2019 was a very strong year for the Australian sharemarket with ultra-low interest rates and record low bond yields pushing global sharemarkets higher. This was despite a sluggish economy which has made for mixed corporate earnings results.
We have always sought good quality companies that, in our view, have a strong competitive advantage, recurring earnings, capable management and the potential to grow their earnings and dividends over time.
We then apply a valuation filter to ensure we buy these companies at what we believe is a reasonable price. We have applied this philosophy for more than 20 years and have achieved returns that have been more consistent and less volatile than the Australian sharemarket over this period.
Given the strong rally in sharemarkets over 2019, we believe it is a time to be very selective given that, in our view, many stocks are looking fairly stretched from a valuation point of view.
Any diversified portfolio will contain some stocks which perform well and some which disappoint – even though they all have the underlying value characteristics we’ve described above.
In this article, we discuss a few of the companies that did well for IML’s portfolios over 2019, some that were disappointing and why we continue to hold these stocks in our portfolios.
Coles (COL) was listed on the ASX in November 2018 after it was demerged from Wesfarmers. IML received Coles shares as a result of the demerger but we made the decision to increase our weighting fairly sizeably after the stock listed. That proved to be a wise decision as Coles shares have rallied more than 30% over 2019.
The main reason that we bought keenly into Coles early in the first half of 2019 – apart from the fact that it fulfils our stock selection criteria – is that unlike Woolworths, Coles was floated off by Wesfarmers with a patchwork of outdated and poorly located distribution centres across the eastern seaboard. In addition, traffic congestion in the areas where the centres are located has worsened over the years, which has also increased the amount of time and money involved in product distribution.
These existing centres operate on very old work practices. Over the next 3 to 5 years, Coles plans to consolidate a number of these distribution centres and replace them with large, highly automated centres which will drive significant cost efficiencies. While the full impact of these efficiencies will not be seen until 2023-24, we estimate that the company can achieve cost savings of around $1 billion per annum once the new centres are up and running.
In addition, Coles is rolling out a new store format which, to date, has shown early promise. These stores are designed to make better use of the existing floor space and will have a bigger focus on fresh food and ready-to-eat meals, both of which attract relatively high margins.
Why do we still own Coles?
Coles shares have been significantly rerated in the last 12 months and we have trimmed our position into strength. However, given Australia’s growing population and a relatively rational supermarket industry, we continue to hold a core position in Coles.
We believe the significant cost benefits of the new distribution footprint plus the new store format should help earnings grow strongly in the next 3 to 5 years.
Telstra (TLS) shares performed well over the last 12 months, rising over 30%. Telstra recovered some of the losses it suffered during 2017 and 2018 as some the intense mobile competition of the last few years appears to be waning.
Mobile market pricing was led sharply lower by Optus’ aggressive price cuts in a strategy to gain market share. This move by Optus did not achieve the growth in mobile numbers that Optus had hoped. However, it hurt Telstra’s earnings as Telstra responded by lowering its prices to maintain its mobile market share – a move which succeeded as the telco industry leader held its subscriber numbers, as seen in the chart below.
Telstra has a strong lead in mobile subscriber numbers
Source: JP Morgan as of 13 Dec 2019
While Telstra managed to retain its leading market share of the mobile market, the price discounting in the sector had a negative impact on Telstra’s mobile division profits. Optus’ aggressive price cuts - which did not result in any market share increase - resulted in Optus’ profits falling heavily, too. However, in the latter stages of 2019, we have begun to see some early signs of improved competitive conditions, as Optus reduces the discount plans available in the mobile market and Telstra follows suit.
The heightened mobile competition of the last few years has had a significant impact on all three mobile network operators in Australia. While Telstra’s mobile division remains very profitable given its scale, profits at Optus and Vodafone have been extremely poor in recent years as competition has virtually wiped out their returns. We believe higher prices in mobile are now inevitable as all 3 network operators have to generate increased profits and returns on capital to justify the investment required to roll out their 5G networks.
Telstra is now also the market leader in the roll-out of 5G technology. 5G networks will provide faster download speeds as well as drive new uses, such as the internet of things. Working closely with its main 4G equipment supplier, Ericsson, Telstra has been able to seamlessly roll out its new 5G network.
