Steer clear of company boards prioritising “polite chats over robust engagement”, and mistrust the adage “this time it’s different,” says Daniel Moore, co-portfolio manager of the Investors Mutual Australian Share Fund.
The manager's strong focus on fundamentals over thematics combines with an emphasis on companies that are expected to boost market share by out-investing competitors. Moore and the team also prioritise companies with non-discretionary revenue streams that should perform well in an economic downturn.
He emphasises that so-called defensive sectors aren’t always safe, and companies that quickly become category leaders can fade into obscurity just as fast.
“Not too long ago, Alta Vista – not Google – was the dominant global search engine company,” Moore says.
Moore also notes that Nokia, not Apple, was for a long time the unassailable category leader in mobile phones. But investors often forget that most booms – and technology is a prime example – end like typical cycles, and structural growth tipped to last forever usually disappoints.
In the following wire, Moore explains how IML’s portfolio has changed during COVID and why he always focuses on quality over momentum. He also reveals some of his best and worst stock calls and views on a few of Australia’s best-loved stocks including Telstra (ASX: TLS), Woolworths (ASX: WOW), Transurban (ASX: TCL) and AGL Energy (ASX: AGL).
How confident are you that Australian businesses have weathered the worst of the COVID storm?
I think it’s fair to say the major downside cases that were possible at the very beginning of COVID have been reduced – but significant uncertainties remain. For instance, to what extent will governments continue to stimulate, and for how long? Where will post-stimulus unemployment land? Are we going to have inflation or deflation? And finally, when are we likely to have an effective vaccine?
We believe the recovery phase for the Australian economy is most likely to be prolonged, rather than V-shaped.
Diminished household spending power, record household debt, and higher unemployment are likely to weigh increasingly on economic activity and on many companies’ earnings. Many companies are actively reducing their labour forces and deferring or cutting capital expenditure, which will have implications for their future growth and earnings, and likewise for other companies downstream.
Our portfolio focuses on companies whose earnings are not dependent on a V-shaped recovery, and which in our view are reasonably valued, have strong competitive advantages, and are run by experienced, capable boards and management teams that can navigate the uncertain economic times effectively.
What hurdles must companies clear before making it into your portfolio?
A company needs to clear a number of hurdles before I’ll consider adding it to our portfolio, to meet our quality and value criteria.
- The company must possess a strong franchise, meaning that it has an enduring and ideally strengthening competitive advantage.
- The company also needs to have some form of bargaining power and control of its destiny, rather than being entirely hostage to the cycle or external forces.
- It also needs to have a strong and capable management team and board, which is critical for effective capital deployment and day-to-day operational execution.
- Financial strength is also key, including a strong balance sheet and recurring and predictable earnings. Given the uncertainties going forward, we’re currently paying more attention than ever to balance sheets and the quality of the board.
- In times of crisis, boards need to be highly competent and actively engaged with the management, strategy, and risks of the company – no polite “tea and scones” chats, we want comfort about board members’ robust engagement.
- Finally, the company must be trading at what we consider to be a reasonable valuation.
You’ve reduced your portfolio weighting in TCL and AGL recently into a couple of other defensive names – what’s the rationale behind that?
We continue to carefully assess the likely demand outlook for each industry in a lower growth environment, as well as the outlook for the prices of goods and services within each industry. Lower prices can have a significant impact on profitability, particularly in a lower demand environment.
In the case of AGL, we’re more cautious about the medium-term outlook for wholesale electricity prices, as demand is likely to be softer than previously expected. But on the supply side, a number of renewable generation projects remain committed. This additional supply is likely to keep wholesale electricity prices and AGL’s profits potentially lower in the medium term.
The decision to reduce our holding in Transurban was more focused on valuation, as the stock price had recovered sharply to a point where we felt the risk/reward was less favourable than other opportunities.
Are there any other defensive themes you’re focusing on in the months ahead?
The kinds of companies we’re looking for in the current environment are:
- industry leaders that should be able to achieve greater market share by out-investing their competitors; or
- companies with non-discretionary revenue streams that will perform well if the economic environment deteriorates.
We’re also looking for companies with company-specific growth drivers such as new product launches, companies with regulated or contracted revenues, companies likely to benefit from restructuring or bolt-on acquisitions, and companies which have the ability to meaningfully take costs out of their businesses. We’re also very focused on ensuring that the companies we’re invested in have sustainable margins.
