18 August 2015
In the first of a new series of thought pieces, Julian Beaumont, Investment Director at BAEP, examines how the team approach the often scary headlines and market volatility, the related issue of trying to time the market, and investment opportunities they currently see in the market.
The headlines can paint a pretty bleak picture these days, and sometimes they’re just downright scary. Add in the fact that the stock market has been on a bull run now for over six years and investors understandably have cause for concern. Against this backdrop, how do we at BAEP approach our important task of prudently investing client funds?
Waiting for the clouds to open up
A number of investors, both individuals and some of our peers, are concerned at the market’s current trading levels; some are seeing ominous clouds and are planning for the rainy day they see ahead. Many hold onto quite high levels of cash, believing the market is due to turn down and that better opportunities will then appear. Whether premised on rich valuations, over-intellectualised as tightened risk premia, a belief about future volatility, or predictions of geopolitical calamity, it essentially amounts to a call on the market. These worried investors are predicting material falls in the stock market, at which point they will apparently put their dry powder to work. They are attempting to time the market.
Cash: a bet against the odds
The problem, as those who have clung to cash in recent years have experienced, is that you miss out on the superior returns generally available from the share market. The market, as represented by the S&P/ASX300 Accumulation Index, has returned 9.5% annually over the last five years, whilst cash has returned approximately 3.5% over the same time period. The difference, which totals up to almost 40% over the full five years, represents the opportunity cost of thumb-sucking, and the amount by which one’s wealth would have otherwise grown. Lest you think that this was a particularly bullish time for equities, and not representative of the long term, I present you the following graph which plots returns since the beginning of last century, a year before our country became a federation.
Source: BAEP, Credit Suisse, 27 July 2015
As the graph above attests, the share market has achieved better returns than cash over the long term. When you then consider that the long term is simply the sum of lots of short term periods, you realise that you’re likely to be betting against the odds in choosing cash over equities at any one particular time.
Today, cash earns about 3% at current rates and has no prospect of growth. By comparison, the share market currently trades on a prospective average price to earnings ratio of 16.1x, which equates to an earnings yield of 6.2%, and pays out a partly franked dividend yield of 4.7%. Of course, that’s just the starting point, and both the earnings and dividend yields can reasonably be expected to appreciate over time as companies invest back into their businesses and grow with the broader economy. On this basis, the odds currently favour equities. In addition, our track record at BAEP shows that we have outperformed the market over time, thereby supplementing the superior returns available from the share market. Given the current fundamentals, we continue to be confident that we can beat cash in the years ahead.
Some may get lucky of course in calling a correction and holding cash on the way down. But the real challenge lies in consistently achieving that feat. Those who boast of having the knack will most likely turn out looking like The Knack, who became famous for a one-hit wonder called “My Sharona”. And if predicting the correction wasn’t hard enough, they also have to predict the length and depth of the correction. Going too early isn’t much different than not predicting the correction at all. Worse still, waiting too long can result in missing out on the opportunity altogether.
There’s always something to worry about
While the bull market feels long in the tooth, it starts from a very low base. It began in March 2009 at levels in line with where we started out this century in 2000. With extraordinarily low interest rates, and an undemanding market multiple, it’s difficult to argue that markets are currently stretched. Famous investor Warren Buffett said in an interview late last year that most of the time the market sits in a ‘zone of reasonableness’, which incidentally is where he sees it now. More interestingly, he also said that it’s only in very rare instances when you can be confident the market has gone to the extremes outside this zone. Tellingly, in his investing career, he has publicly identified the rarity just five times - and he started out in the early 1950s!
The outlook of course is never clear and there are always things to worry about. Right now, it’s Greek sovereign debt issues, Chinese wobbles and potential US rate rises. Tomorrow, the issues will be different but likely just as worrisome. They’re all issues that can upset the apple cart, but not to be flippant, markets have a way of reassembling the apples neatly back into the cart. As evidenced by the GFC and prior upheavals, our stock market is incredibly resilient over time.
Where to in the short term?
