This is the third episode in our series examining the key factors distinguishing successful businesses. These are all learnings from our team’s many years of investing in Australian small companies. Factors #1–4, as discussed in parts 1 & 2, were: 1) Management are owners/founders or otherwise act as if they are; 2) High returns on capital will often dispense with the need for high debt; 3) Re-invest profits – don't perpetually raise new equity; and 4) Stable management who often promote from within. We turn now to an examination of factors #5 and #6, which we illustrate with examples of Australian small companies.
5) Do not needlessly diversify a good core business
Here are some common phrases that help explain factor #5.
"when you're onto a good thing stick to it"
(being good at one thing does not necessarily mean you're good at other things).
"dilution is not the solution"
(diluting a good business by adding a lesser businesses is not a risk diversifier).
(proper focus trumps poor diversification every day of the week).
The best company case study we can offer to explain this factor is an examination of the divergent strategies adopted by two mostly similar businesses, A.P Eagers (APE) and Automotive Holdings Group (AHG). There are many similarities between these two companies. There are also some significant differences.
APE owns and runs one of the largest networks of auto dealerships in Australia. So does AHG. APE has grown its car retailing business over the years through intelligent bolt-on acquisitions of smaller dealerships at attractive prices to add to its network. So has AHG. APE has stuck to its knitting by remaining focused on the one attractive industry sector. Not so AHG.
Whilst APE has remained focused on exploiting opportunities within the auto retailing sector (check out their latest initiative to disrupt used cars at carzoos.com.au), AHG has instead diversified into…wait for it…the transport and logistics sector.
We all know how tough this sector can be, with the likes of Coles and Woolworths to contend with. Now, so do AHG management and its board. AHG shareholders have seen more than five years of management effort and $300m of their capital spent on buying up a bunch of (mostly distressed) refrigerated transport businesses, all in the futile pursuit of an ill-judged diversification strategy. Today we are left with a division that is highly capital intensive, offers low returns on capital, continuously misses earnings expectations and has little growth. All the while, their original core business has continued to grow and prosper.
It is not surprising then that operating performances of these two companies have significantly diverged over this period. Since 2010 APE has grown earnings per share by 120%. AHG on the other has grown earnings per share over the same period by just 7%. A big total shareholder return gap has also emerged over the past five years. APE (+430%) has significantly outperformed AHG (+140%) on this measure.
This is a unique case study of the benefits of good focus over ill-conceived diversification.
Our fund has owned AP Eagers for some time. We did own AHG more than five years ago but sold out just as they embarked on their "diworsification" strategy. Recently we bought back in with a small position now that the company has 'retired" their old CEO and has deemed logistics as a non-core division.
6) Earnings are all-inclusive, not "underlying".
There are a number of companies in the market whose financial statements are a breeze to analyse. Their financial numbers are clean, simple and easily understood. This in itself is a strong quality signal for us as investors. Their reported earnings are their earnings. Their invested capital is their invested capital. No adjustments needed. Some examples that come to mind include ARB, Technology One, and A.P Eagers.
Then there are those companies that engage in the (usually repetitive) practice of offering a range of adjustments to their reported earnings. They call this their "real" or "underlying" earnings. Rarely do such adjustments reduce a company’s reported earnings. In almost all cases they act to boost the reported earnings, a warning sign in itself.
Some more experienced investors may recall an old Australian company called Mayne Nickless (since split up into a number of other businesses). It was a serial offender in making these repetitive "one-off" adjustments to reported earnings, usually to write off parts of their business that had failed or to otherwise adjust for a range of other management missteps.
More recent examples of businesses that are enthusiastic promoters of "underlying" earnings include Super Retail (SUL), Fletcher Building (FBU) and the aforementioned AHG.
Just like AHG, SUL started with an outstanding core business in the Super Cheap Auto chain. It then diversified away from this with acquisitions of lesser quality businesses. Some have worked well, such as the investment in sports retailer, Rebel. Most have not, including Greencross (bicycles), Workout World (fitness equipment) and Rays Outdoors (leisure products). Over recent years these failures have generated a host of adjustments to their reported earnings. The need to explain underlying earnings is nothing but a sign of management's failed past strategies and poor capital allocation decisions. Just like AHG, management now appear to be reforming given the refocus on their best businesses. This should now allow them to dispense with the need to redefine their “underlying” earnings.
FBU is another company with a mixed recent track record of acquisitions. They paid more than $750m for Crane Group in 2010, having also bought the Formica laminates business a few years earlier for $1b. Neither acquisition has worked. The result has been a number of "non-cash" asset impairments and other "one-off" costs over recent years, all added back to derive underlying earnings. Shareholders would surely argue with management's use of the descriptor "non-cash" given that management has paid out real cash in the first place to buy these businesses.
AHG's troubles over recent years have also seen them become enthusiastic promoters of the underlying earnings concept. With their failed escapades into the logistics industry now largely behind them, this should no longer be necessary.
Read Part 1 here: (VIEW LINK)
And Part 2 here: (VIEW LINK)
Written by Victor Gomes, Portfolio Manager, Australian Shares – Small Caps: (VIEW LINK)
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