James Miller, Portfolio Manager
A key aspect of our philosophy is that “every company has a price”. This leads to us looking across the entire market for investment opportunities. In that process we’ve found that a great company doesn’t always translate into a great investment. In fact, in our experience some of the best investment opportunities arise when a company is going through challenging times.
Great companies.….bad investments?
What’s the upside in a company that the market loves? Even if the company has been a great performer in the past, for its share price to continue to outperform it needs to exceed the market’s expectations. This is especially true for companies that are trading at all time high valuation multiples.
In 2015 Telstra was the darling of the Australian telco market. Its key rivals had been underinvesting in their mobile networks. It had negotiated a favourable deal with the government on compensation for the NBN, and the share price was at the highest point since the tech boom of 2000. Everything was going its way!
Fast-forward to 2018 and Telstra’s share price is half that of the 2015 peak. Competitors have reinvested in their networks, and the NBN is now a headwind. Dividends have also been cut by a third. A company that was at the top of its game turned out to be a bad investment in 2015.
Telstra’s earnings estimates have lowered 30% during the period:
Beware of ‘market darlings’
When expectations for “market darlings” are lowered, often the valuation multiple (such as the Price/Earnings ratio) lowers also. If a company is no longer growing as quickly as it used to then why should investors pay such a premium price for the stock?
An example of this in recent years is Domino’s Pizza. This has had both its earnings estimates and valuation multiple reduced. The company has faced challenges including competition from online food order services, franchisee wage audits, and slowing international sales growth. Despite these headwinds the company is still forecast to grow earnings at 20% per year! (Source: Factset consensus, March 2018) But the valuation multiple has fallen from 41x to 27x price to earnings, as earnings growth is still slower than the past. The result: A share price that is down 47% from its 2016 peak.
Domino’s Pizza earnings estimates and valuation multiples have reduced:
Vigilance is certainly required when assessing companies in strong positions, as the two examples above show. Every company has a price, but if there are signs of earnings risk emerging it can be best to steer clear of these ’market darlings’.
Great investments..…bad companies?
Our experience has shown some of the best investment opportunities arise when a company is perceived by the market to be “down and out”. For example, following multiple years of declining earnings, or increased competition in their industry. Human nature often cannot help but look to recent history as a guide for the future. But investing is about looking forward! When expectations for a “down and out” company change, in our opinion, two things will typically occur:
- Earnings expectations increase – the market gains conviction in a turnaround
- Valuation multiples increase – the market re-rates the “cheap” company’s share price upwards
This is the converse of the fall of a great company, and based upon our research can result in significant positive share price performance.
Some great investments over the past few years
The Australian share market has a number of these great investment opportunities. These stocks can be value or growth, large or small, across multiple industries. Whilst the opportunity set is diverse – what is common is that to uncover these unique opportunities requires a fundamental research approach, and conviction to be able to look forward, not backwards.
Some recent great investments in Australia, considered ‘bad companies’ at the time:
The company and year
|The market view at the time||The reality||The share price|
Bluescope Steel in 2015
|A high cost producer of steel in Australia and the US||Steel supply capacity reductions in China and a major cost out program||+326%|
Metcash in 2015
|It’s tough to compete against Coles and Woolworths||Balance sheet repair and cost focus||+198%|
|Qantas in 2014||An airline in a price war with Virgin||Both airlines reduced capacity and increased profitability||
|Treasury Wines in 2014||Tired wine brands and an oversupplied, cyclical industry||Reinvigorated brands sold to a burgeoning Chinese consumer||
|Aristocrat Leisure in 2013||Third largest player in a competitive, declining industry||Games were reinvigorated and competitors overleveraged||
As an investor it is critical to monitor market expectations on both earnings and valuation. Great companies can be harshly treated by the market when earnings are downgraded. Conversely, when market expectations are exceeded for an unloved company it can be a great investment. We believe that in Australia there is an abundance of these opportunities, particularly when you are guided by the philosophy that ‘every company has a price’.
At Firetrail Investments we continue to hunt for the “great” investments, even if the market is calling it a ‘bad company’ at the time.
Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.
Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future. The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.
Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.
Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.