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.

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.

Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Firetrail. Firetrail and its associates may have interests in financial products and may receive fees from companies referred to during this communication.

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.

Hey Earnings, where’s my Cash?

Hey Earnings, where’s my Cash?

James Miller, Portfolio Manager

How can Treasury Wine Estates report cashflow of $27m and profit of $219m? Should we be concerned?

One of the joys of analysing investment opportunities is that every opportunity is unique. In making investment decisions, we look at each company through a slightly different lens. During the February reporting season one of the key issues that arose was the mismatch between cashflow and earnings for many companies.  In the article below we explore why this happens, and how it affects our decision making.

There are three key areas to focus on:

  1. What drives the difference between cashflow and earnings?
  2. When should you be concerned?
  3. How does it affect our decision making?

We conclude that recurring or deteriorating cashflow issues may be symptomatic of a broader issue in the business. In our Absolute Return Strategy, poor cashflow can be a red flag for further research of potential short opportunities.

1. What drives the differences between cashflow and earnings? 

Changes in working capital can often explain the key differences between operating cashflow and earnings. Key drags on cashflow for a company can be:

  • Increasing receivables – a company is yet to be paid from customers
  • Reducing payables – suppliers being paid quicker by the company
  • Increasing inventory – a company is yet to sell goods they have produced

Ideally you have high payables, low inventory and low receivables. The combination means a company is getting paid quickly, for goods you recently produced, and not having to pay your suppliers quickly.

2. When should you be concerned? 

Cashflow is a concern if you believe that the company isn’t going to receive that cash at some point in the future. Two companies that had poor cashflow conversion in the Dec 18 half were engineering firm Worley Parsons and wine exporter, Treasury Wine Estates. Cash conversion is a ratio of operating cashflow to accounting earnings – the higher the better.

We weren’t concerned in February 19 when Worley Parsons announced operating cashflow of $21m versus profit of $98m. For companies with skinny margins and large revenues, such as Worley Parsons, a small move in timing of receivables or payables can have large effects on cashflow. To put it in context, in that 6-month period Worley had ~$2.6b of cash receipts from customers and paid nearly $2.6b in payments to suppliers. Put simply, the scale of the cashflows in and out of the company during the period were large compared to the profit, so a couple of days change in payment timing can make all the difference.

One result that warrants more research was Treasury Wine Estates (TWE). Management went to the effort of explaining that, whilst their 31 December 2018 cash conversion was just 54%, at the end of January this had stepped up to 85%. A possible explanation of changes in cash conversion is the timing of sales. One key question that springs to mind is whether Treasury’s customers have been receiving better payment terms to get sales completed in the half year?

For the contracting sector (think companies like Cimic, Monadelphous and Lend Lease) poor cashflow always requires investigation.  The first sign of a large construction contract encountering problems is often the customer stopping or slowing payments to the contractor until the problem is rectified.  Given that the profit on construction contracts is recognised by a management assessment of completion progress, the profit can be more subjective than the cashflow.

3. How does it affect our decision making? 

Earnings are the key metric we use to assess most companies.  Earnings are far less volatile than cashflow and enable the best comparison for valuation between companies on a timely basis. For example, doing cross-industry comparison, we can compare banks (with very messy cashflows) to resource companies effectively using earnings as the primary metric.

However, understanding a business’s cashflow is also critically important. Typically, a short-term hiccup in cashflow, that is well explained by management, is not a concern.  But recurring poor cashflow, or deteriorating cashflows in certain industries, can be a warning sign.

Summary 

Making investment decisions involves looking at many aspects of a company’s financial position. One critical component is understanding a company’s cashflow. Recurring or deteriorating cashflow issues may be symptomatic of a broader issue in the business. In our Absolute Return Strategy, poor cashflow can be a red flag for further research of potential short opportunities.

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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.

Why WorleyParsons is set to benefit from the oil and gas cycle

Why WorleyParsons is set to benefit from the oil and gas cycle

Blake Henricks, Deputy Managing Director & Portfolio Manager

Worley Parsons is an Australian engineering company that specialises in global oil and gas projects. In this article, I explain why Worley Parsons is set to benefit as the oil and gas investment cycle turns positive. I’ll outline our investment thesis in Worley Parsons, focusing on three key areas.

  1. The oil and gas investment cycle
  2. Cost-out initiatives
  3. Worley Parsons valuation

The article will provide you with a deeper understanding of ‘What Matters’ for Worley Parsons and why I believe it is a material opportunity for our investors.

1. The oil and gas investment cycle 

At the peak of the oil and gas cycle in 2014, oil soared to US$115 per barrel. The subsequent collapse in the oil price to below US$30 per barrel in 2016, resulted in significantly reduced capital expenditure (capex) in oil and gas projects globally, as major energy producers focused on protecting balance sheets.

As shown below, the reduction in oil and gas expenditure significantly impacted Worley Parsons’ revenue, which fell 50% from their peak in 2014.

