What makes a company attractive?
While fund managers are reluctant to reveal their newly-found ‘top picks’ to the public, there is an underlying process which can be used to identify an attractive company to invest in.
In every investment magazine and the business section of weekend newspapers you will see a list of hot stock picks from fund managers. Inevitably these picks won’t represent the fund manager’s top new ideas, but rather five large positions in the funds they manage. You will never see the fund manager’s recently uncovered gems in print, as the managers will be busily building these positions in their portfolios and certainly don’t want other investors driving up the price! In the interests of disclosure I have been guilty of doing this myself. In this piece, I take a step back and look at what actually makes a company an attractive investment.
Easy to understand
We are attracted to companies with business models that are simple and can be explained to any client in two sentences or less and where it can be easily identified how the company makes money. Woolworths’ business model is very simple; they buy groceries and liquor from the manufacturers and have the cheapest mechanism for distributing these goods to the consumer.
This point is frequently forgotten during market and credit booms, where complicated businesses thriving off accounting or credit arbitrage can appear to prosper for a certain amount of time. In 2006 I had several meetings with Allco Finance’s management in an attempt to understand the business. The company’s share price had risen 120% in the previous year and not owning it in the portfolio was hurting performance on a relative basis. After the management was unable to explain how Allco made money sustainably, we did not invest. It was bankrupt in the GFC.
Low capital requirements
The best companies to invest in are those that require minimal ongoing capital expenditure to generate a profit. When a company is required to continually make investments just to stay in business, this represents less cash that is available to be returned to shareholders. Pharmaceutical company CSL requires minimal ongoing capital expenditure to produce its medicines outside the company’s research and development budget and this has allowed the company to return $6.1 billion to shareholders since 2010 in dividends and share buy-backs. Conversely Qantas is a capital heavy business which constantly needs to invest (an A380 costs US$414 million) just to remain competitive in the aviation marketplace. Since 2010, Qantas’ annual capital expenditure has been consistently ahead of the cash flow it generates from its operations, which explains why shareholders last saw a dividend in 2009.
Strong barriers to entry
Strong barriers to entry discourage competitors from entering into the market and thus reducing profit margins. Toll road operator Transurban enjoys high barriers from long-life monopolistic assets. There is zero probability of a competitor building a toll road adjacent to the company’s M2 Hills Motorway in Sydney. Conversely, online accommodation company Wotif.com initially enjoyed strong growth after listing in 2006, but has seen its share price and market share fall dramatically, as larger global competitors improved their internet offer. In Wotif.com’s case along with many other tech companies, the barriers to entry tend to be quite low. Generally high barriers to entry, if they can be maintained, translate into higher profits for shareholders.
Non-reliance on government legislation or a single customer
Owning companies whose business models depend on favourable government legislation can be soul-destroying for investors. Investors in Timbercorp and Great Southern saw these billion dollar companies disappear after the government changed the tax treatment of their agricultural schemes. More recently, salary-packager McMillan Shakespeare’s share price fell 55%, wiping $600 million off the company’s market capitalisation in 2013 after the government proposed changes to the salary packaging of car leases. Similarly, a month ago, former market darling Navitas’ shares fell 30% after key partner Macquarie University announced plans to bring Navitas’ university pathways program in-house. Alternatively food and beverage packaging company Amcor attracts very little interest from governments and has a large global spread of customers. Companies with these characteristics tend to have easily forecastable earnings with far fewer nasty surprises for investors.
When we invest in a company we are effectively entrusting our investor’s funds with a company’s management and entrusting them to both grow that capital and provide a stream of income. A key part of the investment process is an assessment of a management team’s competence to run the business and act in the best interests of shareholders. As a fund manager when I walk into a palatial office suite, not only do I see that my investor’s money is paying for that flashy office with the harbour view, but also the management are unlikely to be serious in cutting costs during the down times. Walking into CSL’s office in suburban Melbourne is like stepping into an unrenovated government office building from the 1960s and then in the boardroom it is clear that management are both highly competent and are focused on shareholders.
Furthermore in assessing all companies in our universe we examine executive remuneration versus total shareholder return and penalise companies that are paying management teams that are not delivering returns for shareholders.
We view that over the long term and across a range of market conditions, outperformance will be delivered by owning a portfolio of companies with stable and growing dividends and earnings that have an easily understandable business with barriers to entry that protect margins, have transparent financial accounts and trustworthy and shareholder-friendly management teams.
Hugh Dive is Head of Listed Securities at Philo Capital Advisers where he runs a $550 million portfolio of Australian shares. This article is general in nature and readers should seek their own professional advice before making any financial decisions. Companies mentioned are for purposes of illustration and education only.
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