Crisis silver lining: resilient business models and validation of competent management
The February reporting season provided a few unusual insights due to the economic impact of COVID-19. In particular, it confirmed our underlying investment thesis regarding the resilience of several business models. As often described our monthly investor newsletters, we are constantly on the lookout for “good businesses” defined as those that hold the balance of power over their stakeholders.
The events of the past year – bushfires, pandemic induced lockdowns, border closures, and enormous government stimulus – not only generated very large forecast risk around future company earnings and cashflows but also clarified “who has the power” in many of the portfolio’s holdings. Several themes played out during 2020 that demonstrated the efforts expended by competent management teams on bolstering already robust businesses.
Our long-held investment in Accent, the dominant footwear company (averaging approximately 1.5 million pairs of shoes a month), is a good example. The company has developed its retail distribution network to ensure customers enjoy seamless transactions either by visiting the physical stores, the online digital properties or even a combination of both.
The company was astute in leveraging its scale and traffic generating ability to optimise rental outcomes – securing sites at attractive rents while helping landlords focus on rebuilding their occupancy levels – and is driving an accretive store rollout program.
Accent’s combination of “click and despatch” as well as “endless aisle” capabilities out of their more than 500 physical stores and significant branded websites generate remarkable logistical efficiencies, making them almost channel agnostic from a cost perspective. This capability goes some way to making them “lockdown proof”.
Several other companies in our portfolio benefitted from this thematic including Woolworths and Super Retail Group. Gaming services company Aristocrat could also fall into this category given their decline in revenue from the sale of gaming machines was mitigated by the strong growth in digital gaming revenues.
Optionality for capital deployment
Two companies in our portfolio clearly demonstrated this capability.
Credit Corp’s ability to allocate capital between its three division – domestic debtors ledgers, domestic consumer loan book and the US debtors ledgers, facilitated an important discipline around the prices paid for loan books in the domestic market. Several local competitors succumbed to the pressure of paying for books in an over-priced market to keep their collection teams fed. Credit Corp’s optionality allowed it to focus instead on its consumer loan business as well as the US market. Over the last six months it was rewarded for its discipline by being offered two large competitor books at very attractive prices.
Similarly, Resmed was able to pivot its production capacity to supply ventilators to hospitals globally during the peak infection rates of the pandemic. The company also benefitted from the recurring nature of its mask division, particularly as the focus on respiratory health focused consumers on the benefits of a faster replacement cycle. These factors more than mitigated the temporary interruption to new patient demand for flow generators.
As greedy shareholders we typically love companies with operating leverage, particularly when revenues are moving in the right direction. Essentially this means a greater percentage of every new dollar of sales falls to the bottom line as the top line grows.
During 2020 those companies with resilient revenue streams generally benefitted from a strong tail wind of cost efficiencies due the wide acceptance of belt tightening – a pause in new hires, new projects, wage increases, promotional activity as well as sharply reduced travel costs.
We recognise that this may be temporary however many companies have taken advantage of the crisis to eliminate unproductive spending.
Resmed, CSL, and Amcor are good examples of companies with operating leverage, with robust revenue growth translating into earnings growth several times higher.
Supply chain strain
An important negative manifestation in the domestic economy relates to the difficulties associated with sharp changes to end user demand on supply chains. For example, the shortage of computer chips (it seems massive computer demand – both work and gaming – has absorbed significant supply) has resulted in manufacturing bottlenecks for the new motor vehicle industry – creating long delays and shortages particularly in Australia. SG Fleet is a strong beneficiary of this as residual values for used cars affects their profitability positively.
Freight costs are sharply higher everywhere. One unanticipated shortfall arising from the fact that cargo carried in the holds of passenger planes was a significant load carrier for the logistics industry. We have contemplated its impact on inflation generally.
Unsustainable Revenue drivers
Probably our biggest challenge as investors is in managing the forecast risk around future company cashflows given the enormous variances in company revenues and profits due to the pandemic, changes in consumer behaviour and government stimulus. Remember that the main reason we look at historic numbers is to use them as a base for predicting future cashflows.
While some clarity should begin to emerge as we cycle through the elevated/depressed (depending on the company) comparisons from the start of the pandemic, the imminent end to Job Keeper will have its own implications. Discerning the underlying trends from the noise will remain difficult for some time.
In summary, recent events have solidified our assessment of the resilient business models within our portfolio. (and potentially of competent management as well). Fortuitously our companies – by and large – have escaped relatively unscathed with business models and balance sheets in good shape. Importantly, while there are many additional companies we could have selected for our portfolio, most have been excluded on the basis of valuation. Given the recent gyrations around the cost of money, we feel it prudent to have a well-diversified collection of businesses that represent growing annuity streams off an attractive after-tax cash earnings yield.
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Rhett is the CIO and Fund Manager of the Pengana Australian Equities Fund, and joined Pengana in October 2007, bringing with him over 18 years of experience as an investment professional at the time.