Growth vs Value (Part 2) – Are value stocks at an inflection point?

Growth vs Value (Part 2) – Are value stocks at an inflection point?

James Miller, Portfolio Manager

Are value stocks at an inflection point?

In almost 20 years of Australian equity market data seen in the chart below, we have observed five distinct growth and value cycles as defined by MSCI Australia. The most recent of these market cycles started around January 2017, a period where ‘growth’ companies have outperformed ‘value’ stocks by approximately 16% p.a. as indicated by the upward sloping trendline.

Source: MSCI Australia

The recent outperformance of growth vs value stocks has led to some market commentators to ask the question, ‘Is value investing dead?’

However, in September 2019 we saw Australian ‘value’ stocks stage a short and sharp recovery, outperforming growth by approximately 4%. And whilst one month’s data point is not a trend, it is a timely reminder that markets move in cycles. And this market cycle is as likely to come to an end as previous growth cycles have done in the past. So, is this the turning point for value stocks? This is a topic we covered in detail in a recent article here.

What factors could have triggered the sudden reversal in trend for value?

With the benefit of hindsight, there are several factors that contributed to the sudden reversal in the trend for value. The most powerful of these was the calming of geopolitical risk. In particular, the de-escalation and potential calming of the trade war between the US and China, as well as a higher probability of a Brexit deal between the UK and Europe.

The above factors triggered a rise in bond yields. Growth and defensive assets subsequently underperformed. And value outperformed. But the rally in value has been relatively subdued. To get a broad-based and sustained rally in value stocks, fiscal stimulus is required to ‘lift all boats’ across the economy, rather than just low interest rates driving asset prices higher.

As an investor, how do you position your portfolio for potentially sharp changes in market cycles? Our approach is to focus on bottom-up stock selection, take a longer-term view, and invest in the best growth AND value companies we can find across the Australian market. We don’t try to predict the next Trump tweet or try to time the turning point in growth and value cycles (both of which we believe are near impossible to predict). Instead, we focus on the company specific opportunities and aim to buy companies at a material discount to their intrinsic value. This allows us to buy undervalued growth and value companies and largely ignore things we can’t control or predict.

Our top pick from today’s value stocks

One of our top picks for 2019 was Nufarm, an Australian company that specialises in chemical crop protection globally. Our investment thesis for Nufarm was covered in detail in a December 2018 article titled, ‘Our number one stock pick for 2019.’

Since writing the article less than 12-months ago, the share price performance of Nufarm has been volatile. The company has dealt with multiple headwinds including two consecutive droughts in Australia and flooding in the US. However, the investment thesis remains intact and we continue to remain patient investors in Nufarm for the long-term. Nufarm is now trading at similar levels to when we first wrote the article, however the chart below highlights that investing in value stocks requires conviction and a longer-term mind-set. It is not for the faint-hearted.

Source: Factset

With that in mind, we move on to our pick for today’s most compelling value stock, Clydesdale Bank.

Clydesdale is materially undervalued, trading on less than 0.5x book value. When we look across the developed market, Clydesdale stacks up as one of the cheapest banks globally. To put the valuation into context, Australian banks trade anywhere between 1.4x to 2.0x book value. So, why is Clydesdale so cheap?

One reason is Brexit. All UK banks are trading at historically low multiples because of Brexit uncertainty. Importantly, we do not know what the outcome of Brexit will be. However, the UK is the world’s 5th largest economy and banking is an integral part of that economy. The UK mortgage market is continuing to grow despite the uncertainty caused by Brexit and Clydesdale is a UK focused business with no European passport issues like some if its major UK banking peers. As long-term investors, the share price reaction to Brexit has created an opportunity to be greedy when others are fearful and buy a good business at a material discount to its historical multiple and peer valuations.

The second reason Clydesdale is undervalued is the company has disappointed on earnings expectations, post the acquisition of Virgin Money in 2018. Short-term earnings downgrades by the company have been disappointing. However, we believe the longer-term prospects from the Virgin acquisition are compelling given it provides Clydesdale with: 

  1. A compelling brand (Virgin) – which resonates in key growth areas for the business. Particularly in metro areas such as London where Clydesdale did not have a strong brand or presence.
  2. Strategic synergies and cost-out opportunities – delivered by a management team with a solid track record delivering on cost-out targets.