Worley Parsons Revenue ($AUDm)

Source: WorleyParsons Financial Data

After four years of underinvestment, we believe we are at the bottom of the oil and gas investment cycle. Our research indicates that investment in oil and gas projects needs to return to meet global energy demand. Worley Parsons is set to benefit from the return of the oil and gas cycle. Pleasingly, early indicators are looking strong. Over the past 6 months, Worley Parsons has won many contracts giving us confidence that the worst is behind us.

2. Cost-out initiatives 

Worley Parsons has embarked on significant self-help initiatives over the past few years. A disciplined focus from management has led to a reduction in costs of around $500m since 2016. For a business that made $299m of EBIT on FY18, the cost-out has been material.

In addition, Worley Parsons announced a transformational acquisition of US based Jacobs’ Energy, Chemicals and Resource business in 2018. Jacobs is also a global engineering firm, with less oil and gas exposure. The acquisition provides attractive synergies and strong EPS accretion for shareholders. Importantly, the purchase was conservatively funded and positions Worley Parsons as a market leader in its key categories. Once the acquisition settles, expected early to mid-2019, the purchase provides shareholders with a more diversified, stable earnings profile and gives Worley Parsons the scale and capabilities to bid on some of the largest energy projects around the world.

3. Worley Parsons valuation

Worley Parsons is incredibly undervalued. Today, it is trading close to a market multiple on FY20 earnings, when factoring in synergies from the recent Jacobs acquisition.

The recent 30% fall in oil price in late 2018 and the near doubling of shares on issue has caused the Worley Parsons’ share price to underperform in the short-term. In our view, the market has incorrectly assumed that lower oil prices will cause a sustained lower level of investment in oil and gas projects. Whilst lower oil prices may cause a pause in 2019 capex, investment in global oil and gas projects needs to return over the medium term for global oil supply to keep up with demand. At this point in the capex cycle, Worley Parsons is incredibly undervalued.

Conclusion 

After four years of underinvestment, the oil and gas cycle is turning positive. Worley Parsons is well positioned to benefit as the market leader in oil and gas engineering. In our view, Worley Parsons is significantly undervalued at this point in the cycle. With significant earnings leverage and a compelling valuation, Worley Parsons will be a material opportunity for patient investors.

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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.

Weathering the storm: An opportunity in Australian Insurance

Weathering the storm: An opportunity in Australian Insurance

Scott Olsson, Analyst

The hail storm that hit Sydney late last year made a lot of headlines, but has not changed our fundamental view that insurance is an attractive sector in the current environment. Losses from weather events are part and parcel of running an insurance business. While they introduce profit volatility and can have some flow-on impacts, we believe the major insurers are in a strong position to mitigate and offset these factors.

Sydney hail storm one of the biggest events of the past 30 years

The Insurance Council of Australia’s latest estimate is that this event will cost the insurance industry $673m. Our analysis suggests the cost could eventually reach $1.5-2.0bn once all claims are reported and paid, which would make it one of the top five most expensive weather events of the past 30 years and possibly the most damaging hail storm since the Sydney hail storm in 1999.

Source: Insurance Council of Australia, Firetrail Investments. Notes (1) Red bar indicates Firetrail estimate of ultimate losses from Dec-18 Sydney hail storm. Most recent estimate from Insurance Council of Australia is $673m.

Direct impacts are quantifiable and contained 

With 60-70% combined share of the NSW Motor and Home markets, at face value such an event could be disastrous for IAG’s and Suncorp’s FY19 profits. Both however, have very strong levels of protection which restrict losses and pass the excess on to reinsurers. The net costs of this event are capped at $169m for IAG and $250m for Suncorp, despite the gross cost likely being multiples of this amount.

Both insurers also have allowances in their guidance for a “normal” level of total weather losses in any given year. While the Sydney event does increase the chance that IAG and Suncorp exceed these allowances in FY19, both also have covers in place that provide protection if claims from multiple weather events over a 12-month period begin to add up.

The combination of various reinsurance protections mitigates a substantial proportion of the direct costs of the hail storm. We believe indirect impacts are more relevant for ongoing profitability.

Price lever can be pulled to offset indirect impacts

Apart from the actual claims from large weather events, there are two main flow-on impacts that need to be considered:

Increases in reinsurance costs

The price IAG and Suncorp pay for reinsurance would normally be expected to rise following large claim events, but over the years both have shown a strong ability to negotiate reasonably attractive terms. Most recently, IAG renewed its reinsurance program for 2019 at “relatively flat” rates, despite incurring losses on its 2018 program.

The ability of IAG and Suncorp to obtain favourable terms can be attributed to the significant surplus capacity that exists in global reinsurance markets, IAG’s and Suncorp’s position as two of the largest reinsurance purchasers in the world, and the attractiveness of Australia as a source of diversification for global reinsurers.

Supply chain pressures

The high number of repairs needed in a short space of time after a weather event can place insurer supply chains under strain. Following a hail storm, motor repairer capacity typically becomes stretched and costs are pushed higher. While any claims blow-outs from the hail storm should be covered by reinsurers, it is inflation in the day-to-day claims over the following six months that can put pressure on IAG and Suncorp.

