The attributes of a long-term winner

Kate Howitt

Fidelity International

A couple of years ago I bought an orange blazer. At the time I felt incredibly stylish and on-trend. But about six months later the romance was over - whenever I pulled it out to wear I felt like I was putting on a high-vis jacket to go onto a worksite. Since then, it has sat crumpled in the back of the wardrobe. Clearly, that purchase was fashion, not style.

Interestingly, when I was buying the orange blazer I also grabbed a well-priced orange and beige chiffon scarf. These days, even years later, I still pull out that scarf regularly. It provides a shot of colour to liven up a subdued outfit, and its lightweight nature means I can stuff in a bag and pull it out if necessary. It has become a staple piece for me for the colder half of every year. So, the jacket came & went in record time, but the scarf has been a keeper.

Now most people who know me would agree that there’s a reason why I’m an investor not an Instagram fashion blogger. But when we are investing we’re making similar decisions about how to spend our money. So what questions can you ask yourself, to make sure you’re buying a must-have piece with longevity, not just a trendy piece you’ll be wanting to quietly dispose of in six or twelve months? In investing terms, what’s the different between a short-term trade and a long-term winner?

Trades vs long term winners 

Well what makes any stock attractive? It’s when we think the current market price isn’t reflective of the underlying value of the business. But we need to be clear on timeframes. If we just want to find something that is cheap today, then we care about its price today vs its value today. We don’t need to worry too much about what it will be worth in 5- or 10-years’ time. But if we want to own something for the long haul, then the valuation we care about is its value in 5 or 10 years. The largest and surest gains come from owning a business which is growing its value through the years. A long-term winner is a stock you can buy and grow with; it’s where your expected uplift comes from the underlying value going up, rather than a mispricing between current price and current value reducing.

The key is to understand the “value creation trajectory” of stocks. In simplest terms, it’s the slope of the line you plot between its value today, next year, and every year after that. Buying stocks with a steeper trajectory will result in greater value in the future - and avoids the costs of rapid turnover in your fund.

What is a "thoroughbred" business?

In economic terms, the drivers of that trajectory are straightforward: the best and steadiest gains will come from companies which have a high return on capital - and which can reinvest those returns to generate further incremental returns. In my investment process I call these businesses “thoroughbreds” - they have the high cash generation of “cash cows” combined with the big growth prospects of “pups”. Thoroughbreds have high returns (ROE, ROIC, CFROI…) and high growth (asset CAGR, revenue CAGR, eps CAGR).

The numbers on a spreadsheet are only as good as the assumptions that go into them. 

To believe that a business can sustain high returns and high growth, they need to have some important - and rare - attributes. Economic theory says that high returns will be competed away. Companies can only sustain high returns when they have competitive advantage, i.e. what Warren Buffett calls a “moat” which stops competitors from eroding their returns. To generate high returns on an expanding asset base the company actually needs to have something like an “expandable moat”.

True competitive advantage is rare, and competitive advantage that can be grown not just defended is even rarer. But we are seeing more and more examples of this. Why? Network effects. When a successful network is created, it delivers more value to users (and owners) the larger it gets. And networks mostly arise from technology - think phones and fax machines. These days, networks effects are even more powerful, since they can be driven by software, without even the cost of hardware. Think of how much more attractive Amazon is to sellers and users than a corner store. For sellers, Amazon offers many more buyers, and for buyers, there are so many more jackets and scarves to be found on Amazon than any physical location could offer.

What other attributes does a “thoroughbred” company need? The other crucial aspect is management. Fast growing businesses are dynamic, and high levels of investment mean lots of potential mistakes. A business can have terrific network effects - but if the team at the helm has weak strategic skills, poor deal-making skills or uncertain ethical standards then the business won’t live up to its potential.

One company that makes the grade

So, what’s a stock in Australia that has these characteristics and could be a long-term winner? A key pick for us is WiseTech Global (WTC). WiseTech’s returns are around 20%, and its earnings are growing at around 30%. What drives these high returns and strong reinvestment? For 25 years WiseTech has been carefully piecing together the world’s disjointed logistics datasets and thereby solving “pain points” for global logistics suppliers. Tariff tables in Poland? Tick. Customs clearance in Brazil? Tick. Shipping container rates in the South China Sea? Tick. And this network has become more valuable as the world’s trade has shifted at the margin from large lot sizes to smaller ecommerce packages whizzing around the world. The WiseTech's core product, CargoWise One, means that data for an international shipment can be entered once only, rather than multiple times throughout the chain. 

This reduces time, effort and error rates, creating value for all users.

Our confidence that the business can continue to deliver its high returns and high growth rates is supported by ongoing involvement of Richard White, WiseTech’s founder. Richard continues to own a very substantial portion of the company, which means his interests are fully aligned with other shareholders. And whilst we reckon he’d look good in a hoodie, Richard is a lot older than your typical Silicon Valley entrepreneur. His experience and track record, and the calibre of the team he has assembled around him, also argue for the business to live up to its potential.

Now the first rule of investing is “past performance is no guarantee of future returns.” We’re sure the future will have some twists and turns for WiseTech. Current consensus expects EPS to grow 37% compound over the next few years. If we were to straight line the business from here, and grow earnings at a slightly more conservative 30%, and if we set the 3 year forward PE to 40x rather than its current 58x, then in 5 years’ time the business would be worth over $17 billion - which would put it into the ASX20. 

Of course, this is an arithmetic exercise, not a forecast and most businesses find that their growth rate slows as their asset base gets larger. And of course, WiseTech’s current PE is very high, and at some point in the next 5 years the market could easily revert back to much lower PEs much more in line with historical norms. But the direction of travel of the business’ fundamentals is clear.

As with everything in investing, it’s always good to check your conclusions. So, it’s heartening to see that our attraction to “thoroughbreds” lines up with Warren Buffet who said:

“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return”. 

We’re not sure how Buffett would feel about buying into a stock that today is on a one year forward PE of 100x as WiseTech is, but we’re confident that he would appreciate the underlying economics of the WiseTech business. And we know that on a crisp autumn morning Buffet would look and feel great in an orange and beige chiffon scarf.

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Kate Howitt
Kate Howitt
Portfolio Manager, Australian Equities
Fidelity International

Kate has sole responsibility for the Fidelity Australian Opportunities Fund. In 2015 she was named Money Management’s Women in Financial Services Investor of the Year, and in 2016 was included in CNBC's "world's top 20 female portfolio managers".

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