The Triumph Of Quality

This story features CSL LIMITED, and other companies. For more info SHARE ANALYSIS: CSL

In this week's Weekly Insights (published in two parts):

-The Triumph Of Quality
-Share Market Sweet Spot
-Conviction Calls
-Rudi On TV
-Rudi On Tour

The Triumph Of Quality

By Rudi Filapek-Vandyck, Editor FNArena

By now, most investors would be well aware Australian shares have not kept up with the equities bull market in the US since March 2009; that Australian banks have had a horrible few years during which elevated dividend yields were not enough to compensate for capital erosion; that large cap stocks have noticeably lagged the performance of smaller caps; that value investors have found the going much tougher with investor focus almost solely concentrated on new economy growth stocks, and in energy and mining sectors over the past 18 months.

What is not often mentioned is that investor appetite has equally made a big switch towards higher quality businesses, which is a rather moot point among investors. Everybody likes to think he/she owns the best of breed when it comes to long term holdings. Irrespective, 'quality' is one of those labels that, whilst frequently used, has no strict definition or even commonly agreed upon definition.

For some, Australian banks are 'high quality'. Others use the same term for BHP and for Rio Tinto, at times including Fortescue Metals. I even hear the occasional reference to Telstra and/or TPG Telecom, still, despite years of falling share prices. Management at Mineral Resources is believed to be of 'high quality', but then so is the team at Wesfarmers and they went terribly wrong venturing into the UK.

In my own market analysis, I try to combine generally accepted characteristics of quality, such as a lowly geared balance sheet, sector leading products and services plus a solid track record, with less tangible factors such as industry dynamics and longevity/sustainability of cash, profit growth and margins.

Combining such elements has in the past led me towards global market leaders CSL ((CSL)), ResMed ((RMD)) and Cochlear ((COH)) with the added observation all three share prices have been extremely strong outperformers in years past. But then I also selected Ramsay Health Care ((RHC)) and here loyal shareholders have had a rough experience since 2016.

For a number of years I have been referring to CSL as "probably the highest quality, most successful growth story in Australia". Judging by the share price moving from below $30 to nearly $200 it's probably fair to assume few are today prepared to dispute that statement, but many would be asking the question how much upside is there still left, and should we now not worry more about potential downside?

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Within this context, I observe Lazard fund manager Warryn Robertson recently visited Australia, confiding to the Australian Financial Review his fund currently owns 25 stocks, of which none are listed on the ASX. Lazard includes in its concept of 'quality' the ability to forecast the future with above-average certainty (I consider this characteristic as vital myself) and as such the London-based international funds manager is keeping a keen eye on the three healthcare champion stocks I mentioned earlier, as well as on Ansell ((ANN)).

Lazard doesn't own them, but would like to, at the right price. Instead, companies like Qualcomm, Medtronic, Intel, Oracle, ADP, Unilever and Procter & Gamble currently sit among the 25 stocks held in portfolio.

For Australian investors I think the message here is clear: don't fret about short term risk of a weakening share price. Longer term potential is still very much embedded in these high quality business models. If you are as yet not on board, maybe adopt the same strategy as Lazard: treat weakness as an opportunity with a confident eye into the future.

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Another proponent of investing in high quality companies are the fund managers at Morgan Stanley responsible for the Global Quality fund and the Global Franchise/Brands fund. Even though many of the equities currently held in these funds are trading at a premium to the overall market, the responsible managers don't seem overly worried, instead arguing their investment philosophy about 'quality' includes "resilience".

The latter is seen as a key ingredient for inclusion. Say the managers: companies in portfolio are the ones that keep the lights on, rather than shooting them out. They have been described as get rich slowly schemes. The companies in portfolios are less likely than the market to disappoint significantly on earnings because of their inherent stability.

Nine years into a very strong bull market, and with investor concern likely to increase about interest rates, economic growth and corporate profits, these fund managers believe their funds remain well-protected to the downside because the inherent resilience in the companies owned means less chance for sustained de-ratings on the back of significant disappointment in earnings delivery.

Equity analysts at Morgan Stanley dedicate part of their global research efforts on what they label "Global Best Business Models"; consider this a close nephew of the Champion stocks or the All-Weather concept (whatever label we like to use). Here last week's update by the team of responsible analysts can provide investors in Australia with some valuable insights.

Since December 2016, a selection of 37 "global best business model" equities has generated an equal-weighted total return USD performance of 31.4% between December 2016 and June 30, 2018; well above the MSCI ACWI (widely used as a benchmark for global equities) which "only" generated 23.1% and certainly more than widely used benchmarks such as the Dow Jones Industrial Average, the S&P500 and the S&P/ASX200 in Australia.

The 'Best Business Model' concept tries to distinguish quality from the wannabes in each sector on a global scale. Apart from quality inputs about profits, management and the balance sheet, Morgan Stanley equity analysts also include quant modeling, specific top-down strategies as well as Environmental, Social and Governance (ESG) inputs.

Here the interesting observation is that, according to a study released by the Responsible Investment Association Australasia (RIAA), investment funds implementing core responsible investment strategies (i.e. they incorporate ESG in their portfolio inclusion choices) are outperforming peers both in Australia as well as internationally over most time horizons.

Is this maybe because quality companies led by quality management teams simply score high on governance as well?