The Australian government ban on using Huawei equipment in 5G networks has caused delays for Optus and Vodafone who had both previously used Huawei equipment in their 4G networks. Since the 4G and 5G networks must work together, Optus and Vodafone have to develop a solution to ensure that whatever equipment they use in their 5G networks will be compatible with their existing 4G networks.
Why do we still own Telstra?
Telstra is in the middle of a $2.5 billion cost-out program which is being rolled out to offset the losses of its fixed-line revenues from the NBN. The mobile market also appears to be becoming more rational as all three players seek to increase returns after aggressive discounting in the market as they have to justify the heavy investment required in this area.
We believe the full benefits of the cost savings and better mobile pricing will help Telstra increase its returns in the next 3 to 5 years and will help underpin the company’s 16 cents a share dividend.
Aurizon (AZJ) shares rallied strongly this year. The company operates two business lines. Aurizon owns the rail network in Queensland, which carries metallurgical coal, used mainly to make iron and steel, and thermal coal, used to generate electricity. Aurizon also owns the above-rail wagons in which it hauls coal through long-term contracts with coal mining companies.
The return Aurizon earns on its rail network is regulated by the Queensland Competition Authority (QCA). In 2018, the QCA proposed a return of 5.4%. This was much lower than expected and led to the stock falling 14% in 2018, which we saw as an opportunity to buy for IML funds.
Over 2019, Aurizon’s relatively new management team worked hard to improve the 5.4% rate of return through discussions with the regulator. As a result of many heated discussions, legal threats and negotiations, Aurizon concluded a new deal, which allows the company to earn a return of 6.3% on its rail network – a far better outcome than previously – in return for more efficient maintenance practices to assist miners’ productivity.
In addition, management has identified a number of cost-out opportunities primarily around the automation of certain maintenance practices which we expect will lead to improved efficiencies and earnings.
Why do we still own Aurizon?
In our view, the relatively new management team at Aurizon, led by Chairman Tim Poole, CEO Andrew Harding and CFO Pam Bains, are doing an excellent job of looking to improve the returns generated by the company.
We still see good, long-term value in the stock with our view underpinned by the 5% fully franked dividend as well as Aurizon’s strong balance sheet which has enabled the company to undertake a recent buyback.
CSL (CSL) is the largest plasma products company in the world. CSL shares had a very strong 2019, rising over 50% on the back of a very strong immunoglobulin (IG) market. IG represents more than half of the company’s revenue.
Over the years, CSL invested heavily in its blood collection centres. The company is now getting the full benefit of this prior investment as demand for IG is forecast to continue to grow globally at 6-8% per annum. Due to increasing awareness as well as new patient groups adopting the product, we saw industry growth rates increase above 10% in 2019.
One of the main reasons for the above-average growth in 2019 was the emergence of a new patient group collectively referred to as secondary immune disorders. These are primarily cancer patients who are now getting treated with new cancer drugs which, while they attack cancer cells, weaken the body’s immune system. It is now becoming common for physicians to treat cancer patients with IG to assist these patients with the recovery of their immune systems post-treatment.
Strong demand for IG has led to tighter supply, which has come about as CSL’s competitors have underinvested in plasma collection over a number of years. As a result, CSL was able to grow market share amid a growing overall market and increased prices for their product.
Why do we still own CSL?
The current tight supply in the IG market will take some time to resolve as it will take their competitors at least 2-3 years to increase their plasma collection. Opening new blood collection centres is a laborious task due to a very strict regulatory framework in most countries.
In addition to the positive fundamentals underpinning the IG market, CSL continues to invest close to US$1 billion in R&D every year with several new products on the horizon. The product that is nearest to launch is a plasma product that has anti-rejection capabilities in transplant surgeries.
CSL continues to invest 10% of its global revenues into R&D
*includes R&D for CSL Behring and Seqirus; m = US$ millions. Source: CSL R&D presentation as of 4 Dec 2019.
While we have trimmed our position in CSL as the shares have rerated significantly, we believe the continued positive dynamics in the IG market as well as new products being developed mean that CSL’s profits look set to continue to increase over the next 3 to 5 years.
Stocks that had a challenging 2019
Despite our detailed research and generally cautious stance towards investing in the Australian sharemarket, we’ve had a couple of stocks which have so far worked out disappointingly.