Industry-wide impacts lead to re-pricing 

The indirect impacts from higher reinsurance costs and supply chain inflation tend to affect all insurers, which typically drives a pricing response across the industry (albeit sometimes with a lag). Following a run of large weather events in 2010/11, Home & Contents pricing increased by 10%+ pa for 3-4 years. Given reasonably rational Motor and Home markets currently, we believe there is a case for recent price increases to continue or perhaps accelerate.

Source: Insurance Council of Australia

Shelter from housing and consumer weakness

Stepping back from the noise of weather claims, one storm that insurers are well positioned to navigate is the current weakness in the housing market and Aussie consumer. While affordability pressures can have some impact, demand tends to be reasonably resilient given the nature of insurance products as mitigants of cash flow and asset risk.

Insurers have typically outperformed relative to the ASX200 during more bearish periods for markets and/or the economy. The chart below highlights how IAG and the ASX200 performed through the GFC. While the GFC is an extreme example, it illustrates the value the market places on the defensiveness of insurance in tougher times. We believe this is an attractive feature against the current consumer backdrop.

Source: FactSet, Firetrail Investments

Summary

The risk insurers face from large weather events will always be a key talking point for investors, but IAG and Suncorp have shown an ability to successfully mitigate a large portion of the P&L and capital volatility through reinsurance and re-pricing. With defensive characteristics in an increasingly difficult economic environment, we believe domestic insurance represents an attractive sector to be exposed to.

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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.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.

Our #1 stock pick for 2019

Our #1 stock pick for 2019

Blake Henricks, Deputy Managing Director & Portfolio Manager

Nufarm is an Australian company that specialises in chemical crop protection globally. It produces products to help farmers protect their crops against damage caused by weeds, pests and disease.

There are two key reasons we believe Nufarm is one of the most compelling opportunities in the Australian equity market today:

  1. Industry consolidation
  2. Omega 3 opportunity

This article explains why Nufarm is undervalued today and why we believe it will be a future winner for our investors over the medium term.

Why Nufarm is undervalued

If you invested in Nufarm at the start of the year it has been a tough investment. The share price has fallen almost 30% and Nufarm is trading at a substantial discount to its global peers.

The underperformance has been driven by two key issues:

  1. Australian drought – The Australian drought in 2018 significantly impacted Nufarm’s Australian earnings (~15% of total company earnings). The drought was a one in fifty year event. But investors need to remind themselves that droughts are cyclical in nature. They are not structural issues and whilst we do not know when it will rain, we like to take the contrarian approach of buying in drought and selling in rain.
  1. Glyphosate concerns – Glyphosate is the world’s most commonly used herbicide. It has come under controversy this year following a US law suit against Monsanto, which ruled that ‘RoundUp’ (which contains glyphosate) caused a former school gardener’s cancer. Glyphosate products currently account for almost 20% of Nufarm’s earnings so this is an issue we are monitoring closely. To date there are no glyphosate cases against Nufarm.

Whilst controversial, we don’t believe there is any reasonable scenario where chemical crop protection is banned globally. Doing so could reduce global crop yields by 40% which would result in a global food shortage. The issue is multi-faceted, but we believe Nufarm is well-placed in any reasonable outcome from the controversy.

The Australian drought and glyphosate concerns have created a buying opportunity for medium to long term investors. Below we explain why we believe Nufarm will be a future winner for our investors.

Industry consolidation

The Global crop protection market is a US$50bn industry. The industry has traditionally been dominated by six large players including multinational brands such as Bayer, Syngenta, Monsanto and BASF. However, the crop protection industry has been going through a major period of consolidation over the past two years. Since 2016, the six largest players have consolidated to four.

Nufarm is a big beneficiary from industry consolidation. Less competition means a better pricing environment across the market. In addition, the frenzy of mergers and acquisitions across the industry has resulted in forced asset sales, giving Nufarm a once in a lifetime opportunity to buy high quality assets directly from competitors at great prices. With competitors distracted and internally focused, we believe Nufarm has an opportunity to gain market share as a focused, independent alternative supplier of crop protection to its customers.

Omega-3 opportunity

Fish oil is a rich source of Omega-3 fatty acids. It is derived from sustainably caught unpalatable fish such as anchovies and other fish by-products and used predominantly as aquaculture feed in fish farms. Omega-3 is required to meet the world’s growing appetite for fish. However, as Chart 1 highlights, the world is short natural sources of Omega-3.

Source: Firetrail

Nufarm has developed the World’s first plant-based source of Omega-3 in partnership with the CSIRO.  Whilst there are competitive technologies being developed, Nufarm will be first to market, with patents beyond 2030 and regulatory approval for commercialisation expected in 2019.

In our view, the Omega-3 opportunity represents 40% additional upside to the current share price despite earning nothing today.

Conclusion

Nufarm has fallen over 30% this year and is currently undervalued versus its global peers. Whilst there are issues regarding the Australian drought and glyphosate concerns, we believe there is material upside to today’s share price. In our view, industry consolidation and the Omega-3 opportunity will provide significant earnings growth for the company. We believe Nufarm is one of the most compelling investment opportunities in the share market today.

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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.

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