Equities

A key aspect of our philosophy is that “every company has a price”. This leads to us looking across the entire market for investment opportunities. In that process we’ve found that a great company doesn’t always translate into a great investment.  In fact, in our experience some of the best investment opportunities arise when a company is going through challenging times.
 

Great companies.….bad investments?

What’s the upside in a company that the market loves?  Even if the company has been a great performer in the past, for its share price to continue to outperform it needs to exceed the market’s expectations. This is especially true for companies that are trading at all time high valuation multiples.

Telstra

In 2015 Telstra was the darling of the Australian telco market. Its key rivals had been underinvesting in their mobile networks. It had negotiated a favourable deal with the government on compensation for the NBN, and the share price was at the highest point since the tech boom of 2000. Everything was going its way!

Fast-forward to 2018 and Telstra’s share price is half that of the 2015 peak. Competitors have reinvested in their networks, and the NBN is now a headwind. Dividends have also been cut by a third. A company that was at the top of its game turned out to be a bad investment in 2015.

Telstra's earnings estimates have lowered 30% over 3 years:

Source: Factset

Beware of ‘market darlings’

When expectations for “market darlings” are lowered, often the valuation multiple (such as the Price/Earnings ratio) lowers also. If a company is no longer growing as quickly as it used to then why should investors pay such a premium price for the stock?
 

Domino’s Pizza

An example of this in recent years is Domino’s Pizza. This has had both its earnings estimates and valuation multiple reduced. The company has faced challenges including competition from online food order services, franchisee wage audits, and slowing international sales growth.  Despite these headwinds the company is still forecast to grow earnings at >15% per year! (Source: Factset consensus, September 2018) But the valuation multiple has fallen from 46x to 28x price to earnings, as earnings growth is still slower than the past. The result: A share price that is down 30% from its 2016 peak.

 

Domino's Pizza earnings estimates and valuation multiples have reduced: 

Sources: Factset 

Vigilance is certainly required when assessing companies in strong positions, as the two examples above show. Every company has a price, but if there are signs of earnings risk emerging it can be best to steer clear of these ’market darlings’.
 

Great investments..…bad companies?

Our experience has shown some of the best investment opportunities arise when a company is perceived by the market to be “down and out”.  For example, following multiple years of declining earnings, or increased competition in their industry.  Human nature often cannot help but look to recent history as a guide for the future. But investing is about looking forward! When expectations for a “down and out” company change, in our opinion, two things will typically occur:

1.  Earnings expectations increase – the market gains conviction in a turnaround

2. Valuation multiples increase - the market re-rates the “cheap” company’s share price upwards

This is the converse of the fall of a great company, and based upon our research can result in significant positive share price performance.
 

Some great investments over the past few years

The Australian share market has a number of these great investment opportunities. These stocks can be value or growth, large or small, across multiple industries. Whilst the opportunity set is diverse - what is common is that to uncover these unique opportunities requires a fundamental research approach, and conviction to be able to look forward, not backwards.

 

Some recent great investments in Australia, considered ‘bad companies’ at the time:

 

The company and year

The market view at the time

The reality

The share price

Bluescope Steel in 2015

A high cost producer of steel in Australia and the US

Steel supply capacity reductions in China and a major cost out program

+379%

Metcash in 2015

It’s tough to compete against Coles and Woolworths

Balance sheet repair and cost focus

+172%

Qantas in 2014

An airline in a price war with Virgin

Both airlines reduced capacity and increased profitability

+430%

Treasury Wines in 2014

Tired wine brands and an oversupplied, cyclical industry

Reinvigorated brands sold to a burgeoning Chinese consumer

+358%

Aristocrat Leisure in 2013

Third largest player in a competitive, declining industry

Games were reinvigorated and competitors overleveraged

+710%

Summary

As an investor it is critical to monitor market expectations on both earnings and valuation. Great companies can be harshly treated by the market when earnings are downgraded. Conversely, when market expectations are exceeded for an unloved company it can be a great investment. We believe that in Australia there is an abundance of these opportunities, particularly when you are guided by the philosophy that ‘every company has a price’.

For further insights from the team at Firetrail Investments, please visit our website



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