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ASX and Firetrail Investments: 3 fundamental rules of investing

ASX and Firetrail Investments: 3 fundamental rules of investing

Which house is the better investment?

House A. A Wooden shack on the outskirts House B. Harborside mansion
Source: Shutterstock

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:

  1. Every company has a price
  2. Focus on “What Matters”
  3. 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:

  1. Balance sheet and cashflow: could Qantas survive an extended period of lockdowns?
  2. 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:

  1. How much cash did Qantas have on its balance sheet?
  2. How much cash was it burning through in a lockdown scenario?
  3. 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:

  1. 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.
  2. 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.
  3. 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:

  1. Cash: Qantas had sufficient cash to survive an extended period of lockdowns beyond our worst-case scenario domestically.
  2. Domestic recovery: A rational domestic market, cost-out program, and strong QFF business underpinned a better-than-expected earnings recovery over the medium term.
  3. 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.

In our view, this is a proven approach to invest in companies such as Qantas, which is a key position in the Firetrail Australian High Conviction and Absolute Return portfolios.

 

This communication was prepared by Firetrail Investments Pty Limited (ABN 98 622 377 913, AFSL 516821) (Firetrail) as the investment manager of the Firetrail Absolute Return Fund (ARSN 624 135 879) (the Fund). It is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. It 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. Any persons relying on this information should obtain professional advice before doing so. Past performance is not a reliable indicator of future performance.

The Fund is issued by Pinnacle Fund Services Limited (ABN 29 082 494 362, AFSL 238371) (PFSL). PFSL is not licensed to provide financial product advice. The relevant Product Disclosure Statement (‘PDS’) is available at www.firetrail.com. Any potential investor should consider the relevant PDS before deciding whether to acquire or continue to hold units in a fund. Please consult your financial adviser before making a decision.

Firetrail Analyst Series 2021 | One Aussie company that’s just doubled its appeal

Firetrail Analyst Series 2021 | One Aussie company that’s just doubled its appeal

To kick off the analyst series for 2021, Firetrail Portfolio Manager, Ramoun Lazar, takes us on a deep dive into the US housing market. The current market conditions, including low interest rates, record-breaking consumer savings and seemingly never ending stimulus, have created the foundation for a global housing boom! Ramoun discusses how Firetrail is taking advantage of these conditions through portfolio holding James Hardie (ASX:JHX), and the future growth potential for the stock.

 


This communication was prepared by Firetrail Investments Pty Limited (ABN 98 622 377 913, AFSL 516821) (Firetrail) as the investment manager of the Firetrail Australian Small Companies Fund (ARSN 638 792 113) (the Fund). It is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. It 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. Any persons relying on this information should obtain professional advice before doing so. Past performance is not a reliable indicator of future performance.

The Fund is issued by Pinnacle Fund Services Limited (ABN 29 082 494 362, AFSL 238371) (PFSL). PFSL is not licensed to provide financial product advice. The relevant Product Disclosure Statement (‘PDS’) is available at www.firetrail.com. Any potential investor should consider the relevant PDS before deciding whether to acquire or continue to hold units in a fund. Please consult your financial adviser before making a decision.

Monthly Insights | Don’t bet against the house!

Monthly Insights | Don’t bet against the house!

February 2021

Easy monetary and fiscal policies are driving a sharp recovery in economies and markets. And one of the key winners globally is the housing market. Stimulatory conditions, increased consumer savings and record low interest rates have created perfect conditions for a global housing boom.

At Firetrail, we believe this global boom in housing and related industries has a way to play out. And we have positioned our portfolios to gain exposure to the housing thematic through our best stock ideas. In this article, we do a deep dive into an Australian company that is a global leader in wall and floor building products for new and used homes, James Hardie.

 

James Hardie – A global leader in wall and floor building products

James Hardie is one of few successful Australian overseas stories. It sells building materials products centred mainly on exterior fibre cement siding and generates 70% of group sales in the US housing market.

Today, James Hardie is one of our best stock ideas exposed to the global housing cycle based on our thesis of:
1) Prolonged US housing recovery; and
2) Structural growth opportunities for James Hardie’s product portfolio.

The US market really is the key driver or ‘what matters’ to James Hardie given it generates >70% of earnings from the US market. 60% of products sold in the US (by volume) are sold into the repair and remodel (“R&R”) segment and 40% into new single-family housing.

At Firetrail, we are positive on the outlook for both segments and explore this in further detail below.

R&R – The housing cycle could be longer than anticipated

The R&R story is relatively straightforward. Firstly, there are around 140m existing housing units as part of the US housing stock. The chart below shows that over 50% of these homes were built before 1979, i.e. are over 40years old. This underpins a long-term structural tailwind for R&R spend in our view as homeowners spend to maintain and improve these older houses.

Source: US Census bureau

Source: US Census bureau

Secondly, over the past year we have seen a significant uplift in Do It Yourself (“DIY”) spending. The COVID pandemic has resulted in more people at home, with more time to spend on small repair jobs (such as plumbing). What has suffered is the Do It For Me (“DIFM”) segment.

James Hardie’s products are DIFM, requiring specialist installers on site to complete re-siding works.  As vaccines continue to rollout in the US, we believe DIFM will benefit from significant pent-up demand, resulting in higher activity. Both these factors support our expectations for solid growth in R&R driven earnings.

