Investors Love Quality Businesses but at what Cost

Australian Growth Firms

At times capital markets could be extremely optimistic as well as exceptionally pessimistic, and the expectations bar of investors often plays an important role in empowering the optimism, while a reality-check usually sends pessimistic waves.

A report by a global investment bank suggests that high growth firms in Australia are the most expensive ones across the global markets, as the medium P/E of high growth firms in the country is highest compared to any market.

Short activists have targeted Australian companies this year, dragging the stock prices to lower levels. In August, Rural Funds Group (ASX: RFF) – an ASX-listed agricultural REIT was targeted by a short seller, sending stock price down by just over 42%, presently the stock is available at $1.71 with an annual dividend yield of 6.07% on 8 November 2019.

In September, RFF was again attacked by a short seller, and the stock crashed by around 12%. In FY 2019 for the period ended 30 June 2019, RFF paid a total of 10.43 cents in distributions compared to 10.03 cents in FY 2018.

Last month, WiseTech Global Limited (ASX: WTC), which trades around at a P/E of 150x, was on the radar of a short seller for accusations, including inflation accounting and misrepresentation of financial statements that saw the erosion of substantial investor’s wealth.

WiseTech Global, Altium Limited (ASX: ALU), Appen Limited (ASX: APX), and IDP Education Limited (ASX: IEL) are among the high growth firms in Australia. In August, these companies disclosed full-year results except for Appen, which disclosed half-year results.

Post disclosure, only two of the four companies were trading higher – WTC and ALU, while APX & IEL lost substantial gains.

Legendary investor, Philip Fisher, stated:

One should also note that good quality businesses with reasonable prospects often command high P/E compared to other average businesses, and maybe sometimes the high P/E reflects intrinsic value rather than discounting for future growth.

Investors across the globe have an affinity towards quality stocks and in the era of low growth, the rush towards quality growth stocks is intensified further.

How to spot quality?

Quality businesses have certain unique traits that help them command a premium in the market. Few of the common and time-tested ones are discussed below.

Innovation

Apple launches at least two iPhones a year, and the company has other businesses as well including Mac, iPad, ear pods, watches, among others. The innovation follows in each of the product, making them much efficient, reliable and equipped with new technologies.

Innovation has been at the forefront of many high-growth firms, and it is a building block for companies trying to achieve product differentiation, gain market share, consumer preference, and most importantly, growth.

Investors should look at the expenses incurred by the company in research and development, employees, and capabilities. It is also important to note whether the investments in enhancing capabilities are delivering adequate results.

Management

Successful management is often recognised for its effective decisionmaking capability, strategies, and execution skills.

Treasury Wines Estates Limited (ASX:TWE) had announced last month that its CEO, Mr Michael Clarke would be leaving the company next year; this news had wiped out gains from the market value after the release.

Mr Clarke had been doing a solid job at the helm, growing revenues of the company from ~$1.79 billion in FY 2014 to ~$2.88 billion in FY 2019. And, this speaks the volume of effective management along with its impact on share prices.

One of the most critical decisions that managers have to make are related to capital management of the company. Efficient capital management would be perhaps the most important factor for a going concern of a company.

Management together with the board members plays an important role in making decisions related to capital management, including dividend, sources of financing, investment, and savings. Frugal decisions are always favourable for a firm, and cost-benefit analysis of the decision also plays a critical role as well.

Cash Flows

High growth companies generally burn more cash than other companies, and it could be due to various reasons, including capital expenditure and revenue expenditure. Cash flow-based principles are said to be a better indicator in growth companies compared to earning based principles, as it will help the investor to validate the quality of the earnings.

Economic Moat

This term was popularised by Warren Buffett, primarily focusing on the competitive advantages required to be maintained by the firm in order to continue with its consistency in the long-term.

The concept is based on continuously improving competitive advantages, including cost advantages, scale advantages, intangibles, or maybe exceptional management. Such companies are usually able to grow the incremental capital at higher ROE, as the moat protects the business from competitive forces eating away its returns.

Some examples:

• Any firm investing substantial capital in maintaining and growing its valuable intangible assets, including patents, copyrights, human capital etc.
• Joining forces with the most prolific competitor, which was seen in the merger of Automotive Holdings Group Limited (ASX: AHG) & A.P. Eagers Limited (ASX: APE).

Scuttlebutt

Perhaps the most effective research techniques adopted by smart investors. In this, the idea is based on the observations of our daily lives, and the impact of those observations on companies. This also includes collaborating with people, society, employees, customers to receive insights from the ground.

As such, Peter Lynch – a renowned money manager, stated that the investment ideas he developed while walking in shopping centres, talking with his wife had generated better than average results.

For example – Gleaning information about the reasons for the declining population of lambs in Australia from farmers, farm loan providers, meat industry, etc. could give better insights, than just relying on media reports.

Growth Stocks by T Rowe Price

Mr Thomas Row Price was the founder of T Row Price Inc, and he is called the father of growth investing. He stated that earnings per share should increase at a rate more than the prevailing rate of inflation, allowing the investors to retain growth in purchasing power terms.

He also said a cyclical slowdown causing the earnings growth to decline might not be the end of growth for the firm, and the reverse is true in the periods of a cyclical recovery. Moreover, investors should be careful when a cyclical recovery results in earnings growth and avoid mistaking the companies as growth stocks.

Price briefly used price-to-earnings multiples in his valuation techniques, evaluating multiples with historical data, and preferring not to pick stocks at high price-to-earnings multiples compared to the historical average.

Price often picked the companies well before markets, while building stakes in those companies when they are smaller and unnoticeable in the markets. He believed that growth stocks should be held in the portfolio until the time growth in these businesses stops or they were no longer growth stocks.

Reasonable Price

Entering positions in a quality company is a critical decision that an investor is required to make for capital allocation. And, fear of missing out has led investors to chase quality companies regardless of their valuations.

As WiseTech trades around at a P/E of 150x, meaning at these constant earnings per share each year with no growth, the investment would take around 150 years to recover the cost paid at the time of acquiring shares in per share earning terms.

Valuation becomes imperative to build a successful long-term portfolio.

Cash flow based techniques are popular when valuing a growth company. Discounted cash flow valuations are widely used in projecting a company’s intrinsic value, using discounted future free cash flows projections.

Effective prediction of FCF would require an assumption about the future state of industry and company, projecting the company’s growth in revenues, operating margins, capital costs, and return of invested capital.

Thus, understanding quality businesses’ and the role of valuation helps the investor to build a good long-term portfolio with a higher probability of success vis-a-vis chasing quality stocks at unreasonable valuations and better understand the value gap in prevailing market price.

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