competitive and profitable. Manufacturers of consumer staple products are feeling the pain of the retailers that they sell through – retailers want bigger discounts, longer payment terms and more shelf space for private label, while consumers want to see more niche brands on the shelf.

Costco is different in almost every respect. Costco is a membership-only warehouse where members can find low prices on a limited selection of nationally branded and high-quality, private-label products in a wide range of categories. The approach has proved highly successful and the low mark-up is compensated by high sales volumes and rapid inventory turnover.

Costco’s culture is to pay its employees well, including full health and retirement benefits, and give its customers great discounts. Satisfaction levels for both employees and members are industry leading. The customer value proposition is strong and most items it sells are cheaper at Costco than on Amazon.

Very few retailers successfully grow outside of their home market. Costco’s model has worked well in many non-US countries, including Australia, and we see significant potential for further growth in both the US and international markets. Costco has net cash on its balance sheet, and has a strong corporate culture with stable and long-tenured management.

Costco has grown EPS at a compound rate of 12.8% p.a. over the last decade, with no acquisitions and no use of debt. It earns a return on invested capital of 21%, despite owning 80% of its stores.

Could you discuss some of the ways that the extreme stresses of market crises can affect investor psychology and behaviour?

In market crises there is a sense of wealth destruction, regret, anxiety over employment and livelihood and, in the case of COVID-19, the added fear for health and personal wellbeing, and the disorientating effect of radical changes to daily life patterns. Some of the ways that the extreme stress from market crises affect investor psychology and behaviour include:

  • Follow the crowd – in market crises, fear is the prevailing emotion. The daily news media is overwhelmingly full of negative stories, which reinforces a sense of doom. The compulsion to ‘do what everyone else is doing’ becomes powerful.
  • A dramatic shortening of one’s time horizon – everyone’s a long-term investor when markets are rising, but there becomes a myopic focus on daily price moves during a crisis. This is reinforced by dramatic events unfolding on a daily basis – central bank decisions, emergency government stimulus programs, corporate failures, profit warnings, and government news conferences.
  • Buy the bottom – once investors have suffered dramatic market falls and endured a few false recoveries, they are emotionally spent. If they haven’t already thrown in the towel, all they are interested in is ‘have we passed the bottom?’ and if not, ‘when will it be?’

It certainly takes effort and fortitude to think and act independently; to maintain focus on one’s long-term investment objectives; to think in terms of business value and long-term prospects, and the attractiveness of price relative to value or ‘worth’.

The SARS outbreak resulted in a big boost in the adoption of ecommerce in Asia. What are some of the trends you expect to see accelerate due to the COVID-19 pandemic?

There are certainly the prospects for long-lasting changes in society, government, commerce and international trade and relations. For example, an increasing willingness for some people to work from home, even only one day a fortnight would have major implications for commercial real estate and public transportation, not to mention the demand for oil and office attire! However, changes in societal behaviour is not an area where we feel confident making predictions.

We do expect the growth in ecommerce, both personal and business, to accelerate as a result of the COVID-19 pandemic. Our portfolio has a number of direct beneficiaries. For L’Oréal, 20% of their sales are already via online channels. Remarkably, in the March quarter of this year their sales in China grew by 6.4% in a beauty market that the company estimates contracted by 15–20%. This was attributed to their very strong position online. Pre-coronavirus, 47% of L’Oréal’s sales in China were online – far above the market average.

Likewise, Nike derives 20% of sales online even though it sells nothing on Amazon. Nike’s strength in digital media, as well as supply chain and logistics, positions it well to use ecommerce to continue to take market share.

Lastly, ecommerce needs to be supported by digital communication. Accenture is now the world’s largest and fastest growing digital advertising agency, ahead of the likes of WPP, Omnicom and Interpublic, with revenues from these activities of over USD10 billion last year.

In closing, who knows when it will be okay again to go to bars and football games, and shake hands when greeting? Whenever that may be, we are confident that the world’s leading businesses, like L’Oréal, Accenture and Nike, will be stronger and more valuable than they are today.

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nick payne

Great insightful piece.