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Rudi’s View: The Secret Ingredient

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Nov 25 2021

This story features SONIC HEALTHCARE LIMITED, and other companies. For more info SHARE ANALYSIS: SHL

In this week's Weekly Insights:

-The Secret Ingredient
-Conviction Calls
-Research To Download
-All-Weather Model Portfolio

By Rudi Filapek-Vandyck, Editor FNArena

The Secret Ingredient

Imagine two similar companies, competing in the same sector. One is hellbent on doing the right thing, the other cares a lot less about the long-term picture and instead is obsessed with its share price in the short term.

To many an investor, the difference between these two investment options is rarely obvious and mostly simply a matter of personal preference. One year one is in fashion and performs better, the next year the competitor catches up and proves the doubters wrong.

This is where the art of investing shares shows one crucial similarity with the appreciation of visual art: stand too close and you might see a lot of details, but you'll never enjoy the full beauty of the artist's creation.

Let's assume our two companies are equally profitable, which could be something like 25c out of every dollar in sales. The first company decides to invest for longer term benefit, while the second is happy to pay most of it out to happy shareholders.

Usually what happens in the share market is the second company is instantly rewarded while the first one sees its share price being punished for not spending its cash profits on pampering the shareholders. At least, that's what first optics show us, with share prices heading south every time management at a listed company announces increased investment.

It's a tough gig, being at the helm of a publicly listed company, but investors should not assume the share market prevents boards and managers from making long-term decisions; it's just that tough questions will be asked, in particular for unlikely or unproven strategies.

If the first of our companies decides to spend 5c out of the 25c in cash profits each year on future benefits, this is only a headwind in the short term. Once investors get comfortable with the extra spending and the returns that are achieved, and can be expected, today's initial scepticism will turn into tomorrow's reward.

Sure, profits for company number one might start to accelerate faster, though this is not always immediately obvious, certainly not when both companies operate in a booming environment. But everyone can figure out that applying the same valuation multiple for both companies doesn't seem 'fair' or even logical.

For starters: company one could easily report the same profit as company two, it's just that it chooses not to for an identifiable purpose: achieving higher rewards for longer for today's shareholders. Investors in the share market can be emotional, single-eyed and short-term obsessed, but they are not completely without a brain.

Give them enough evidence that those investments bring tangible rewards, and they will sit up and pay attention.

Under favourable circumstances, it is possible there is no genuine difference in profitability between our two competitors, but as investors we do understand that company number one could stop its investment if it wanted, and this would instantly increase its profits and thus the short-term valuation of the business. Thus it makes little sense to value company number one less than its competitor.

One way to close the gap between these two is by applying a slightly higher multiple to the 20c in profits at company one vis-a-vis the 25c reported by number two. After all, company one is not simply throwing those 5c out of the window and the board could stop spending that cash any time.

What we are witnessing here is the birth of a valuation premium.

Any investor unaware of the specifics would look at the face value valuation for both companies and conclude: one is on par with the other but reports less profits and pays a smaller dividend. This makes no sense! The common mistake being made is to declare company one is "expensive".

Logic tells us, it might take a while, but the relative gap in operational performances between our two competitors will widen over time, further enlarging the gap in valuations. Of even more importance is that when the tough times arrive for the industry, and they will, investors will learn one extra invaluable lesson: company one is much better protected than competitor number two.

As with a property that has received no maintenance, when proper headwinds arrive investors might discover there are a lot more leaks in the roof that cause a lot more damage, while the building on the other side is standing firm and tall. There is value in the knowledge the next storm won't simply blow off the roof or decimate the front of the house, though we don't know exactly how much that value is.

The share market does have a collective memory. It builds as booms follow downturns; peaks follow troughs; cycles wind-up and wind-down.

In credit markets, it is but basic practice to reward the most solid and reliable borrower with a loan at lesser cost. In the share market investors have equally come to appreciate the worth of reliability and steadiness, albeit with a less defined, less identifiable benefit, but it is there in the share price valuations for companies that have gained investors' trust and confidence.