This can happen often as a result of external factors, such as a change in industry dynamics or other external factors over which management often has little or no control such as a sharp rise in input costs.
Pact Group (PGH) is the largest rigid plastics packaging company in Australia. Its shares fell around 25% over 2019 as the company was impacted by higher input costs – mainly higher resin and electricity prices. It’s also fair to say that management had let the company’s customer service standards slip and was not as disciplined as we had hoped for on capital allocation decisions.
Why do we still own Pact Group?
We continue to hold Pact for several reasons. Firstly, it looks very cheap at current levels on a price earnings multiple of around 10 times (a 50% valuation discount compared to most other industrials). Secondly, we see the appointment of new CEO Sanjay Dayal as a positive. Mr Dayal has a very strong reputation and track record in the manufacturing industry. He is also having a significant impact on improving standards within the organisation.
In addition, we are now starting to see input costs normalise as resin prices fall due to new global supply and as Australian electricity prices stabilise. Rather than being a headwind, this area could become a tailwind for the company’s profits in the years ahead.
Pact’s new CEO is also working on a material cost-out plan for the group which will involve the consolidation of a number of Pact’s manufacturing plants. The size of the cost-out programme will be announced to the market early in the new year.
Mayne Pharma (MYX) had a poor year, falling over 30% primarily due to price deflation in the company’s generics division. This generics price deflation was caused by the consolidation of the number of drug wholesalers in the US from 5 previously to 3 today. The consolidation of major customers led to significant price deflation in the generic US market which will take some time to resolve as weaker generic players exit the industry.
Why do we still own Mayne Pharma?
Mayne Pharma has a much stronger balance sheet than most other generic players in the US. This means that the company is in a much better position than most others in that market to ride out the current weakness in generic pricing. We believe at some stage will see a return to more rational pricing as competitors leave the sector, plants are shut down, and many US generic companies cut back their R&D in this area - which appears to be occuring.
In addition, Mayne Pharma has two other divisions – a contract services and a branded drugs division. We expect both these divisions to post strong growth in the years ahead.
The contract services division is a supplier of contract research and development (R&D) and contract manufacturing to other pharmaceutical companies. This area of the pharmaceutical industry is growing very rapidly, and we expect that this division will grow strongly in coming years as the benefits of a new US$80 million facility based in in Greenville, North Carolina start to come through.
The branded drugs division should also grow strongly in coming years as Mayne Pharma has invested heavily in this division in recent years, and there are a number of new product launches scheduled over the next 6-18 months.
Over the next 12 months, we are looking forward to the following developments in the branded drugs division:
- Strong US growth in Mayne Pharma’s proven anti-fungal drug Tolsura following FDA approval in December 2018
- FDA approval for a new women’s oral contraceptive called Esterol which Mayne Pharma has the rights to distribute in the US and which has far fewer side effects than the current available contraceptive pills
- Mayne’s signing of other licensee arrangements which make it the sole distributor of other branded products into the US market.
Generics currently represents 60% of Mayne Pharma’s earnings, with branded drugs 30% and contract services 10% making up the balance. In the next few years, we believe this mix will change to branded drugs being 55% of earnings, generic drugs 25% and contract services 20%.
This is a big positive for Mayne Pharma because branded drugs have patents that last 10-20 years, so the earnings stream from this division will be far more predictable than those of the generics business.
Once all the above occur, we expect Mayne’s shares should rerate significantly and, thus, are happy to maintain our current holding and to add to our position on any significant further weakness.
Mayne Pharma’s earnings mix as of FY19. . . and forecast future earnings mix
Source: Mayne Pharma FY19 earnings results (left) and IML Research
We continue to look for and invest in companies that fulfil our stock selection criteria, companies that we believe represent value and that we believe should do well in the next 3 to 5 years.
Stocks that fall into this category may not always be popular with many other investors – but if we assess a company to be of sound quality and good value, we are prepared to be patient and own it for the long term.
We believe this patient approach gives management the opportunity to deliver the growth we believe is achievable from the companies we have selected based on their long-term strategies.
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Really disappointing performance from Mayne Phara. Stock gapped down and then seems to drip feed bad news. Because it holds a lot of (shareholder) Capital it can ride out the market problems. Are we relying on the competitors to go broke in the interim or before Mayne Pharma