Putting the revenue and cost opportunities together, we believe Clydesdale can grow earnings over the next few years, despite the challenges that Brexit and acquiring a new business represent. At current prices, the market believes that things will not get better for Clydesdale from here. However, experience has taught us that some of the most compelling value opportunities are in unloved companies in an unloved sector. At 0.5x book value, Clydesdale is a compelling value opportunity for the patient, long-term investor.

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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.

Firetrail believes 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 disclaims 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.

Growth vs Value – Is this the turning point?

Growth vs Value – Is this the turning point?

James Miller, Portfolio Manager

At the start of September 2019, we saw some of the strongest signs of life from value stocks since 2016. Whilst the equity market moves themselves were small, the rotation from growth to value stocks within the market was fierce and rapid. A big question in the market is currently whether this is the beginning of a value phase, or simply a blip in the road for growth stock performance.

We don’t proffer to have a definitive answer to the question – picking turning points is as difficult as timing the market (covered in detail in our market timing article here). However, decades of experience (and history) has taught us that markets move in cycles. Changes in the cycle are not a matter of if, but when. In this insight piece we explore recent market performance, future conditions which are conducive to growth or value stocks, and how we think about navigating changing market cycles.

Growth companies have been outperforming materially since 2016

Since the end of 2016, the market has been in a strong growth cycle. Global economic growth has slowed and uncertainty has increased – impacting end markets for many value stocks (defined as companies trading at low price or earnings multiples). Many earnings forecasts have been downgraded and price to earnings ratios have been compressed. In contrast, sectors with long-term growth profiles such as technology and healthcare have outperformed with valuations expanding over the past 3 years. The extent of the latest growth cycle can be seen graphically in the chart below.

Source: MSCI Australia

However, what is also worth noting is that whilst growth might be in vogue now, value had a great run between 2008 and 2014. We also saw a material swing when value outperformed in 2016. The key question is, where to from here?

Below, we argue the case for both growth and value outperforming in the coming years and how we think about positioning the Firetrail portfolios to navigate changing market cycles.

Why growth stocks could continue to outperform

1. Are low interest rates here to stay? The Australian 10-year government bond yield has fallen from 2.8% to ~1.0% within a year – a rapid decline. As a proxy for the risk-free rate used in a discounted cash flow (DCF) valuation, it doesn’t get much better than the long-term government bond yield. Yet when we look at sell-side broker forecasts, the risk-free rates for many valuations are still 3% or higher.

The biggest beneficiaries of lower rates in a DCF valuation are growth stocks – they have long dated cashflows which are worth increasingly more as interest rates (and the cost of capital) falls. If this normality of lower rates continues, it is possible to see valuation uplifts for growth stocks continuing. The key risk is that investors are already ahead of the sell-side brokers in reducing the risk-free rate in their equity valuations.

2. Do we have a period of economic stagnation? Slower economic growth typically hits the earnings of value stocks harder than growth stocks. This is because many value stocks can be linked to the economic cycle. Think about a construction company with a business model set up for 180,000 housing starts in Australia, however, housing starts come in at 160,000. Higher costs and lower revenue (the operational leverage) for the company will result in a material earnings hit. Similarly, across the retail sector, when times are tough and unemployment is rising, consumers spend less and save more, impacting the sales lines of retailers. In contrast, technological innovation will continue, as will our demand for better healthcare.

3. Does the hunt for income intensify? The going rate on a 1-year term deposit in Australia is ~1.60%, compared with the dividend yield on the ASX 200 index of 4.2%. Could we see further rotation into defensive equities as savers require a higher income to fund their retirement? Whilst not strictly limited to growth stocks, likely beneficiaries of this would be companies with stable, predictable long-term earnings with long dated cashflows like Transurban (with a current dividend yield 4% and growing).

