Warren Buffett’s favourite metric is return on equity, or ROE, which gives investors a measure of how well a company’s management team is using its equity to generate value.
CSL is a classic example of a company with a high ROE, and this has been instrumental to its long-term success. Using Bloomberg data, we screened the market to shortlist five midcap stocks that have had an ROE above 15% for each of the last three years.
In this episode of Buy Hold Sell, Jeremy Hook from TMS Capital runs these five names past Jelena Stevanovic from Platypus and James Miller from Firetrail Investments to see if this filter may have picked out the next crop of CSLs.
Jeremy Hook: Welcome to Buy Hold Sell. I’m Jeremy Hook from TMS Capital. With me today on the panel is Jelena Stevanovic from Platypus and James Miller from Firetrail. There are some terrific mid-cap companies in the Australian market, but ones we want to focus on today, for this session, is the ones that return a very good return on equity, something above 15%, three years in a row, in the last three years. And we thank Bloomberg data for that.
We’re going to look firstly at QANTAS. Jelena, what do you think? Buy, hold, sell?
Jelena Stevanovic: It’s a hold for me. Look, QANTAS is operating in a better environment than where it exited second half of last year in terms of fuel costs as well as its international portfolio, but it is trading at a two-times premium to its listed PE. So at this level it’s a hold.
Jeremy Hook: Okay, a hold for you Jelena. James, QANTAS, taking off, buy, hold, sell?
James Miller: QANTAS is a buy. There are two crown jewels in that business. It’s got a frequent flyer business, which is attached to 35% of all credit card transactions in Australia, that’s growing at double digits. And then you’ve got a domestic franchise, which has had five years of industry rationality, so QANTAS is undervalued.
Jeremy Hook: Okay, good one. Medibank Private, since it listed, it hasn’t received much of the rave reviews of a lot of stocks. It’s done pretty well. Buy, hold, sell?
James Miller: Hold on that one. It’s a great asset. It’s about 25% of health insurance members in Australia, and I think that will look attractive to an acquirer at some stage, but right now you’re paying about 21 times PE for not much earnings growth. It’s a hold.
Jeremy Hook: Yeah, they’re losing members and no real earnings growth at the moment, but a good basic business. Buy, hold, sell, Jelena?
Jelena Stevanovic: It’s a sell for me. It’s to your point, trading at a top end of its PE range and EPS growth profile is flat at best. Capping health insurance premium increases is still front of mind on political agenda. All that in mind, hard to see earnings growth.
Jeremy Hook: Okay. And Nick Scali has been a really good stock for a long time, but just last month, a profit warning. Buy, hold, sell?
Jelena Stevanovic: Look, sell for me, despite recent derating. The trading update provided by the company was significantly worse than a lot of its listed peers. It should benefit from improving domestic housing market. However, really, really downbeat trading update. Cannot not question company execution at this point.
Jeremy Hook: Interesting. James, it did bounce after being sold off pretty aggressively. Buy, hold, sell on Nick Scali?
James Miller: It’s a hold for us, and that’s really around timing. It is going to be a great beneficiary of this house price and house transaction lag, but that’s probably six months away.
Jeremy Hook: Yeah. Okay. Now, A2 Milk, since its result in August has gone sour. It’s gone down by $12 now. Is that a buy, hold, sell?
James Miller: It’s a great company and we’ve owned it in the past, but right now, it’s a sell. And the reason for that is that the China infant formula market has got competition heating up, and it has high costs as well in terms of serving the channels there too. So short-term earnings pressure, but medium term, it’s a good company.
Jeremy Hook: Okay. Jelena, A2 Milk, is that to your liking?
Jelena Stevanovic: Look, it’s the hold for me. There’s no doubt the low hanging fruit in the China infant formula market has been picked, and the company needs to invest in various marketing initiatives to grow further, but the US opportunities are immature, and it’s a huge potential. The company has a strong track record of executing. There’s no reason to believe they won’t be able to replicate success in the US market.
Jeremy Hook: Another one going very well in the US as Credit Corp. It’s almost doubled this year. Buy, hold, sell?
Jelena Stevanovic: Sell, purely on valuation. To your point, they have excellent track record of delivering earnings growth, have proven themselves to have good risk management and pricing strategy, but on a valuation, it’s a sell.
Jeremy Hook: Okay. James, do you agree? Is it too expensive? Buy, hold, sell?
James Miller: It’s a hold, and the main reason is valuation. It’s been growing at a great rate because it’s been buying these debt ledgers up to grow earnings, but when cash flow is severely lagged from where earnings are, we struggle with valuation.
Jeremy Hook: So we’ve given you five terrific stocks to look. But James and Jelena quite rightly don’t think all of them are buys at the moment.
This insight was originally posted by Livewire Markets