It is usually granted to sector leaders with pricing power who have the ability to defend their territory. It may not always be visible or obvious, but continuous investments made can act as a genuine moat around the business, which further adds to investors' confidence and trust.

Understanding the above is appreciating that successful investing is so much more than simply jumping on bombed-out, 'cheap' looking stocks. It also explains why many of the outperformers over the past decade(s) never once landed on the radar of bargain-obsessed, value-seeking investors, but their outperformance stands undisputed.

The above also explains why some companies deserve to be labelled 'High Quality' and others never will, as well as the differences in valuation and share price performances beyond the 'right here, right now'.

Compare Sonic Healthcare ((SHL)) and Healius ((HLS)) and you'd be forgiven to think 'valuation' no longer matters in this market (it still does, rest assured, it's just not as simple as solely applying a multiple on next year's estimated profit). The same can be said about Aristocrat Leisure ((ALL)) versus Ainsworth Game Technology ((AGI)), REA Group ((REA)) versus Domain Australia Holdings ((DHG)), Woolworths ((WOW)) versus Coles Group ((COL)), Hub24 ((HUB)) versus Praemium ((PPS)), Computershare ((CPU)) versus Link Administration ((LNK)), and so forth.

But as with the sector premium granted to CommBank ((CBA)), investors should equally never assume things can never change, or market leaders can never lose their status. In the case of Ramsay Health Care ((RHC)), for example, a generally challenging environment for the private hospitals sector internationally has placed a firm ceiling above the share price since 2016. And who can forget the time when hubris took hold of the board and management at Woolworths with its share price tanking between 2014-2016?

In 2021 it is the status of CommBank versus other banks in Australia that has come under investor scrutiny. Similar to all cited examples, CommBank shares started building a relative valuation premium since the second half of the 1990s, only a handful years after its IPO in 1991. The shares have very rarely not traded on a sector premium since.

The explanation as to why is multi-fold (as is often the case with other examples too). One measurable metric is CommBank's return on equity (RoE) has consistently beaten all others in the sector over the past thirty years. As Australia's dominant retail bank, CommBank has steadfastily enjoyed the largest group of loyal shareholders, which has helped with protecting and maintaining its premium status.

A consistent stream of investments made, while others were um-ing and ah-ing, means CommBank is miles ahead of ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)), and even further ahead of the regionals, when it comes to technology. This might also explain why CommBank has built a track record of the most consistent operational performance for the sector in Australia.

As with other examples, CommBank shares are seldom hailed as an investment opportunity, and banking sector analysts always have a preference for other banks, with CommBank usually placed on number 3 or last in the Big Four picking order. But as with other examples, CommBank shares have significantly outperformed all peers on mid- and longer-term horizons.

On calculations made by analysts at Wilsons recently, total performance of CommBank shares since its IPO thirty years ago is almost twice as high as that of ANZ Bank, the second best performer over that period. Investors might want to take a deep breath and read that last sentence again.

Never the cheapest, steadfastly the superior performer. If only Warren Buffett had been investing in Australian shares, investors and market commentators might be less obsessed with 'cheap' valuations, and with a better understanding of what makes a sustainable, superior, longer-term investment.

Among banks in Australia, CommBank is the only one whose shares have risen above the peak from May-2015 as well as pre-GFC. Berkshire Hathaway would be owning a large chunk of CBA shares today, and of CSL ((CSL)) and a number of the other examples mentioned.

But more than anyone else, Warren Buffett also understands that hubris can just as easily creep into a share price, which is why loyal shareholders could be in for a prolonged re-adjustment, which is another way of stating: don't expect too much for the months ahead.

CommBank is likely to retain its status as Australia's premier bank, but that valuation gap between it and other banks might have blown out too far in recent years. Or as some sector analysts put it post the recent disappointing quarterly market update: it's a bank, not a technology growth stock. And also: it's the superior among peers, but still a bank.

If we take a leaf from history, CommBank shares on average enjoyed a valuation premium of circa 20% versus other banks. Post Royal Commission, that premium had quickly ballooned to 50%-70%, depending on what metric is used. It is this large premium upon the usual premium that has analysts almost in perfect synchronicity expecting relative underperformance for the sector leader in the year ahead.

