Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 412

Five stock recoveries not hanging on COVID predictions

Let’s face it. We couldn't predict COVID and we couldn't predict the impact on the economy of the stimulus and which sectors would benefit. We couldn't predict the fact that people would start buying more because they weren't traveling and all the other consequences of the COVID recovery.

What we can do is pick stocks, using a disciplined investment process to find businesses that have sustainable competitive advantages on a three- to five- year view, with strong financials that we believe will preserve investor capital in a crisis like COVID where the market collapses precipitously.

With or without COVID, investors want businesses with predictable earnings and recurring revenues, especially disruptive businesses benefitting from change in the global economy, with a large addressable market.

Here are some examples of what happened during COVID.

Two great Australian companies, ARB and Breville

The first two stocks are companies that we have owned in our portfolios for over 10 years. We believe that over three- to five- years, they will innovate and export their IP from Australia to the world, where they have low market shares relative to their penetration in Australia.

ARB Corporation (ARB) is a 4X4 accessories producer that has spent more than 30 years investing in R&D on its products. It has cash on its balance sheet and a big distribution network in Australia and increasingly, overseas.

Breville (BRG) not only makes toasters and small items but also sells $4,500 coffee makers in many countries around the world. In fact, their sales in the US are 2.5 times the sales in Australia and in Europe, they're 1.5 times. Breville is growing rapidly but they own only a small part of the appliance market globally.

The price charts of the two companies are below.

Source: Factset. Price returns shown. Data 31 December 2019 to 31 May 2021.

Source: Factset. Price returns shown. Data 31 December 2019 to 31 May 2021.

When COVID hit, the market sold ARB as investors thought nobody was fitting accessories to their vehicles. What actually happened - and we couldn't predict this - was that people couldn't go to Bali or Disneyland and they bought second-hand four-wheel-drives because they couldn’t buy new ones. And then they spent $50,000 a pop on 4X4 accessories, and that happened in both Australia and the US generating record earnings for ARB.

Likewise with Breville, as people initially thought stores would close and nobody would replace their home appliances. What actually happened was people stayed at home when the coffee shops shut, or people did not feel comfortable going out, so they bought top-of-the-range coffee makers for their own espresso at home. And they bought rice cookers and bread makers, plus they shopped online in both Australia and the US, either directly or through various other means. The result was worldwide record sales.

Clearly, we couldn't predict what happened. What we did was pick great businesses with a three- to five-year view, and then we bought more as the earnings came through. Many of our peers may have sold out because they thought earnings in these companies would collapse or underperform when stores closed. 

But we didn’t make any recovery prediction. We stuck by our opinion and these companies suddenly became incredibly cheap on a longer-term view of two great Australian companies. The businesses were already growing at double digit, and then COVID supercharged them.

Online travel will also recover

We have two long-term travel holdings in our portfolio because they are global, Australian businesses leveraged to the travel market. Corporate Travel Management (CTD) is a global leader in business travel, having invested in innovative software which is driving efficiencies for its customers globally. It's gaining market share but with many company employees not travelling, the share price of CTD has not recovered to pre-COVID levels, as shown below.

Similarly with Webjet, which is a long way off its high. It is better known for its Business-to-Consumer travel in Australia, where people go to the web portal for tickets. This part of the business is recovering, but it's a digital company. On both companies, we take our three- to five-year view despite the hit from COVID. Webjet still has a way to go because holiday travel has yet to recover, but it is a digital platform delivering travel solutions to companies and to consumers.

Source: Factset. Price returns shown. Data 31 December 2019 to 31 May 2021.

Source: Factset. Price returns shown. Data 31 December 2019 to 31 May 2021.

We don't own Flight Centre because we've taken a view around the lack of a sustainable competitive advantage in its business. It is far less of a digital business. We are concerned about the balance sheet liability associated with its significant store lease footprint that we believe will be challenged in the future.

IDP Education as a global provider

IDP Education delivers English language testing globally, especially for students studying at English-speaking universities in the UK and North America. It was adversely impacted by COVID initially, but what actually panned out was that in the UK, the market was open to international students to the detriment of Australia. North America was also open and IDP was able to sell more of its digitally-enabled market-leading university placement products. COVID helped in bringing forward its digital business.

Source: Factset. Price returns shown. Data 31 December 2019 to 31 May 2021.

Australia is still not open to international students but IDP returned to pre COVID price levels quickly. We think this is a great business that is disrupting an industry using its English language client base to start a student placement programme, which is gaining share globally.

