Lessons from an analyst

Thursday, March 10th, 2016

Jonathan Wilson

Written by Jonathan Wilson, Analyst, StocksInValue

Original article first published in StocksInValue


Equities investing is a journey of continuous education. This being my first thought piece in the series I thought it would be a good time to share a few things I’ve learnt about investing in my first year as an analyst with StocksInValue / Clime Group.

My formal education was largely based around Modern Finance Theory, where risk equals volatility, markets are always efficient and optimal investment portfolios are mathematically derived. But theories are only as good as their assumptions and ability to describe reality. Investors who focus on earnings quality, downside protection and optionality can do very well in spite of the theory.

The following are some points I didn’t fully appreciate at first but became more apparent in practice so I hope they’re useful things to consider for you too.

lessons-learned-final

1. The ASX is a top-heavy market

A striking feature of the ASX is just how top-heavy it is. The ASX200 index is typically referenced to summarise market events and changes, however it’s not often accompanied with the distribution of market value across its constituents. As shown below the largest 20 stocks make up 56% of the ASX 200’s (float-adjusted) capital.

With little constituent turnover the ASX 20 is dominated by financials, including the big four banks, and resources companies, including BHP, RIO Tinto and Woodside, which grew to their large sizes on the back of the respective cycles of falling costs of debt (from ~1990) and the mining boom (from ~2000). The resources cycle began to unwind from 2011 while the banks’ profitability climbed until 2015 when higher capital requirements were introduced to address accumulating risks across the sector.

Reviewing the one year performance across indices we can see the ASX 20 accounted for 84% of the ASX 200’s falls, and that the decline of the remaining constituents was modest.

Market cap (float-adjusted) of constituents  ($t)One year change (%)One year change ($b)Incremental change ($b)
ASX200

1.39

-15.24%

-249.85

-12.99

ASX100

1.26

-15.82%

-236.86

-13.88

ASX50

1.06

-17.38%

-222.98

-12.78

ASX20

0.776

-21.31%

-210.19

-210.19

 

The concentration of market liquidity in unpredictable commodity-type businesses operating near or past cyclical peaks makes for a more challenging funds management environment. Large companies with predictable long term earnings are in short supply. As the tide recedes conservative positioning and downside protection will become an increasingly important differentiator. We will probably also see growing demand for higher quality businesses with more stable and ongoing sources of demand.

2. Australian banks are risky

Though Australia’s major miners and banks are some of the best in the world and should remain so through the cycle, outcomes for investors are less certain. This is obvious for mining stocks but perhaps less so for banks after more than two decades of almost uninterrupted year on year earnings growth.

A buy and hold strategy over this period yielded outstanding results, especially for investors in CBA, WBC and ANZ, however the situation today is different. Previous earnings growth coincided with rapid household debt expansion, mainly in mortgages, which account for around two thirds of the banks’ loan books.

Banks are now challenged by the nexus of record house prices, particularly in the Sydney and Melbourne, record household debt, historically low interest rates, historically low provisions for bad debts, and increasingly uncertain wholesale funding costs (about a third of bank funding is sourced from wholesalers). There is a more tenuous balance between credit growth and lending standards. The risk is a spike in funding costs results in impaired loans at the tail of the banks’ stretched mortgage books, which could reduce earnings significantly or even result in losses.

3. Investor competition is much stronger in large caps

The ASX is also top-heavy in the degree of competition among investors across the market capitalisation spectrum. There are on average 15 institutional research analysts covering $10b-plus market cap companies, however the average number of analysts per stocks falls to less than one for sub-$100m market cap companies. This suggests large companies are likely to be more efficiently priced, while the less-researched small cap segments should generally provide more opportunities to exploit mispricing for individual investors who do their homework. Fund managers are often unable to participate in such opportunities because the stocks aren’t liquid enough.

Although there’s less competition the small cap universe contains early-stage and failing businesses that are highly unpredictable, so it is also an area of market to be extremely cautious in.

Market capAverage analysts per company
10b to 100b

15.2

1b to 10b

10.7

0.1b to 1b

3.0

less than 0.1b

0.2

4. Some stocks can be valued, others can’t

Valuations are just an estimate of the present value of expected cashflows and are only plausible when the model assumptions are reasonable for the company in question.

