Investing is simple, but never easy. This statement seems to ring particularly true today as the ASX trades close to all-time highs more than 10 years since the last major market crash. Here at Airlie, we're looking for strong balance sheets, high quality management teams, attractive industries, and reasonable valuations - simple, but not easy.
To get an idea of where some of these opportunities can be found today, Frank Casarotti recently sat down with Portfolio Manager, Emma Fisher, to get her take on where she’s finding great opportunities today. They discuss a couple of larger stocks at big discounts to the market, small cap retailers with net cash balance sheets, and a market behemoth that’s poised to keep on growing for many years to come.
Emma, Australian equity valuations look pretty stretched versus historical measures. Where do you see value in 2020?
For us it's always about bottom up stock picking and you're right in the sense that valuations are pretty stretched across the board, but not everything always fires at once. What we're looking for are companies with good balance sheets, good management teams, attractive industry structures, and where we can find them at attractive valuations.
Now in a market like this, that last piece is thin on the ground. Some stocks that make the cut for us at the moment include Mineral Resources and Suncorp. Mineral Resources, it's currently trading on six times EV EBITDA and that is a whopping 40% discount to the market multiple. Now this is a business with a phenomenal track record of shareholder value creation. It's run by a very good management team that have skin in the game. The CEO owns 11% of the shares himself and it has a net cash balance sheet. So the core business that we like is the crushing business, so crushing ore for a number of customers across many commodities in Western Australia. And because it's a crushing business, it's production linked. And what that means is it's very difficult for their customers to swap them out. And you can see this in average customer tenure of over 10 years for the business. We think it's a very attractive business with a good industry structure and we see really no reason for this 40% discount, so that's one that we think is very undervalued.
A very different business that we also like is Suncorp. Suncorp we just see a lot of opportunity for self-help. So the new CEO, Steve Johnson, he's taking a back-to-basics approach and we think that makes sense for insurance, because it really is a nuts and bolts business. There are some headwinds there. The regional banks for example, it's very difficult for regional banks at the moment, but ultimately what we're attracted to is the core insurance business. When you look at its peers, IAG is trading at about five PE points higher valuation. And so we think over time potentially you could see some sort of merger or spin off of their regional bank and that re-rates the business towards the business that we like, which is the insurance business. And as a result, we think that valuation gap versus peer would close. And in the meantime you're getting a very attractive, nearly 6% fully franked dividend yield. Essentially we think you being paid to wait with that one.
You've mentioned balance sheets a couple of times, from an investment perspective, what is it that you look for, especially given the low interest rate environment that we're in at the minute?
When you look across the board, I think corporate Australia balance sheets are in pretty good shape. But I think that the temptation is always there for businesses that shouldn't be carrying a lot of debt, because of the nature of their business model. When the world is awash with cheap debt and low interest rates, the temptation is always there. We're very much alert to that fact at the moment. When we look at the balance sheet, really what we're asking ourselves is what's the right financial structure for the business model? That changes depending on what the nature of the industry is.
For example, when we look at a retailer, those businesses inherently have pretty high operating leverage, so even if no one comes through the door that day, you still have to pay your rent, you still have to pay your wages. We think it's pretty dangerous when you take a business with high operating leverage and you throw in financial leverage as well. When we're looking at a retailer, really we want to see very little debt or no debt. In the fund, the retailers that we are and include Premier Investments, which obviously own Smiggle and Peter Alexander, so there's a global retail rollout story, but it's net cash importantly.
And Nick Scali is the other one. Nick Scali, it's a cheap opportunity there for us because everyone's worried about the housing cycle, but ultimately it's a net cash business model. We have confidence that no matter what the permutations of the cycle look like, we're not really taking the true risk onboard in that investment because of the net cash balance sheet.
CSL is a key holding within the portfolio and we've recently seen its share price hit an all time high. Can you give us a bit of an update on how you see its valuation at the moment?
CSL has been a core portfolio holding as you say since we've launched the fund, and I think something that's often missed in any discussion about CSL's valuation is the fact that it's core product, a product called IG, is a 30 year old therapy, and demand for that therapy has grown at 6 to 8% per annum for 30 years and it's still growing at 8%. I can't think of any other product globally that's got that kind of demand profile. When you're talking one or two years out with near term valuation metrics, you're always going to be missing the point for this company.
Then when we look at the demand side, we see it as very attractive from a structural perspective. And then we look at the supply side, it's a three player market and there's been a lot of change in the other two players in the market in terms of their ownership structure, well for one of them in terms of their ownership structure, it's now into its third set of corporate hands in as many years.
And the implication of that is this a business where if you want to meet the demand that you see in say five years time, you need to be putting into place capital investments today. And so when you've got distracted competitors and when you can see that they're not investing enough today to meet the demand that's coming over the next three to five years, you can come to this conclusion that CSL is poised to take market share in an industry that you'd invest in off its own bat even if they were just growing in line with market with that 8% demand profile. Not only that strong demand profile but layer in the market share gains that we see as a result of their investing ahead of peers, and essentially we gain our conviction in the current valuation from the fact that the industry structure and the demand and supply factors are so favourable for them at the moment.
Westpac's a position in the portfolio. It's topical at the moment. Do you have any comments or learnings from that exposure?
Obviously the Austrac scandal has been very disappointing, but it's actually really just been the final straw in a series of disappointments. You've got a running bill of remediation now. You've got strategic missteps over the last few years, particularly within the wealth business for example. The question for us, it is a portfolio holding and the reason that we are into Westpac and the Commonwealth Bank in the fund is that we think banking is a scale game and so you want to own the scale players. But clearly we didn't foresee this issue and so we've gotten that wrong.
The question is where to now from here? History would suggest that when a bank is completely up against the wall, it's just lost its CEO, its chairman is about to leave, I guess there's a similarity there with the situation that NAB was in around this time last year. History tells us that in the short term these can be good buying opportunities, because you do get a lot of investors selling out.
That said, when we look at banking as a whole in Australia, our concern is with the long-term structural pressures on returns in a low interest rate world. We remain significantly underweight the banking sector, however, we have selectively added to our position in Westpac on the back of this Austrac scandal.