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Don’t set and forget

As value investors, we buy high quality companies with good long term prospects. A company that is able to produce a product that is in high demand, whilst maintaining its competitive advantage, may be able to enjoy above average returns for a considerable period.

Yet the lure of excess profits can be too much for competitors to resist. A strong competitive advantage supports earnings growth, but there may come a time when a company’s defences are breached, and the share price comes tumbling down. This reversion can be quite dramatic, so while we advocate investing for the long-term, it doesn’t mean you should discount short-term developments.

To illustrate this concept, there have been three market darlings that have experienced material share price declines in recent months. These companies are Coca-Cola Amatil (ASX: CCL), Super Retail Group (ASX: SUL) and Cochlear (ASX: COH). Investors that maintained an active interest in their investments would have been better placed to identify the negative structural shifts experienced by each company than those that kept their holdings in the ‘bottom drawer’.

You would all be familiar with Coca-Cola Amatil, one of the largest bottlers of beverages in the Asia-Pacific region. The company controls iconic brands, which has translated to strong financial performance. Between 2006 and 2011, the company’s earnings per share grew by 12% each year.

Yet since 2012, Coca-Cola’s volumes in the Australian soft drink market have declined from 50% to 42%. The oligopoly that makes up Australia’s grocery retail landscape has put Coca-Cola Amatil on a strict diet of shrinking volumes, values and loss of market share, particularly to ‘private label’ soft drinks.

As such, it has become unclear if Woolworths, Coles and Aldi are significant distributors of Coca-Cola Amatil’s products, significant competitors, or both? To find the answer, the company has launched a strategic review, which typically marks the beginning of a prolonged, and costly, turnaround programme. The CCL share price has declined from over $15 to around $9.50 in the past 14 months, such is the uncertainty of the company’s long-term prospects.

Super Retail Group is another company that has generated consistent earnings growth with quality brands such as SuperCheap Auto, BCF, Rebel and Amart Sports. Between 2006 and 2013, the company increased its average annual earnings per share by 20%.

Super Retail Group has experienced a number of hurdles this financial year; the leisure category has been impacted by customers in regional and mining areas spending less on fishing and recreational equipment; the implementation of a company-wide IT system has not gone to expectations; and existing store sales have been cannibalised by an overlapping store network.

One of Super Retail Group’s core competitive advantages has been its ability to integrate large acquisitions into its network – Rebel Sports being a case in point. But the more time management is focused on remedying the above issues, the less time is spent looking at large scale acquisition opportunities to assist growth.

While management has a clear strategy to remedy these issues, they cannot confidently state if these benefits will be realised in 2016, 2017 or 2018. The market has certainly reacted unfavourably, with the share price falling by around 35% in the past six months.

The final example is Cochlear, the company that brought hearing to the deaf with the cochlear implant. This incredible leap in technology allowed the company to enjoy many years of favourable growth. From 2004 to 2011, the company grew earnings per share by an average 24.7% per annum.

But problems began to emerge in 2011 when the company was forced to announce a product recall. Recalls can be very costly events, in terms of the financial burden to replace the damaged goods, and the potential reputational damage. Cochlear was able to maintain its strong brand power after this event, and by the end of 2012 the share price was above the pre-recall price.

Yet since the beginning of 2013, the company’s share price has again declined materially. It is becoming increasingly apparent that Cochlear is ceding market share to its competitors. Even for a company like Cochlear that is dedicated to a strong innovation, research and development program, it seems that competitors have been able to replicate their technology and are stealing market share with lower prices.

The aforementioned companies have built their quality reputations by withstanding and overcoming adversity. But during these periods of material uncertainty, even the companies with the longest records of success may not emerge with their competitive position intact. While investors should always invest with the long-term in mind, at times it can be quite painful to simply ‘set and forget’.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able


 

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