At some level model assumptions are unrealistic for any company. The key question is what kind of companies are most suited? They are those that are likely to continue operating, reinvesting and maintaining its competitive position over the long term. Value investing is therefore applicable to high quality businesses. There is no such thing as a cheap, low-quality business, if the valuation is based on a discounted cashflow calculation.

Valuation is less-suited to companies whose performance is driven by external factors such as commodity prices, currency, lumpy income sources such as contracts, or companies for which there is low of certainty of ongoing demand.

The point is investors should calibrate their scepticism of certain valuations with their model’s assumptions and their understanding of the sustainability of company drivers.

5. Selecting stocks by ‘nature’ is easiest way to limit exposure to significant downside risks

The most efficient way to reduce catastrophe risk and generate satisfactory returns is to restrict investments to conservatively financed, cash generating businesses whose revenues and earnings are recurring in nature, and to not overpay for them.

Digital marketplaces and enterprise software as a service providers can be particularly good examples of businesses of this nature.

Successful digital market places often benefit from network effects, which can lead to a monopoly industry structure. As we have witnessed with the likes of REA Group (REA), Carsales (CAR), Seek (SEK), and ASX (ASX), the dominant player’s market position is incredibly difficult to disrupt. They have a consistent source revenues from ongoing activity, and their capital-light nature translates to strong free cash flows, which can be put to platform enhancements to further pricing power.

The main downside risk for these businesses is competitive erosion of their market position, which is at least visible and can be tracked over time, unlike many commodity businesses whose risks are often hidden.

Enterprise software businesses such as Technology One (TNE), Objective Corp (OCL), Hansen Technologies (HSN), Infomedia (IFM), Iress (IRE), and Rhipe (RHP) provide products that are critical for the daily operations of their customers. High switching costs result in a sticky customer base from which the service providers generate recurring revenues. With the shift to ‘as a service’ delivery over the cloud, periodic subscription payments produce more reliable and predictable revenue streams, allowing for more effective planning of costs and strategies.

The key attraction of these businesses is their grip over customers. By simply considering a business’s power over consumers we can sort those we want to own and those we don’t.

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7 Responses to “Lessons from an analyst”

  1. Peter Turnbull says:

    Hi Jonathon I totally agree with your five points however it is important to note that client risk profile is an important factor in stock selection as are the clients current and future income and Capital Growth needs As part of my qualifications and work experience over 55 years i have found that a knowledge of market psychology is as equally as important as technical skills and client profile Peter Turnbull

  2. A Webb says:

    Thank you. A really clearly “argued” set of points presented briefly.

  3. Alec G. Wood says:

    Excellent comment Jonathan. Look forward to more insightful comment and analysis.

  4. Bruce Aulabaugh says:

    Your reflections are much valued. Should an investor look outside standard equities to preferreds and corp bonds/hybrids of the top heavy asx to maximize risk/ return? Do you have scope to consider those in portfolio formation?

  5. Patrick says:

    Great article Jonathan. I’m not sure I can agree with you on this point, however:

    “There is no such thing as a cheap, low-quality business if the valuation is based on a discounted cash flow calculation.”

    Warren Buffett, Walter Schloss and Benjamin Graham (to name a few) have all made good money investing in cheap, low-quality stocks. I expect there’s a few Australian fund managers (who I won’t mention by name) who might disagree that DCF isn’t applicable too.

    Personally, I think DCF has a place, as does valuation based on ROE and book value. Different types of stock can be valued using different methods, I don’t think there’s a universally right or wrong answer. DCF certainly has its drawbacks (like being based on the EMH for one), but that doesn’t mean it serves no purpose.

  6. Jonathan says:

    Thanks for your comment Patrick.

    I should elaborate because it’s a strong statement. I’d agree that ostensibly low quality businesses can make good investments provided there’s downside protection. Say a business generates low and unpredictable returns but has a pristine balance sheet. It could certainly be viewed as cheap if the stock trades near or below book value and capital requirements a low.

    However by ‘low quality’ I had in mind businesses with a combination of both high gearing and weak and unpredictable cash flows. The downside can be extreme and permanent so as a general point it’s best to just avoid them. In some cases I think DCF’s can be less than helpful.

  7. RG says:

    Well stated Jonathan. Particularly the ability to generate free cashflow from light capital requirements. Extremely poignant in the current economic environment.

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