Rudi’s View: The Secret Ingredient

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

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.

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