Why value stocks could make a comeback

1. Have interest rates nearly bottomed? In the context of the Australian market, the cash rate at the time of writing sits at 1.00%, and market consensus forecasts have this lowering to 0.50% within the next 12 months. The effectiveness of the RBA dropping rates lower than this rapidly diminishes, as banks would find it hard to pass on the full impact to borrowers. Thus, at that point we would likely see alternative monetary policy, such as quantitative easing (QE) kick in. QE would likely provide a broad-based economic uplift (good for value stocks), rather than the asset price inflation of lowering the cash rate that we have seen so far.

2. Does Australian fiscal stimulus emerge? Whilst the political promise of producing a fiscal surplus in May 2020 continues to be the agenda of the current government, beyond this the spending may begin. Whether the spending is on infrastructure, tax reductions/refunds, or other initiatives – government is likely to spend on broad reaching policies that improve the confidence and hip-pockets of the Australian voting public. A good environment for value stocks.

3. Is the trade war resolved? The biggest impact we are seeing from the trade war between the US and China is the impact on business confidence. When a company’s end markets (and sometimes their cost base) are impacted by tariffs, it has a direct impact on their earnings, and more importantly confidence in future investment. Not to mention the constant headlines drumming up fear and uncertainty in consumers and investors alike. Any resolution may see a pick-up in business and consumer confidence – any subsequent spending could end up on the revenue line of value stocks (think retailers, builders and the like).

How does Firetrail think about navigating value and growth?

Picking the turning point on growth vs value cycles is as difficult as timing the market… which is near impossible! Our efforts remain focussed on finding and investing in companies that we believe are trading at cheap valuations, regardless of whether they are value or growth. The high conviction portfolio currently contains companies which have one-year forward valuations ranging from 4x EV/EBITDA to 24x EV/EBITDA. Providing exposure to both value and growth stocks.

Importantly, over the long term whether value or growth, the key determinant of what drives share prices is earnings, rather than the multiple put on those earnings. By focusing our deep fundamental research on a company’s earnings and using sensible and appropriate valuation metrics, we believe we will generate superior investment performance for our clients over the medium to long-term.

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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.

Firetrail believes 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 disclaims 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.

Three reasons to own Downer Group

Three reasons to own Downer Group

James Miller, Portfolio Manager

Downer Group is an Australian listed company that designs, builds and sustains major infrastructure assets and urban facilities. The company’s core business activities are backed by long-term contracts (some lasting more than 20 years) typically with Government clients.
To put the scale of this business into perspective, it employs more people than the Commonwealth Bank, BHP or even Telstra.
There are three reasons why we believe Downer is a compelling investment opportunity

1. A high-quality business

When you think of engineering it may conjure up visions of large fixed-price projects and cost blow-outs. In recent times, engineering firms have been doing it tough. RCR Tomlinson went bust, Lendlease lost hundreds of millions of dollars building infrastructure and many other large-scale projects have been disasters.

Downer doesn’t do the mega, one-off, fixed-price projects. They specialise in low-risk, urbanisation projects. Think roads, rail, schools, stadiums, hospitals and power. It’s highly recurring and they have $43 billion of work in hand, spanning up to 30 years.

In our view, these twin tailwinds will drive Downer’s continued growth: 

• Population growth and urbanisation: Creating increased demand for urban infrastructure services.

• Demand to outsource: Particularly from government, to companies like Downer who have the expertise to plan, build and service urban infrastructure projects often at a cheaper price and higher quality

2. An un-demanding valuation

In the 2019 financial year, Downer is set to deliver strong earnings growth. The future years are likely to grow steadily in the high single-digit range, driven by continuing contract wins as well as operational improvements.

Downer’s current share price puts it on a price to earnings (P/E) multiple below the market average, despite the robust growth outlook that is higher than the market. This, in itself, a compelling investment proposition.

In addition, Downer delivers a dividend yield above 4%, backed by high quality earnings and cash conversion of around 90% over the past 7-years.