The truth is that no one really knows where the market is going in the short term. It can go both up and down in good times and bad. To appreciate this possibility, just think back to the best times to buy, and the market in the three months that led up to such an opportunity.
What we do know is that the market is made up of stocks that represent interests in real companies. Investing in the share market is investing in businesses that sell things like mortgages, groceries, car insurance, electricity and mobile plans. They are companies that should sell more and more over time, and whose earnings will grow accordingly. So, while we cannot know where the market is going in the short term, we can be reasonably confident that the companies being traded each minute on the market will generally be worth more in the future, and the stock prices that reflect their worth will ultimately follow suit. The market will have its up and downs, to be sure, but the fundamentals will ultimately prevail. A starting earnings yield of over 6% suggests relatively decent returns ahead, whilst a partly franked dividend yield of almost 5% gives you the patience to see through any tough times.
At BAEP, we invest according to an investment philosophy that ensures we invest in real companies, with real earnings, and real growth plans. We invest based on the fundamentals of the companies, rather than the headlines then moving markets. We believe that it is far easier to focus on outperforming the equity market than obsess over the market itself, and to then let the market run its own course over time. If our investment philosophy is our compass for navigating turbulent times, then company fundamentals represent our true north.
We build our portfolios one stock at a time. Holding cash is just an outcome of being unable to identify decent opportunities, and right now, we hold minimal cash levels across the portfolios we manage. When we look into the Fund’s holdings, we feel optimistic about future returns. Furthermore, we continue to find new ideas that we find attractive and we are selectively adding some of these to our portfolios.
One example is REA Group, which operates the dominant online real estate classifieds site (realestate.com.au).
REA is one of the highest quality companies on the Australian share market. Its dominant competitive position owes itself to the popularity of its website, which is entrenched and indeed strengthened by a natural circularity: those looking to buy a property use REA’s site as their most valuable resource because it has the most listings, while vendors find it essential to list their property on REA’s website because it has the largest and most engaged audience.
The competitive advantage that derives from this so-called ‘network effect’ affords it considerable protection against the competition. It also enables REA to have considerable pricing power, particularly given its offering is cheaper and more effective than alternatives such as newspapers and suburban magazines. In fact, despite the obvious advantages of REA’s website, the transition of advertising dollars from print to online is roughly only half way progressed in the case of real estate, and REA stands to benefit tremendously as this transition unfolds.
Source: BAEP; company data as at 30 June 2014
The quality of REA’s business is best seen in its return on equity of 35%, which it achieves without leverage, and with a net cash position of $100 million.*
REA’s share price has fallen about 25% in 2015. This has coincided with a slow-down in REA’s business, which has ironically suffered in recent times from a hot property market. Vendors have been able to sell their properties very quickly, particularly in the important Sydney and Melbourne markets. This in turn has meant vendors have been listing their properties on REA’s website for only a short time, or in some cases, not at all. While we have owned the company before and know it well, we recently took the share price fall as an opportunity to carry out extensive research on the company’s near and medium-term outlook. This included macroeconomic research on the current dynamics of the housing market, a large number of meetings with real estate agents and industry bodies, trawling through industry data, and of course meetings with the company itself and its various competitors. Our research suggested listings are now on the up for REA Group, and that the medium-term outlook is indeed solid. In addition, the company continues to exercise significant pricing power, which it achieves by moving the market up towards premium display advertisements and other higher priced listings. Those that fail to pay the higher prices will find themselves with a less glossy advertisement that is further down in the search results. Not a good outcome when it comes to selling what is most people’s most valuable asset.
We were able to buy REA Group in the past month on a PE multiple of 18x next financial year’s earnings. We found this particularly attractive given the quality of the company and the long term growth ahead.
