Three companies we're backing whichever way the wind blows

On a windy, rainy, day the streets of Sydney are often littered with cheap, low-quality umbrellas, abandoned by their owners. The same thing happens when stormy weather hits the sharemarket. Investors flee low-quality companies and look for a place to shelter. But while it’s pretty easy to spot a low-quality umbrella, low-quality companies can often seem like they have exciting prospects while in reality they have little substance to them. Definitions of what makes a ‘quality’ company vary and many companies are experts at marketing their positive attributes, while hiding their shortcomings.

At IML our definition of what makes a ‘quality’ company has stayed the same since we started in 1998. We define quality companies as having:

• A competitive advantage
• Recurring earnings
• Capable management
• Reasonable growth prospects.

In times like this, with heightened volatility and uncertainty, quality companies are better placed to ride out the rough weather.

Where to invest amid the volatility and uncertainty

Inflation may have peaked, but exactly where interest rates will end up, and when they’ll start coming down again, is anyone’s guess. Recent banking collapses and ongoing problems in the global financial sector show that increasing interest rates are putting pressure on economies and companies around the world, and causing things to break in unintended ways. Exactly how this will play out, and who will be impacted next, is unclear.

In this uncertain environment, the quality criteria we always look for become even more important. High quality management, in particular, is crucial for companies to be able to manage a changing environment and make good decisions in difficult times. Right now, there are two other criteria that significantly improve company resilience:

• Pricing power/scale – allows companies to raise their prices to offset the increased input costs that accompany higher inflation, also it gives companies the buying power to keep costs lower than competitors.
• Strong balance sheets – give companies security, and the flexibility to make the right long-term decisions even if placed under short-term operational stress.

Three companies that we think meet all of these criteria and are well positioned during this inclement investing weather are: Sonic Healthcare, The Lottery Corporation and Medibank.

Sonic Healthcare (ASX: SHL)

Sonic is an industry leader in medical diagnostics. It’s the number one pathology business in Australia, Germany, Switzerland and the UK and number three in the USA. Like other similar companies, it benefitted strongly from a boost to revenue and profits during peak Covid times. While this one-off boost has now tailed off, Sonic has emerged stronger on the other side.

Here’s three reasons we’re backing Sonic to perform well through this period of uncertainty:

1. Competitive advantage. Over the past three decades, Sonic has continued to invest in growing its business and improving its technology. This has enhanced its brand and created a virtuous cycle where the best medical specialists want to work there and doctors want to refer patients there because they receive excellent service. Sonic’s windfall profits from COVID have significantly strengthened its balance sheet, and it now has little debt and significant capacity to grow via acquisitions.
2. Scale/cost control. Sonic’s strong industry positions and global footprint give it scale and bargaining strength which allows it to drive harder bargains with suppliers that its competitors find hard to match.
3. Good growth prospects. Diagnostic testing is a growing industry: the world’s population is ageing and the increased burden of chronic disease means demand for testing is likely to grow. We think this could drive industry growth around 4% per annum. Amid this overall growth Sonic is likely to grow its market share, both organically and through acquisition. We think it is well placed to deliver consistent growth over the medium to long term.

Medibank Private (ASX: MPL)

In October last year Medibank was in the media for all the wrong reasons. Cybercriminals had hacked into its systems and stolen large volumes of data, then threatened to release the personal information of millions of customers unless it paid a multi-million dollar ransom. As Medibank was pilloried in the press, its share price suffered and investors pondered the impact on its future.

We were already shareholders in Medibank, which scored highly on our quality criteria. With confidence in Medibank’s long-term prospects we took the opportunity to increase our holding while the share price was suffering on the short-term bad news. Now, nearly six months after the incident, we can see what the true impact was. Medibank lost less than 1% of policyholders due to the incident and in fact is now increasing its customer numbers again.

Here’s three reasons we think Medibank is well placed to continue performing well:

1. Strong brand. When it came out of government ownership in 2014-15 it was losing customers, its net promoter scores (NPS – a measure of customer satisfaction) were low and its brand was weak. Medibank then invested heavily in IT infrastructure, customer service, and brand-building and is now Australia’s leading private health insurer with very strong levels of customer satisfaction.
2. Leading position in growth industry. Medibank is Australia’s largest private health insurance company. Australia’s growing and ageing population will need more medical care and investment in the public health sector has been constrained. This, along with the increased importance placed on health through COVID, has helped Medibank’s policy holder numbers to grow around 3% for the past two years.
3. Pricing power/scale. Medibank’s strong brand and leading position within the industry give it a greater ability to keep claims costs down and realise efficiency benefits. It also has the ability to lift prices annually, typically linked to healthcare cost inflation. Finally, its strong balance sheet (no debt) gives it great resilience to ride out any tough economic times, while earnings from its large investment portfolio benefit from rising interest rates.

The Lottery Corporation (ASX: TLC)

The Lottery Corporation has existed as an independent business for less than a year, after it demerged from Tabcorp in May 2022. In our view the lotteries and wagering businesses were fundamentally different, so we were pleased when the board agreed to demerge the two businesses, after much lobbying from us and other shareholders. Since the demerger we think both businesses have improved their competitive position and proved their resiliency.

In its FY23 first half result The Lottery Corporation announced that group revenue was up 8% and both of its business segments (Keno and Lotteries) had grown in terms of customers and revenue. TLC announced an interim dividend of 8c and a special dividend of 1c, both fully franked.

The Lottery Corporation is particularly well placed to ride out these turbulent times. Here’s three reasons why:

1. Strong competitive advantage. TLC is the largest lottery operator in Australia and operates in all states of Australia except Western Australia. It has very high-quality, long-term, monopoly licenses across both Lotteries and Keno, which effectively shut out competition.
2. Resilient, recurring revenue. TLC has a loyal, engaged customer base that continue to use its products through all parts of the economic cycle. When large jackpots occur, participation increases significantly – 1 in 2 Australian adults bought tickets for the $160 million Powerball jackpot in October last year.
3. Good growth prospects. Its revenue grew by a healthy 8% over the last year, but what is more impressive is its profitability – group EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) was up 16%. As more and more of its customer base buy tickets digitally, rather than physical tickets through retailers where they lose a percentage on commission, margins are improving. A few years ago around 15% of customers bought tickets digitally, now it’s 38%. As this trend continues TLC is likely to continue to improve its margins and will also continue to increase the data it holds on its customers, giving it a low-cost, effective direct marketing channel to its customer base.

While its share price has appreciated by around 10% since the demerger, we think it’s still reasonably priced, trading at 25 times price to free cashflow for a monopoly business with strong recurrent earnings, growing both revenue and profit.

Now’s not the time to gamble on quality

Everyone invested in the sharemarket made a lot of money from the long bull market that ran for over a decade after the end of the GFC. Back then everything went up, regardless of its quality or profits, but times have changed. High-quality businesses with strong foundations are performing better and they’re in a much better position to prosper, regardless of what’s happening in the broader economy. These are the types of businesses we are invested in, and the ones we’d recommend investors should focus on.

IML offers a range of Australian equity funds that implement a disciplined bottom-up research process, with the aim of identifying quality and value stocks with a focus on the longer term. To learn more, visit our website or fund profile below.

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