Why is Downer undervalued in our view? One of the problems is that it has no peer listed in Australia. You need to travel to the UK to find companies who do similar things such as long-term facilities management. Companies like Compass and Serco are both trading on 20x P/E ratios. Downer trades on a P/E ratio of around 15x today.

3. Key catalysts for Downer’s valuation to re-rate

So how does the company trade at a higher multiple to generate capital growth for investors?

We believe there are two key catalysts on the horizon.

Downer is rumoured to be selling their mining services division. It makes up around 13% of earnings but consumes almost 50% of Downer’s capital expenditure to generate those earnings. In our view, a sale of this business over the medium-term would move the company into a more capital light business model which is looked upon favourably by investors.

Secondly, the company currently loses money on the Royal Adelaide Hospital contract. It’s a long-term contract with limited downside (less than 2% of Downer’s market capitalisation). While not overly material, any positive outcome of a renegotiation of that contract in the medium-term would be better than the current situation and looked upon favourably by shareholders.

Conclusion: A high quality business with an un-demanding valuation

In our view, Downer is a compelling investment opportunity because of the quality of the business and exposure to urban services. In addition, the valuation for the business today is un-demanding with strong growth, good cashflow and some potential catalysts for a re-rate. For us, Downer ticks all the boxes.

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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.

Firetrail believes 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 disclaims 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.

The winners and losers of a more sustainable approach to plastics

The winners and losers of a more sustainable approach to plastics

July 2019 – Ramoun Lazar, Equity Analyst

Demand for convenience has seen plastic use multiply and today plastics are fundamental to many aspects of daily life. As consumers we interact with plastics many times a day. Whether it be drinking water from a PET bottle, eating yoghurt from a flexible plastic pouch, or using shampoo from a rigid plastic bottle, the applications are numerous within a modern consumer economy.

Plastics combine unrivalled functional properties with low cost. This has seen plastic use increase 20x over the past 50 years. And plastic use is expected to double again over the next 20 years. So, what are the key challenges for both consumers and producers of plastics in the twenty first century? In this insight, we look at the environmental and social costs of plastic use, the future of plastics and the challenges for consumers and companies in plastics. We conclude that companies offering a technology focus – whether it be shelf life, recyclability, and ultimately less waste dictating terms are expected to be winners from the change to more sustainable plastics use. Whilst companies less adept to change, will be expected to continue to lose market share and may be left behind.

The environmental impact of plastics has been largely ignored… until now!

One third of the 300 million tons of plastics used every year is only used once (single-use plastics). In addition, one third of disposed plastics escape collection systems at a cost to oceans, natural landscapes and urban infrastructure. At present, only 15% of plastic packaging is collected for recycling globally.

Recent media attention on marine pollution including the BBC’s Blue Planet series, has shone a new light on the problem of plastic waste and garnered significant backlash against this convenient substrate. Plastic has become a serious environmental and social issue that warrants attention and action. Policymakers, NGOs, industry and local community action groups have led the initiative to reduce our consumption of plastics.

Are all plastics bad?

Growing awareness of plastic waste impact is now triggering action. Single-use plastics such as plastic straws, bags, cutlery, lids and wrappers are being challenged by policy makers and communities, particularly where a more sustainable alternative is available. The city of Seattle recently became the first major US city to ban single-use plastic straws, with other US states following suit. Chile has approved a nationwide ban on plastic bags, while at home in Australia consumers now pay for plastic shopping bags.

So, should consumers expect further restrictions on single use plastics? Our view is yes. Given the wave of public support we expect more regulatory power to protect the environment against plastic waste. There is little doubt support exists for the view that all plastics are bad and should be banned or replaced by other more earth friendly substitutes. This is possible in some cases, e.g. paper straws replacing plastic straws, and will likely continue to garner favour. However, the phasing out of plastic packaging and plastic consumer products is highly unlikely and poses significant challenges and complications for modern society.

