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.


Register here to receive the Firstlinks weekly newsletter for free

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 17, 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 17, 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 17, 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

Three new lessons about listed companies during COVID-19

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.