Value investors have to act quickly in today’s expensive market for large companies

Thursday, April 20th, 2017

ASX large-caps have rerated due to improving world economic growth and a related reversal of the 2014-16 rotation to small and mid-caps, amongst other sector-specific reasons. There is now very little value in the ASX 50, which means two things: 1) investors need a rational approach for knowing what stocks are worth plus a system which signals when large companies are undervalued and 2) opportunities to buy value in quality ASX large-caps are rare and fleeting, so you have to be quick. Our current experience is these windows last only a few days.

Recently we saw such an opportunity to buy more shares in Ramsay Health Care, one of the ASX’s highest-quality names, for our model portfolio. Between 10 and 16 March, as the stock dipped to an 11-month low of $62.15, we nearly doubled the weighting on the view the stock was as much as 15 per cent undervalued against our 2018 valuation of $73.

We acted quickly because we thought the disappointment dampening the share price was temporary. The stock had trended lower from an overbought peak of $84 in September but dropped sharply after highly regarded CEO Chris Rex unexpectedly announced his retirement at the interim result on 23 February. Profits had risen sixfold during the CEO’s nine-year tenure, so the departure was a shock. Some investors wondered if the outgoing CEO knew something the market didn’t.

Instead we took the view Chris Rex retired because he didn’t desire to lead the company through its next 10-year journey of diversifying away from private hospitals into community healthcare and chronic disease management, where the current expansion in pharmacy is the first step.

We also thought attention would soon return to Ramsay’s consistent profitability, ability to compound earnings at 10% and excellent cash conversion. In a sector with overcapacity in some districts, Ramsay has worked out how to manage local admissions volatility by growing capacity (beds and procedures) in prospective suburbs and regions, maximising the casemix’s profitability and extracting economies of scale in procurement cost savings. Ramsay’s portfolio is less volatile than its industry. Longer-term, demand for healthcare will continue to grow faster than the economy as the population ages.

We also think the model can be exported to countries where private healthcare is prominent. Currently, margins at Ramsay facilities in the UK and France are under some pressure from government tariff cuts and nursing costs but volumes are growing as the public sectors outsource more work and this trend has a long way to run. Further acquisitions in France are likely as Ramsay refines its portfolio to maximise bargaining power with local health authorities.

The French presidential election is probably neutral for healthcare but full success in France, via brownfields expansion, will take some years. Sterling’s depreciation is denying shareholders the benefits of some excellent operational achievements in the UK. It’s necessary to look through these headwinds to the rollout of Ramsay’s successful Australian model over several years, so only long-term shareholders should own this stock.

Interim Australian operating margins surged 77 basis points on solid admissions growth and earnings realisation from previous brownfields expansion. This effect will contribute at least another 20 basis points of margin gain in the second half. The stock has probably levelled out for now around $69 but remains on our watchlist for further buying towards $60 in any market correction.
Originally published in The Australian on Tuesday, 18th April 2017.

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