Certain plastics cannot be easily substituted. Some plastics provide significant benefits to consumers and society that can’t be matched by other substrates. In our view, these technologies will continue to gain prevalence. For example, a high barrier film packaging helps improve the shelf life of fresh produce, reduces spoilage and can even extend distribution opportunities. Most supermarket meats and cheese products utilise high barrier films, where the product is vacuum packed, minimising exposure to the external environment. This enables delivery of a fresher product resulting in reduced waste, extended produce life, reduced transport costs and lower carbon footprint.

The benefits of high barrier plastic technology seem obvious, yet a third-party survey by Sealed Air, a major global packaging provider, in the US showed that 40% of consumers aren’t familiar with vacuum packaging features and/or benefits. The same survey also found that once educated on the features of barrier packaging, nearly 90% of respondents acknowledged the benefits of these products to the wider community, while 70% said they were willing to pay more to ensure a fresher more sustainable product is delivered and consumed.

The plastic challenges are multi-faceted and complex in nature. Whilst some plastic technologies can have material benefits to consumers it is clear there is a significant environmental cost to plastic use. Below we look at the response to these challenges from both a corporate and government level as different stakeholders respond to consumer demands to find solutions to the environmental and social costs of plastic use.

How corporations are responding?

Increasingly major corporations around the world are taking their own initiative towards more sustainable business practices. Amcor is a flexible plastic packaging company owned within the Firetrail portfolios. It is the global market leader in high barrier packaging and the world’s largest buyer of resin, the key raw material input in producing plastic.

So how has Amcor been responding to the challenges facing the plastic industry over the next two decades? Amcor was the first global packaging company pledging to develop all its packaging to be recyclable or reusable by 2025. Today, around half of Amcor’s products are fully recyclable. Amcor’s large US$200m annual R&D commitment will focus on developing more recyclable materials wherever they are used, while at the same time also using more post-consumer recycled resin – lowering demand for virgin resources.

The company is also a signatory to the Ellen Macarthur Foundation’s New Plastics Global Commitment (EMF), an organisation that is leading the initiative against plastic waste. The EMF includes signatories from over 400 other companies that include packaged goods, retailing, hospitality and food service companies, raw materials producers, durable goods producers, the recycling industry and investors. Major brands such as The Coca Cola Company, Danone, L’Oreal, Mars, PepsiCo and Unilever are working with other key industry stakeholders to create a circular economy for plastics that starts with packaging. At its core EMF is focusing on the elimination of problematic plastic packaging through re-design, innovation and recycling. The EMF believes approximately 70% of plastics can ultimately be reused or recycled.

Increasingly corporations are responding to the public’s concerns regarding environmental issues such as plastics which is resulting in innovation and change. In our view, governments will likely be the next force to ban highly wasteful and damaging plastic products such as shopping bags and straws as we have seen in some parts of the world. Importantly, governments will also need to invest in the infrastructure to reuse and recycle waste streams to ensure these are in place to support a more sustainable future.

The winners and losers of a more sustainable approach to plastics

Plastics will continue to play an important part in consumer packaging. However, this role will likely be very different to today. Companies like Amcor will continue to benefit from the obsession by consumers on freshness, recyclability, and ultimately less waste dictating terms. Other sectors that may benefit are fibre and aluminium packaging, which is seen as having higher recyclability rates compared to plastic. Companies orientated around recycling should also be winners, albeit we believe this is longer dated and requires government support to improve collection and processing infrastructure, and ultimately returns.

In our view, businesses not adept to change such as commodity style single-use plastic packagers will continue to see share losses and revenue pressures. Producers of virgin materials, such as resins, are also likely to suffer as the proportion of recycled plastics increases over time.

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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.

Firetrail believes 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 disclaims 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.

 

 

Why high conviction investing requires a long-term mindset

Why high conviction investing requires a long-term mindset

Patrick Hodgens, Managing Director & Portfolio Manager & Kyle Macintyre, Investment Specialist

At Firetrail, we believe that high quality, high conviction investment managers can outperform the index over the medium to long-term. Over the short-term however, even an investor with perfect foresight will have periods of underperformance.

In the article below, we explain the findings from an experiment we conducted to assess the risk and return profile of a high conviction stock picker with perfect foresight. The amazing excess returns generated over the long-term may not surprise you. What might surprise you, is the conviction and long-term thinking required to stay the course and reap the rewards from our ‘perfect stock picker’.