New Housing – New housing starts are on the rise

New housing construction is a relatively smaller but more volatile driver of volumes and earnings for James Hardie. Housing starts have recovered only very slowly since the financial crisis of the late-2000s (see chart below).

Source: US Census bureau

Total housing starts are finally inching back to the 1.5m 30-yr average. Expectations embedded within Consensus James Hardie’s forecasts simplistically assume starts revert to the long term average and then grow by around 1-2%p.a. Roughly in-line with US population growth.

However, digging deeper into US housing demand suggests a significant underbuild of new housing post financial crisis could result in a higher and potentially more sustained peak in starts over the coming years. On our estimates the US needs around 1.5m starts annually to stand still. This factors in average population growth of c.1%p.a. (average since 2000) and the obsolescence rate of the existing stock as provided by the National Association of Home Builders (“NAHB”), see table below.

Source: NAHB

Looking back since 2000 highlights a period of overbuild from the early to mid 2000s, followed by a period of significant deficit from around 2006 through 2017. On our estimates it appears there has been a cumulative underbuild of >5m units since 2000. Simply reverting back to a mid-cycle starts appears simplistic in this regard. Consensus is not positioned for what may be a period of significant catch-up due to pent up demand.

Source: US Census bureau, Firetrail estimates

Further underpinning our expectation for a more sustained US housing cycle is the level of current inventory of existing and new homes, which are sitting at 30yr lows, see chart below. Should housing starts test previous peaks (up to 1.8m starts for single family) we could see significant earnings momentum continuing for James Hardie over the next several years.

Source: US Census bureau

Additional share opportunities are expanding the total addressable market (TAM)

Housing cycle aside, we believe James Hardie is also a market penetration story. Since entering the US market in the 1990s James Hardie’s focus has been to take share in the Wood Look siding category with its Fibre Cement suite of products. James Hardie has a >90% share of the Fibre Cement category in the US. We estimate Fibre Cement siding has grown to around 20% of annual siding installations. Its share of annual installations has increased by around 1%p.a. James Hardie has traditionally targeted a 35% share of annual US siding installations, with no firm time period to achieve this goal. This additional share should come at the expense of Vinyl, a cheaper albeit inferior quality product compared to Fibre Cement. Vinyl’s share is not insignificant at around 25% of annual installations. On the current trajectory James Hardie has substantial runway to continue to deliver above market growth as it battles to take share from inferior wood look products such as Vinyl.

Source: US Census bureau

Source: US Census bureau

While James Hardie has clearly been successful at growing share this is likely to become harder as maturity approaches across target wood look markets. As a result, James Hardie management are proposing to expand the Fibre Cement product offering further across the siding category. The most obvious markets to target are Stucco and Brick, which combined still account for 47% of annual siding installs and are not yet targeted by James Hardie products. Expanding into these categories will effectively double the US Total Addressable Market (TAM) for James Hardie and push out the growth runway well beyond the next 10yrs.

James Hardie will launch new products in FY22 to initially target Stucco. Stucco is a traditional exterior wall covering using cement plaster. The concept behind Stucco dates back centuries. Its installation is labour intensive, and its prone to cracking and water damage. James Hardie products due to be launched in the US will consist of panel like Stucco look products made of Fibre Cement. So the core focus and technical knowhow remains relevant with the portfolio expanded through R&D to expand its potential application. These products are expected to significantly improve ease of installation and could be 10-25% cheaper on the wall than traditional Stucco siding in the US. While success is not a given, the new products have seen encouraging results in Australia where they were first rolled out.

We believe the market is not ascribing any additional value to James Hardie expanding its TAM beyond the wood look category. We have estimated what this additional share could mean for valuation. Our base case is that JHX hits its 35% share of annual exterior siding installations by 2030. Each additional share taken from Stucco/Brick adds around $0.80/share or 2% to our current valuation in today’s dollars.

 

Source: Firetrail estimates

Conclusion

At Firetrail, we believe James Hardie is well positioned to benefit from an ongoing cyclical upswing in US housing activity alongside structural drivers that are likely to elongate the current cycle further. In addition, a new product strategy adds to the longer term growth profile of James Hardie which we don’t believe is currently being reflected in the valuation of the business today.

James Hardie is a key position in Firetrail’s high conviction portfolios.

 

 

This paper was prepared by Firetrail Investments Pty Limited (ABN 98 622 377 913, AFSL 516821) (Firetrail). It is general information only and has been prepared without taking account of any person’s objectives, financial situation or needs. It 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. Any persons relying on this information should obtain professional advice before doing so. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. This document may contain information contributed by third parties. Firetrail does not warrant the accuracy or completeness of any information contributed by a third party. Any views expressed in this document are opinions of the author at the time of writing and do not constitute a recommendation to act.

Pinnacle Insight Series: Blake Henricks – Australian Equities Large Caps

Pinnacle Insight Series: Blake Henricks – Australian Equities Large Caps

Join Firetrail’s Deputy Managing Director and Portfolio Manager, Blake Henricks, as he discusses his views on the outlook for Australian large caps and the opportunities Firetrail foresees in 2021 and beyond during an online event dedicated to Australian large cap equities.

The presentation (streamed live on March 4th, 2021) is now available on demand. Click below to access the video.

Link to Video