Have you been surprised at the selloff of Telstra?
We were surprised by the magnitude of the recent selloff of Telstra. Our view is that mobile prices in Australia are at a low point in the cycle. Optus and Vodafone’s recent financial results have shown that current prices are unsustainable, as both companies’ mobile divisions are losing money. We believe prices need to rise, not only to cover Optus and Vodafone’s losses, but also to fund the capital expenditure required for their 5G network rollouts.
The principal reason we’re positive about Telstra is because the company is well ahead in its 5G network rollout, which should enable Telstra to increase its prices relative to its competitors and potentially gain market share in the coming years.
On these grounds, we have been adding to our existing position in Telstra.
Coles and Woolworths have seen a bump from COVID, but how confident are you of their longer-term outlook?
We continue to have a positive view about the outlook for the supermarket sector. The industry has only recently emerged from a very competitive period, during which margins fell for the three listed players - Coles, Woolworths, and Metcash.
We’re seeing a much more rational industry environment with price inflation returning, which is positive for margins. Coles and Woolworths have had a short-term sales spike from COVID-19, which we expect to unwind, but have also experienced higher costs from increased expenditure on personal protective equipment, cleaning, and distribution inefficiencies to meet the surge in demand.
Longer term, we believe Coles and Woolworths are well-placed, even if the economy deteriorates, as people tend to eat at home more regularly in tough times. We’re also positive about the growth of Coles’ and Woolworths’ online businesses, and the additional income streams they can earn, such as advertising revenue.
Are there any COVID thematics largely missed by local investors that you’ve been exploring?
I think investors are overly focused on thematics now rather than fundamentals, which I think might ultimately prove to be to their detriment. The technology sector has many exciting themes at the moment, whether it’s software-as-a-service companies, electric vehicles, online retail or buy now pay later companies. The price you pay for these companies is an afterthought, because they are in “the right space” and have “structural growth”.
What many investors are missing is there have been many technology booms over history and most end like a typical cycle. Many investors assume these technology companies have permanent structural growth, but miss the fact most technology companies inevitably face competition. Also, the structural growth that is being forecast into perpetuity often disappoints (there are a few exceptions). Money and success always attracts competition.
Investors may say “this time is different” or that they are investing in the market leaders giving them a sense of security that their moats are insurmountable, and the risks are low. The facts of history are many market leaders in technology have ended in failure or insignificance, even in market segments that have had great growth.
Not too long ago, Alta Vista – not Google – was the dominant global search engine company. In mobile phones it was Nokia, not Apple, that seemed to be the category leader. And in social media, My Space was first and in fact was the most visited website in the US in 2006 - well ahead of Facebook. These examples prove that investing in technology, even in dominant global leaders, is not a guarantee of success.
Who’s your most important investment mentor, and what’s the most valuable advice you’ve been given?
I’ve been very fortunate to have had two great investment mentors, Anton Tagliaferro and Hugh Giddy, and to have worked with them for over 10 years. The most valuable advice they’ve given me has been to focus on the quality of the business first, and its current share price second.
Can you talk about a stock you’ve got wrong in recent years, and what you learnt from that?
The times that I’ve got stock calls wrong have been when I’ve strayed from Anton and Hugh’s advice, and have bought a lower quality business because I was swayed by a short-term improvement that in the long run turned out not to be sustainable.
Myer Holdings was an example of this. A new management team came in, recapitalised the balance sheet, and started refurbishing the stores and reducing the store network. This led to an improvement in like-for-like sales growth for the first time in a number of years.
But as we know, this turned out to be a false dawn and I eventually sold out of the stock.
What about your best pick of recent times – which stock, and why did it perform so well?
CSL has been one of our best recent picks. This is because we bought a large holding in the company in 2010, when it wasn’t particularly popular. We’ve held it ever since, and our investors have benefited significantly. We identified CSL had long term sustainable growth drivers, being demand for immunoglobulins and increased sales of speciality products, and this has played out well over the past decade.
It’s fair to say when we bought CSL back in 2010, we didn’t envisage the extent of the share price appreciation we have received, and the quality of the management team was instrumental in this. CSL has achieved growth rates far above its industry peers due to management’s operational execution and disciplined but bold capital allocation. CSL has had an exemplary track record on acquisitions and buybacks over its 25-year history.
Unfortunately, this is in stark contrast to most companies on the ASX.
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