The Warren Experiment: Designing the ‘perfect stock picker’  

For our experiment, we wanted to assess the performance of a perfect high conviction stock picker over the short, medium and long term. To be clear, in order to conduct this experiment our ‘perfect stock picker’ is required to have perfect foresight. That is, they know which stocks will win prior to investing. For fun, we named our perfect stock picker Warren, after one of the greatest stock pickers of our time, Warren Buffet.

For the Warren Experiment, we selected parameters that reflect the Firetrail high conviction investment strategy and style. The key inputs for Warren’s portfolio are summarised below:

  1. Investment universe and benchmark: S&P/ASX 200 Accumulation Index
  2. # of positions held: The top 20 performing stocks in the universe over the period, equally weighted at the beginning of the period
  3. Holding period/rebalance: 3-years, to reflect our own medium-term forecasting and holding period
  4. Time period: 31st December 2000 to 31st December 2018

How did Warren’s portfolio perform over the long-term?  

The long-term results of Warren’s stock selection are unsurprisingly impressive. As the table below highlights, Warren generated 32.8% per annum above the Benchmark over the 18-year period. If you had invested just $10,000 in Warren’s high conviction portfolio, you would have over $4.5m at the end of the experiment. If you invested the same amount in the market, which still provided a solid return of 7.7% per annum over the same period, your investment would be worth $38,000. Due to the power of compounding, excess returns can have a significant impact on return outcomes for investors over the long-term.

The Warren Experiment: Return Statistics

Source: Firetrail Research

Of course, Warren has perfect foresight in our experiment and the portfolio returns are theoretical. So, the incredible performance result is to be expected. In reality, the risk required to generate the above returns would make Warren’s strategy ‘uninvestable’ for the typical investor.

The Warren Experiment: Risk Characteristics

Source: Firetrail Research

The table above highlights the Risk Characteristics of Warren’s portfolio. To put this into context, an average high conviction manager would expect to have a Tracking Error of 3% to 5%. Under normal conditions, the investor would expect to out/underperform the Benchmark by approximately the same range of 3-5% p.a. over the long-term. Warren’s portfolio had a Tracking Error almost 3 times the average high conviction manager. The Portfolio Volatility is also higher than the market. Whilst the theoretical returns in the Warren Experiment are high, so is the active risk taken to achieve those returns.

Long-term vs short-term performance  

To outperform the Index, your portfolio needs to be different to the Index. High conviction investors typically differentiate their portfolios through:

  1. Portfolio concentration: Typically investing in 20 to 40 of their best ideas
  2. Position sizing: Position sizing generally reflects the conviction the investor has in the underlying stock. Higher conviction = larger position size
  3. Risk management: Which differs among investors. Our approach aims for the risk and returns of the portfolio to be driven predominantly by stock selection, where we believe we have an edge (as opposed to macroeconomic factors which we believe are largely binary and unpredictable)

Due to the differences in a high conviction portfolio’s positioning, the performance outcomes can vary significantly from the Index and the average investor. Put simply, if a high conviction investor gets more stock calls right than wrong, they will outperform. Conversely, if they get more stock calls wrong than right, then they will underperform.

In our view, a high quality, high conviction investor should get 60% or more of their stock calls right over the medium to long-term. After all, even Warren Buffet (arguably one of the greatest investors in our history), doesn’t get every stock call right. But an investor who gets 60% or more of their stock calls right should generate meaningful outperformance over the long-term.

However, in the short-term, even an investor with perfect foresight will experience performance volatility. The below chart highlights the significant drawdowns experienced by Warren in our perfect stock picker experiment over multiple short-term periods. Despite getting 100% of stock calls right over the medium-term, Warren experienced 17 significant short-term underperformance periods of 5% or more under the Benchmark.

The Warren Experiment: Short-term underperformance of 5% or more below the Benchmark

Source: Firetrail Research

The largest drawdown Warren experienced was 26% below the Benchmark between June 2008 to October 2008. This drawdown took almost 2 years to recover and raises the question as to whether Warren would have survived as an investment manager post the GFC?