And it's not as if the sector in general is experiencing boom times.

Of course, those doubting whether CommBank deserves to trade on a higher valuation than the rest of the sector will most likely be proven wrong, as its technological leadership places CBA in a much better position to fend off aggressive fintechs and other changes impacting on the industry over the decade ahead.

In the short term, however, that premium upon the premium remains a problem now that operationally, CommBank has proven just as vulnerable as the lesser gods on the ASX.

As with all other examples, the secret ingredient is what you don't see when you simply look at the share price, the balance sheet or the financial numbers. Only this time, it is working as a negative.

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Next week will be my final Weekly Insights for 2021.

Recent editions of Weekly Insights

Ansell, Mach7, Nitro Software, ResMed And Santos:

https://www.fnarena.com/index.php/2021/11/18/rudis-view-ansell-mach7-nitro-software-resmed-and-santos/

Three Risks Into Year-End:

https://www.fnarena.com/index.php/2021/11/11/rudis-view-three-risks-into-year-end/

Bonds Versus Earnings:

https://www.fnarena.com/index.php/2021/11/04/rudis-view-bonds-versus-earnings/

Australia's Share Market Sweet Spot:

https://www.fnarena.com/index.php/2021/10/28/rudis-view-australias-share-market-sweet-spot/

Conviction Calls

The duo of software sector enthusiasts at Shaw and Partners has stuck with their three sector favourites, in order of preference: Mach7 Technologies ((M7T)), Whispir ((WSP)), and Gentrack Group ((GTK)).

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Guardians of Model Portfolios at stockbroker Morgans didn't think too long before signing up for the opportunity to own extra shares in Aristocrat Leisure ((ALL)) and Macquarie Group ((MQG)) recently (2x capital raisings), but they also made the difficult decision to sell all shares in Magellan Financial Group ((MFG)) for the Growth Model Portfolio.

The latter decision was, on their own admission, "a very difficult call" that has resulted in the Portfolio realising a "chunky loss".

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Market strategists at Canaccord Genuity released their most preferred sector allocations –Best Investment Ideas– which saw Newcrest Mining ((NCM)) being added as a large cap and BlueScope Steel ((BSL)) as a mid-cap idea. Following the merger between the two, Saracen Minerals has been replaced with Northern Star ((NST)).

The full list of Best Investment Ideas, as per below, contains a few odd choices (in my humble view) and I can only think of "too cheap" as a justification for their selection. (Apart from the fact that Amcor doesn't belong under building materials).

Best Investment Ideas by Canaccord Genuity

CYCLICALS

Resources
-BHP Group ((BHP))
-Newcrest Mining
-OZ Minerals ((OZL))
-Iluka Resources ((ILU))
-IGO ((IGO))
-Northern Star
-Gold Road Resources ((GOR))
-Orocobre ((ORE))
-Perseus Mining ((PRU))

Oil&Gas
-Woodside Petroleum ((WPL))
-Origin Energy ((ORG))
-Santos ((STO))
-Carnarvon Petroleum ((CVN))

Banks
-National Australia Bank ((NAB))
-Westpac ((WBC))

Mining Services
-MacMahon Holdings ((MAH))
-Perenti Global ((PRN))

Building Materials
-Amcor ((AMC))
-Reliance Worldwide ((RWC))
-BlueScope Steel
-Calix ((CXL))

Financials
-Macquarie Group
-Insurance Australia Group ((IAG))

Consumer Discretionary
-Dusk Group ((DSK))
-Marley Spoon ((MMM))

SENSITIVES

Industrials
-Brambles ((BXB))
-Aurizon Holdings ((AZJ))
-Cleanaway Waste Management ((CWY))
-Downer EDI ((DOW))
-Electric Optic Systems Holdings ((EOS))
-Fleetwood ((FWD))

Info Tech
-REA Group ((REA))
-Elmo Software ((ELO))
-Whispir

Utilities
-Spark Infrastructure ((SKI))

Infrastructure
-Transurban ((TCL))
-Atlas Arteria ((ALX))

Communication Services
-HT&E ((HT1))