Increasingly, professional fund managers are separating quality from lesser quality companies by paying attention to corporate culture. Wall Street legend Paul Tudor-Jones recently explained this as follows: "If you have a motivated workforce that you pay and treat well, you produce a high quality and low-cost product that has some benefit, and you treat your customers throughout with respect, this is a winning formula and these companies are outperforming those that don't."

Now cue the many embarrassing revelations at the Royal Commissions into Banking, Superannuation and Financial Services and into Franchising. Or think about the current situation at Aurizon Holdings where management is operating in open conflict with both regulators and key customers. Should investors be genuinely surprised that Telstra and AMP have lost -70%-80% off their value since the late 1990s?

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Morgan Stanley's selection of Global Best Business Models spans 37 companies, spread over 33 industries across four different regions, but unfortunately, none of the selected companies are listed on the ASX. I think the fact that Australia only represents 2% of equities worldwide probably has a lot to do with this.

Instead, the selection contains companies such as Anheuser-Bush InBev from Belgium, Accenture, Amazon, Boeing and Facebook from the USA, Iberdrola from Spain, LVMH from France, Nestle from Switzerland, Sinopharm Group from China, and TSMC from Taiwan.

Performance for the twelve months to June 30 has been 11.8%, indicating performance overall is slowing, but still good enough to beat the 10.6% achieved by MSCI ACWI. Of equal importance is the observation that 29 of the 36 stocks have performed positively, but seven inclusions thus far are performing negatively. Only twenty of the stocks have outperformed the MSCI ACWI.

Even though Morgan Stanley equity analysts work off a more liberal methodology than myself or the aforementioned fund managers, the underlying basic observation still holds its value for all investors elsewhere: even good companies can at times underperform expectations, the broader market, and their inherent potential.

As a group, higher quality companies are most likely to deliver sustainable rewards for shareholders. Traditionally, their true value starts shining during periods of distress, as also highlighted by the responsible managers for the Morgan Stanley funds, but outperformance has equally occurred for the years past.

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The equity analysts note 17 of the stocks included are rated Overweight by their respective sector analysts (that certainly is "only" 17) with the equally weighted price target upside 17%, +11.7% for the median, with FY18 dividend yield estimated at 2.8%. Some of the best performers seem to have rallied well past intrinsic value (Ferrari) but most are projected to simply add further upside.

Some of the laggards are trading well below Morgan Stanley's price target, such as Brazil's Kroton and Phillip Morris in the USA. Which takes me to two laggards of my own selection of All-Weather Performers here in Australia. One is TechnologyOne ((TNE)) and the second one is Ramsay Health Care ((RHC)).

When I was asked last week to nominate one stock tip for the financial year ahead, I nominated TechnologyOne. My reasoning is that overall sentiment towards the stock has turned too negative, despite the odds remaining in favour of the company continuing to grow at double-digits. Company management even suggested they'll probably be in a position to lift their guidance for annual growth in the not too distant future.

My personal view was backed up on Monday with stockbroker Ord Minnett initiating coverage on four small cap software companies in Australia, and TechnologyOne is the only one starting off with a maiden Buy rating. In line with my own assessment, Ord Minnett sees attractive growth and improving earnings quality. Even on projections that are below company management's long term guidance, Ord Minnett still sees 29% upside from today's share price.

As for Ramsay Health Care, investor sentiment is possibly even worse, which makes Monday's update by CLSA even the more remarkable. Having taken another view into industry dynamics and projections, CLSA remains of the view (with conviction) that today's share price looks way too low on a longer term horizon.

On the stockbroker's observation, public hospitals are not investing in beds, and thus waiting lists will continue to build. This will redirect patients into private hospitals.

Among private hospitals, Ramsay seems to be the only one who is still investing in expansion. Ramsay is planning 13 new operating theatres in 2019 and historically there is a well-established relationship with subsequent EBIT growth one year later. CLSA does not see operating theatres becoming less profitable in Australia.

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As for the FNArena/Vested Equities All-Weather Model Portfolio, total return for the financial year ending on June 30th ex-costs has been 16.59% whereas the ASX200 accumulation index stopped at +13%. The portfolio performance overall was weighed down somewhat by the fact we increased cash levels in anticipation of the risk off environment that, ironically, has actually benefited the Australian share market thus far.

The latter shows up through the fact the Model Portfolio added 1.72% in June, while the index added no less than 3.27%, most of it in the final two weeks of the month. Window dressing by funds managers and profit taking by investors further widened the gap towards the end of the financial year.

Without wanting to sound alarmist, but we think investors should adjust their expectations for the year ahead downwards. If tougher times do announce themselves, we remain as confident as the experts cited earlier that the quality and the resilience of the stocks held in the portfolio will continue to serve their shareholders' best interest, which shall also be reflected in the All-Weather Model Portfolio's performance.

Rudi On TV

This week my appearances on the Sky Business channel are scheduled as follows:

-Tuesday, 11am Skype-link to discuss broker calls
-Thursday, from midday until 2pm
-Friday, 11am, Skype-link to discuss broker calls

Rudi On Tour

-ATAA members presentation Newcastle, 14 July
-AIA National Conference, Gold Coast QLD, June 29-August 1
-ASA Presentation Canberra, 3 August
-Presentation to ASA members and guests Wollongong, on September 11
-Presentation to AIA members and guests Chatswood, on October 10

(This story was written on Monday 9th and Wednesday 11th July 2018. Part One was published on the Monday in the form of an email to paying subscribers at FNArena, and again on Wednesday as a story on the website. Part Two shall be published on the website on Thursday).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.) 

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