Hugh Dive, Head of Listed Securities

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Tales from the Trenches - What makes an attractive company?

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In every investment magazine and the business section of every weekend paper you will see a list of hot stock picks from fund managers, inevitably these picks won't represent the fund manager's top new ideas, but rather five large positions in the funds that they manage. You will never see the fund manager's recently uncovered gems in print, as the managers will be busily building these positions in their portfolios and certainly don't want other investors driving up the price! In the interests of disclosure I have been guilty of doing this myself. In this piece, I am not going to run through our top investment ideas, but rather take a step back and look at what actually makes a company attractive investment.

The business is easy to understand

We are attracted to companies with business models that are simple and can be explained to any client in two sentences or less and it can be easily identified how the company makes money. Woolworth's business model is very simple; they buy groceries and liquor from the manufacturers and have the cheapest mechanism of distributing these goods to the consumer.

This point is frequently forgotten during market and credit booms, where complicated businesses thriving off accounting or credit arbitrage can appear to thrive for a certain amount of time. In 2006 I had several meetings with Allco Finance's management in an attempt to understand the business. The company's share price had risen 120% in the previous year, not owning it in the portfolio was hurting performance on a relative basis. After the management was unable to explain how Allco made money sustainably, no investment was made. 

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Low Capital Requirements

The best companies to invest in are those that require minimal ongoing capital expenditure to generate a profit. This is important as when a company is required to continually make investments just to stay in business, this represents less cash that is available to be returned to shareholders. Pharmaceutical company CSL requires has minimal ongoing capital expenditure to produce its medicines outside the company's research and development budget and this has allowed the company to return A$6.1B to shareholders since 2010 in dividends and share buy-backs. Conversely Qantas is a capital heavy business which constantly needs to invest (an A380 costs US$414M) just to remain competitive in the aviation marketplace. Since 2010 Qantas' annual capital expenditure has been consistently ahead of the cash flow it generates from its operations, which explains why shareholders last saw a dividend in 2009.

Barriers to entry

Another key factor that quality companies have strong barriers to entry that discourage competitors from entering into the market and thus reducing profit margins. Toll road operator Transurban enjoys high barriers to entry from long life monopolistic assets. There zero probability of a competitor building a toll road adjacent to the company's M2 Hills Motorway in Sydney. Conversely, online accommodation company Wotif.com initially enjoyed strong growth after listing in 2006, but has seen its share price and market share fall dramatically, as larger global competitors improved their internet offer. In Wotif.com's case along with many other tech companies, the barrier to entry tends to be quite low. Generally high barriers to entry if they can be maintained, translate into higher profits for shareholders.

Not reliant on Government legislation or a single customer

Owning companies whose business model depends on favourable government legislation can be a very soul-destroying for investors. Investors in Timbercorp and Great Southern saw these billion dollar companies disappear after the government changed the tax treatment of their agricultural schemes. More recently salary-packager McMillan Shakespeare's share price fell 55%, wiping A$600M off the company's market capitalisation in 2013 after the government proposed changes to the salary packaging of car leases. Similarly two weeks ago former market darling Navitas' shares fell 30% after key partner Macquarie University announce plans to bring Navitas' university pathways program in-house. Alternatively food and beverage packaging company Amcor attracts very little interest from governments and has a large global spread of customers. Companies with characteristics tend to have easily forecastable earnings with far fewer nasty surprises for investors.

Quality management

When we invest in a company we are effectively entrusting our investor's funds with a company's management and entrusting them to both grow that capital and provide a stream of income. Consequently a key part of the investment process is an assessment of a management team's competence to run the business and act in the best interests of shareholders. As a fund manager when I walk into a palatial office suite, not only do I see that my investor's money is paying for that flashy office with the harbour view, but also the management are unlikely to be serious in cutting costs during the down times. Walking into CSL's office in suburban Melbourne is like stepping into an unrenovated government office building from 1960s and then in the boardroom it is clear that management are both highly competent and are focused on shareholders.

Furthermore in assessing all companies in our universe we examine executive remuneration versus total shareholder return and penalize companies that are paying management teams that are not delivering returns for shareholders.

Philo Capital Advisers' approach to investing in Australian shares is founded on the principles of quality, value and sensible risk management. We view that over the long term and across a range of market conditions, outperformance will be delivered to our investors by owning a portfolio of companies with stable and growing dividends and earnings that have easily understandable business with barriers to entry that protect margins, have transparent financial accounts and trustworthy and shareholder-friendly management teams.

Disclaimer

This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.



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Tagged in: Australian Equities

Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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