What about the higher income from banks?

We are often asked questions on banks and bank yields. The following chart shows that despite the heavy position of high-yielding banks in 50 Leaders Index, the small cap and mid cap indexes have done better over any of time periods in the chart. These total returns include the attractive yields that the banks deliver.

The key takeaway is that if an investor can identify businesses that are innovative and growing and can protect capital due to privileged assets with long-term contracted revenue, they should deliver better returns over time.

Bank yields or innovation and growth? Small and mid caps taking the lead.

Source: Bloomberg. Total returns shown to 30 April 2021.

Where are we now in the cycle and outlook for small and mid cap companies?

The answer is very stock specific. We have recently seen some major falls in overpriced companies where investors did not understand the risks. While the Small Cap Index is up about 27% in the year to end-May 2021 and our portfolio has outperformed over the same period, it’s unlikely we will see such results again. There are strong, disruptive businesses but there are also pockets of small caps that are overpriced, especially when they don't have a strong business producing free cash flow and funding their own growth. But businesses with sustainable competitive advantages, strong financials and predictable earnings should continue to do well.

 

Dawn Kanelleas is Head of Australian Small and Mid-Cap Companies at First Sentier Investors, a sponsor of Firstlinks. This article is for general information only and is not a substitute for tailored financial advice. Any stock mentioned does not constitute any offer or inducement to enter into any investment activity.

 

For more articles and papers from First Sentier Investors, please click here.

 

4 Comments
Scott
June 16, 2021

This article shows how hard it is to be a successful stock picker over time.
I bought the small companies VSO ETF last year and so far its returning 61%.

Below is some great wisdom from Jack Bogle: 10 Mistakes Every Investor Makes
https://www.youtube.com/watch?v=ukJ77ycGNC8

Below is also some great wisdom from Stanley Druckenmiller who talks about what makes a great investor.
https://www.youtube.com/watch?v=uTeFU1qivbs.
He makes a very clear point on why the likes of Warren Buffett, Carl Ikahn and George Souris do so well, is because "they make very big high conviction investments into a small number of stocks/assets."
This goes against the what is normally taught in business school about diversification.

CC
July 25, 2021

Scott, plenty of small company fund managers outperform the VSO or XSO small cap index in Australia.
I own several of them.
Small caps and microcaps is an area of the market where skilled fund managers are far more likely to outperform than in larger caps. There are plenty of poor quality small cap companies in the index that are best avoided.

Frankie
June 16, 2021

I like the idea that smaller companies are covered by fewer analysts and therefore gems can be uncovered, and often have better growth paths because they are still small, but it worries me that they might fall more in a declining market as people rush for safety.

Steve Mattani
June 16, 2021

While Webjet will in all probability return to pre Covid profitability, it's return metrics will be far less attractive due to the massive increase in equity issued over the last 15 months. Headline profits will rise on re-opening but I anticipate pre-viral ROE will be impaired for many years to come based on historicals.

 

Leave a Comment:

RELATED ARTICLES

The companies well placed to weather an economic storm

Three new lessons about listed companies during COVID-19

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Retirement

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Shares

On the virtue of owning wonderful businesses like CBA

The US market has pummelled Australia's over the past 16 years and for good reason: it has some incredible businesses. Australia does too, but if you want to enjoy US-type returns, you need to know where to look.

Investment strategies

Why bank hybrids are being priced at a premium

As long as the banks have no desire to pay up for term deposit funding - which looks likely for a while yet - investors will continue to pay a premium for the higher yielding, but riskier hybrid instrument.

Investment strategies

The Magnificent Seven's dominance poses ever-growing risks

The rise of the Magnificent Seven and their large weighting in US indices has led to debate about concentration risk in markets. Whatever your view, the crowding into these stocks poses several challenges for global investors.

Strategy

Wealth is more than a number

Money can bolster our joy in real ways. However, if we relentlessly chase wealth at the expense of other facets of well-being, history and science both teach us that it will lead to a hollowing out of life.

The copper bull market may have years to run

The copper market is barrelling towards a significant deficit and price surge over the next few decades that investors should not discount when looking at the potential for artificial intelligence and renewable energy.

Property

Global REITs are on sale

Global REITs have been out of favour for some time. While office remains a concern, the rest of the sector is in good shape and offers compelling value, with many REITs trading below underlying asset replacement costs.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.