DEFENSIVES

Healthcare
-CSL ((CSL))

Wagering & Gaming
-Aristocrat Leisure
-Tabcorp Holdings ((TAH))

Consumer Staples
-Treasury Wine Estates ((TWE))
-Ricegrowers (SGLLV))

LISTED PROPERTY
-Stockland ((SGP))
-Scentre Group ((SCG))
-Lendlease ((LLC))
-Abacus Property Group ((ABP))

Research To Download

Independent Investment Research (IIR) reports on:

-Clime Capital ((CAM)):

https://www.fnarena.com/downloadfile.php?p=w&n=B27297EB-9DC9-B9F6-E07B75AEA3322184

-Initiation on Loomis Sayles Global Equity Fund ((LSGE)):

https://www.fnarena.com/downloadfile.php?p=w&n=B27DBC6A-0C73-D1C7-6CA1C3453C1FC60F

-Antipodes Global Investment Company ((APL)):

https://www.fnarena.com/downloadfile.php?p=w&n=B28448C8-B597-344F-3F45B008A1853B80

All-Weather Model Portfolio

Since late 2014, the FNArena/Vested Equities All-Weather Model Portfolio has been based upon my research into All-Weather stocks on the ASX.

Monthly Portfolio reviews published in 2021:

-October: https://www.fnarena.com/downloadfile.php?p=w&n=4BA408AC-AF35-78F5-F42D94A2CF808BF1

September: https://www.fnarena.com/downloadfile.php?p=w&n=B6798F75-0375-ACE0-CAB39BEDF04567BE

August: https://www.fnarena.com/downloadfile.php?p=w&n=B674AF06-E339-5816-5FD0DA4AE7D29F80

June/July: https://www.fnarena.com/downloadfile.php?p=w&n=B66CC435-9758-005C-77B2719A92612A9B

May: https://www.fnarena.com/downloadfile.php?p=w&n=B66804C2-BB83-93BF-AEFB5A28EC0E4A5A

April: https://www.fnarena.com/downloadfile.php?p=w&n=B664E73A-FBB4-1456-8EF79590D64EBF29

March: https://www.fnarena.com/downloadfile.php?p=w&n=B66218E0-DB14-B8D4-360E91AE22EA01AC

February: https://www.fnarena.com/downloadfile.php?p=w&n=B65DC629-929F-1743-8FF1EEFE600DF5A8

(This story was written on Monday 22nd November, 2021. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

(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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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $450 (incl GST) for twelve months or $250 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index.php/sign-up/

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CHARTS

ABP AGI ALL ALX AMC ANZ APL AZJ BHP BSL BXB CAM CBA COL CPU CSL CVN CWY CXL DHG DOW DSK ELO EOS FWD GOR GTK HLS HT1 HUB IAG IGO ILU LLC LNK M7T MAH MFG MMM MQG NAB NCM NST ORG OZL PPS PRN PRU REA RHC RWC SCG SGP SHL SKI STO TAH TCL TWE WBC WOW WPL WSP