Another company we’ve recently added to our portfolios is Carsales.com, which operates the dominant online car site of the same name. The share price of Carsales.com has been roughly flat for the last three years, and yet it has grown earnings about 40% over that time and invested considerably in new ventures that should add to earnings in the longer term. We believe the market underestimates the company’s strong competitive position. The company has all but seen off a potentially powerful new competitor in CarsGuide, which is a joint venture between News Corporation and a group of car dealers. We also believe the market underestimates the company’s longer-term growth outlook as, similar to the case of real estate, auto advertising spend continues to transition from print to online, and Carsales.com stands to benefit most.
While their businesses have most certainly matured over the last decade, and their valuations have grown well into the billions, we believe the best days for REA Group and Carsales.com remain ahead. We find opportunity as the market sees indifference and prices its stock accordingly.
Another company we’ve added to a number of portfolios that we manage is Eclipx, a company that floated in April. Most will know BAEP as putting the picky in stock picking, and true to form we are very selective when it comes to participating in IPOs. Eclipx stood out as a particularly compelling opportunity. The company is predominantly focused on providing vehicle fleet leasing and management services in Australia and New Zealand, having been formed by bringing together a number of like businesses over the past few years, the best known of which is FleetPartners. The company is run by a very experienced, disciplined and astute management team, which is paramount for a finance company like Eclipx where the true profitability of business written today only reveals itself as it matures in ensuing years. We came to very much respect the management team when they previously worked together at FlexiGroup, during which time FlexiGroup’s share price approximately quadrupled.
Management now has the opportunity at Eclipx to run the collective businesses more efficiently and thereby take out significant costs. A significant opportunity exists, for example, to integrate the various businesses onto the one IT platform that is more productive and avoids the duplication of costs from running multiple systems. To quantify the cost-out opportunity, we note that Eclipx’s cost to income ratio, one of the best measures of a finance company’s operational efficiency, is approximately 55%, whilst its peers are closer to 40%. Eclipx’s recent financial results reveal that this ratio is moving in the right direction.
At the revenue line, the industry is seeing solid growth, on top of which Eclipx is taking market share, owing to certain management initiatives and some of its competitors being distracted by sales processes and other internal issues. In particular, our analysis of industry data and discussions with industry players indicates that Eclipx’s business volumes are well ahead of what the company guided to in its prospectus. Further out, the company has two embryonic businesses - a commercial equipment leasing business and an online car loans broker operating through the website carloans.com.au - both of which could add meaningfully to earnings as they build scale in coming years.
While Eclipx has performed well since listing, rising from its IPO price of $2.30 to now trade above $3, we continue to believe that it looks attractive. The company currently trades on our numbers, on a multiple of 13x this financial year’s earnings, which is a discount to peers, despite the company being higher quality and offering better growth prospects.
All new portfolio additions of course fit squarely within our investment philosophy. They are all high quality companies, with strong long term growth prospects and earnings strength, making them well placed to meet or outperform expectations, and whose stock is being mispriced. Again, our investment philosophy is our investing compass, and the company fundamentals our true north.
The pull back in the June quarter, in which the broader Australian market fell 6.5%, evidenced a skittish underbelly to our market. In addition, some investors remain cashed up or are cashing up. If anything, we take this to be a positive sign. It’s not that cashing up results in ‘cash on the sidelines’ –where does this so-called sidelined cash go when it gets reinvested? – but that it reflects short term fears that gives rise to attractively priced opportunities. After all, markets are discounting mechanisms, and markets are far from buoyant at present.
At BAEP, we continue to aggressively hunt for great companies that are well priced and that should provide decent returns over time. More importantly, we continue to find them. In many respects, our general stance on this issue is a reflection of our game plan at BAEP: play to win rather than to not lose.
Information is current as at 31 July 2015.
 Bloomberg, as at 31 July 2015.
 BAEP, calculated as at 31 July 2015
 BAEP, calculated as at 31 July 2015
 Company financials; BAEP estimates for financial year ending 30 June 2015.
 Based on the latest financial results, Eclipx’s cost to income ratio was reported as 55.3% at its 1H15 result; FlexiGroup reported a ratio of 40.3%; and SG Fleet Group’s ratio was 46.4% (all on an equivalent basis).
 The Prospectus is dated 26 March 2015.
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