The second largest drawdown was over 12% and occurred during the December quarter of 2018, a period where many active Australian equity managers including Firetrail underperformed. Interestingly, despite the underperformance, Warren’s theoretical portfolio still delivered 45.3% pa over the 3 years to 31 December 2018, 38.6% pa above the Benchmark return over the same period. An impressive result if you were able to maintain conviction and stay the course.

Conclusion: High conviction investing requires a long-term mindset  

Finding a high conviction manager that can deliver excess returns can have a material impact on your returns over the long-term. However, a high conviction approach is not for everyone. It requires a long-term mindset and a belief that your investment manager will get more of their stock calls right than wrong over the medium to long-term.

As our Warren Experiment shows, even an investor with perfect foresight will experience short-term periods of underperformance. These periods of short-term underperformance are painful for investors and investment managers alike. In our experience, high conviction investors that maintain conviction, stay true to their approach and focus on the longer-term will be rewarded over time.

If you would like more information including presentation slides, charts or underlying data from the Warren Experiment for use with your clients, please contact us at ClientReporting@Firetrail.com

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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.

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Three reasons Baby Bunting is booming

Three reasons Baby Bunting is booming

Eleanor Swanson, Analyst

Baby Bunting is a baby specialty goods retailer with a network of 50 stores across Australia. The company has 12% share of the $2.4 billion of the domestic baby goods market, generating $300 million of sales last financial year. In this article, we highlight three reasons why Baby Bunting is booming, and why it is one of our top picks in the Australian small cap retail sector.

1. Market Consolidation: Bye-bye baby retailers 

During FY18 there was an unprecedented level of store closures in Australia’s baby retail sector. Four of Baby Bunting’s major competitors went into administration including Babies “R” Us and Baby Bounce. The collapse of these speciality retailers has left $138 million or almost half of Baby Bunting’s annual turnover up for grabs. Given that its nearest competitor now has just three stores, Baby Bunting is in a unique position to benefit from the significant consolidation within its sector. We expect the company to capture approximately 30% of the sales from these defunct retailers where store catchments overlap.

2. Store roll-out: Baby Bunting is growing up 

Baby Bunting intends to increase its store count from 50 to 80, with six new stores opening FY19. In December 2018, the company opened its first mall location at Chadstone, the biggest shopping centre in the Southern Hemisphere. Not only will Chadstone be a top performing store, it represents a new opportunity for Baby Bunting to branch out from its big-box, home-centre roots, to a premium retail offering in malls. The mall opportunity is not factored into its current store-roll out plan.  Baby Bunting is one of the few retailers on the ASX with both a store roll-out story and a significant market share opportunity. We expect Baby Bunting to deliver up to 15% revenue CAGR over the next three years.

3. Scale benefits: The big kid on the block 

The size and scale of Baby Buntings’ store network and operations creates a formidable barrier to entry. First time parents wish to see, touch and receive advice on big ticket items such as car seats and prams due to the emotional nature of the purchase. Suppliers are conscious that they need an in-store presence. Given Baby Bunting is the sole baby retailer with a footprint in 5 out of 6 states, it is crucial that a strong relationship with the retailer is nurtured by suppliers. Baby Bunting is therefore in the driver’s seat when negotiating buying terms and product exclusivity deals. Its sheer size means it is also eligible for large volume discounts, which competitors with three or less stores cannot attain. As a result of its market dominance, Baby Bunting can offer competitive pricing and product differentiation, driving in-store traffic whilst expanding gross margins.

Conclusion: The Baby Bunting boom continues  

Baby Bunting presents a rare opportunity to own a retailer that is growing sales and expanding margins.  An unprecedented level of market consolidation in the Australian baby retail sector is allowing Baby Bunting to grow sales and profitability materially in a short space of time. Over the next few years, we expect Baby Bunting’s earnings to double as it continues to benefit from market consolidation, revenue growth and improving scale benefits.

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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.firetrail.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.