For more info SHARE ANALYSIS: ABP - ABACUS PROPERTY GROUP

For more info SHARE ANALYSIS: AGI - AINSWORTH GAME TECHNOLOGY LIMITED

For more info SHARE ANALYSIS: ALL - ARISTOCRAT LEISURE LIMITED

For more info SHARE ANALYSIS: ALX - ATLAS ARTERIA

For more info SHARE ANALYSIS: AMC - AMCOR PLC

For more info SHARE ANALYSIS: AZJ - AURIZON HOLDINGS LIMITED

For more info SHARE ANALYSIS: BHP - BHP GROUP LIMITED

For more info SHARE ANALYSIS: BSL - BLUESCOPE STEEL LIMITED

For more info SHARE ANALYSIS: BXB - BRAMBLES LIMITED

For more info SHARE ANALYSIS: CAM - CLIME CAPITAL LIMITED

For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA

For more info SHARE ANALYSIS: COL - COLES GROUP LIMITED

For more info SHARE ANALYSIS: CPU - COMPUTERSHARE LIMITED

For more info SHARE ANALYSIS: CSL - CSL LIMITED

For more info SHARE ANALYSIS: CVN - CARNARVON ENERGY LIMITED

For more info SHARE ANALYSIS: CWY - CLEANAWAY WASTE MANAGEMENT LIMITED

For more info SHARE ANALYSIS: CXL - CALIX LIMITED

For more info SHARE ANALYSIS: DHG - DOMAIN HOLDINGS AUSTRALIA LIMITED

For more info SHARE ANALYSIS: DOW - DOWNER EDI LIMITED

For more info SHARE ANALYSIS: DSK - DUSK GROUP LIMITED

For more info SHARE ANALYSIS: ELO - ELMO SOFTWARE LIMITED

For more info SHARE ANALYSIS: EOS - ELECTRO OPTIC SYSTEMS HOLDINGS LIMITED

For more info SHARE ANALYSIS: FWD - FLEETWOOD LIMITED

For more info SHARE ANALYSIS: GOR - GOLD ROAD RESOURCES LIMITED

For more info SHARE ANALYSIS: GTK - GENTRACK GROUP LIMITED

For more info SHARE ANALYSIS: HLS - HEALIUS LIMITED

For more info SHARE ANALYSIS: HT1 - HT&E LIMITED

For more info SHARE ANALYSIS: HUB - HUB24 LIMITED

For more info SHARE ANALYSIS: IAG - INSURANCE AUSTRALIA GROUP LIMITED

For more info SHARE ANALYSIS: IGO - IGO LIMITED

For more info SHARE ANALYSIS: ILU - ILUKA RESOURCES LIMITED

For more info SHARE ANALYSIS: LLC - LENDLEASE GROUP

For more info SHARE ANALYSIS: LNK - LINK ADMINISTRATION HOLDINGS LIMITED

For more info SHARE ANALYSIS: M7T - MACH7 TECHNOLOGIES LIMITED

For more info SHARE ANALYSIS: MAH - MACMAHON HOLDINGS LIMITED

For more info SHARE ANALYSIS: MFG - MAGELLAN FINANCIAL GROUP LIMITED

For more info SHARE ANALYSIS: MMM - MARLEY SPOON AG

For more info SHARE ANALYSIS: MQG - MACQUARIE GROUP LIMITED

For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED

For more info SHARE ANALYSIS: NCM - NEWCREST MINING LIMITED

For more info SHARE ANALYSIS: NST - NORTHERN STAR RESOURCES LIMITED

For more info SHARE ANALYSIS: ORG - ORIGIN ENERGY LIMITED

For more info SHARE ANALYSIS: OZL - OZ MINERALS LIMITED

For more info SHARE ANALYSIS: PPS - PRAEMIUM LIMITED

For more info SHARE ANALYSIS: PRN - PERENTI GLOBAL LIMITED

For more info SHARE ANALYSIS: PRU - PERSEUS MINING LIMITED

For more info SHARE ANALYSIS: REA - REA GROUP LIMITED

For more info SHARE ANALYSIS: RHC - RAMSAY HEALTH CARE LIMITED

For more info SHARE ANALYSIS: RWC - RELIANCE WORLDWIDE CORP. LIMITED

For more info SHARE ANALYSIS: SCG - SCENTRE GROUP

For more info SHARE ANALYSIS: SGP - STOCKLAND

For more info SHARE ANALYSIS: SHL - SONIC HEALTHCARE LIMITED

For more info SHARE ANALYSIS: SKI - SPARK INFRASTRUCTURE GROUP

For more info SHARE ANALYSIS: STO - SANTOS LIMITED

For more info SHARE ANALYSIS: TAH - TABCORP HOLDINGS LIMITED

For more info SHARE ANALYSIS: TCL - TRANSURBAN GROUP LIMITED

For more info SHARE ANALYSIS: TWE - TREASURY WINE ESTATES LIMITED

For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION

For more info SHARE ANALYSIS: WOW - WOOLWORTHS GROUP LIMITED

For more info SHARE ANALYSIS: WPL - WOODSIDE PETROLEUM LIMITED

For more info SHARE ANALYSIS: WSP - WHISPIR LIMITED