Which house is the better investment?
|House A. A Wooden shack on the outskirts||House B. Harborside mansion|
I’ve asked investors this question many times. Some speculate that the wooden shack is on hectares of valuable land. Most choose the harbourside mansion overlooking Australia’s east coast. But the answer is, we do not know. We are missing the fundamental inputs to make an informed investment decision.
Whether you are investing in real estate, a private venture or a publicly listed company, you need to know the price of the asset. Without a firm view of the quality of the asset and what you are paying for it, you move from the realm of investing into speculation.
At Firetrail, we follow three simple fundamental rules of investing to guide our company research and investment decision making:
- Every company has a price
- Focus on “What Matters”
- Take a longer-term view
In this article, I explore these fundamental principles and provide an example of how you can incorporate them into your own company research, using Qantas Airways (ASX: QAN) as our case study.
Rule 1: Every company has a price
When you are looking to buy a house, most people have a price in mind that will make their purchase a good or bad investment. If you overpay for a house, no matter how nice the home or the suburb, it is likely to turn out to be a bad investment.
Investing in a listed company requires the same thinking. Every company has a price. And the price you pay is a critical factor in whether your investment turns out to be good or bad.
So, how do you compare what different companies are worth?
One of the most used approaches in the equity market is to look at a company’s valuation using a price-to-earnings (P/E) ratio. Commonly referred to as the price multiple, the P/E ratio provides investors with a guide to how much they need to invest to receive a dollar’s worth of earnings in return.
Importantly, P/E ratios (or valuations) are not static. They generally rise when things are going well for a company and fall on the back of negative news. These valuation re-ratings can create opportunities for fundamental investors to uncover undervalued companies.
Qantas has historically traded at a P/E ratio of 9 times – a significant discount to the average Australian listed company, which typically trades at around 16 to 20 times.
The reason for the discount is that Qantas operates in a volatile industry (all global airlines trade at a discount) and its earnings are cyclical – often affected by external events such as travel demand, consumer confidence, oil prices, and a global pandemic!
In March 2020, the Qantas valuation hit a low of around 4 times P/E. Its share price traded from above $7 to a low of almost $2 in under 2 months.
As a fundamental investor, the question for Firetrail team was whether the current price was justified due to the global pandemic, or whether the market had incorrectly extrapolated Qantas’ current misfortunes into the future?
The key to answering this question was to understand “What Matters” for Qantas.
Rule 2: Focus on “What Matters”
When researching a company, it is important to cut through the noise and focus on what will drive the earnings and the share price of the business into the future.
At Firetrail, we call it focusing on “What Matters”. We believe focussed research gives us an edge to uncover opportunities when other investors are distracted by negative news and sentiment.
In March 2020, two key things mattered for Qantas:
- Balance sheet and cashflow: could Qantas survive an extended period of lockdowns?
- The domestic market, which has historically accounted for around 85 per cent of Qantas’ earnings.
The key questions our balance-sheet and cashflow analysis tried to answer were:
- How much cash did Qantas have on its balance sheet?
- How much cash was it burning through in a lockdown scenario?
- What were CEO Alan Joyce and the team doing to raise additional capital and reduce costs?
Following our research on the balance sheet, speaking to management, and our own desktop and field research, we believed Qantas would be able to raise sufficient cash and cut costs to survive until late 2021 in an extended lockdown scenario.
Many investors do not realise Qantas’ international business is only a small driver of company earnings. In FY19, international travel was only around 15 per cent of the airline’s earnings.
The bigger driver of Qantas earnings is the domestic business, including domestic travel (corporate and leisure) and the highly valuable Frequent Flyer business.
In our view, to invest in Qantas you did not need to believe international travel would return anytime soon. But you did need to believe domestic travel would return before international borders opened.
In addition, our analysts’ research indicated that once domestic travel did reopen, Qantas would be in a stronger position than most investors expected, due to:
- Private equity acquisition of key competitor Virgin Australia: Our view was that private equity owners would focus on industry profitability as opposed to market share. As the market leader (around 65 per cent domestic market share) with industry-leading profit margins, Qantas stood to gain the most from a rational competitive environment.
- A transformational cost-out program aimed at reducing the cost base for Qantas: We believed this would result in a leaner Qantas with greater profit potential in the domestic market as travel returned post the pandemic.
- Qantas Frequent Flyer business (QFF): The QFF business had proved resilient during the pandemic. Some of Qantas’ largest customers, such as Woolworths, received record sales and demand for QFF points during the pandemic.
Putting the research together, our analysts believed that:
- Cash: Qantas had sufficient cash to survive an extended period of lockdowns beyond our worst-case scenario domestically.
- Domestic recovery: A rational domestic market, cost-out program, and strong QFF business underpinned a better-than-expected earnings recovery over the medium term.
- Valuation: The current valuation factored too much negative news about international travel into the share price, which was only a small part of Qantas’ earnings.
Rule 3: Taking a longer-term view
The final fundamental principle of investing at Firetrail is to take a longer-term view.
We believe a 3-year view provides a realistic timeframe to be rewarded for your investment. And is a long enough timeframe to differentiate your views from market participants such as sell-side analysts who generally take a 12 to 18-month view, in our experience.
Firetrail materially increased its position in Qantas during March 2020, almost doubling our investment following our company research focussed on the fundamentals, including valuation, earnings drivers (What Matters), and taking a longer-term view.
Today, the Qantas share price has more than doubled from that investment in March 2020 to around $5 per share in late April 2021.