Quality pays dividends, again

Mark Arnold

Mark Arnold

“Results from this reporting season reveal that the best Australian companies have a competitive advantage and grow their businesses on the back of sustainable earnings rather than debt. Weaker ones lack pricing power and are unable to guarantee a predictable earnings stream.”

These are the comments of Mark Arnold, Chief Investment Officer at Hyperion Asset Management, who yesterday explained what the February reporting season results reveal about winners, losers and businesses worth watching.

“For us, winners are those companies with ‘earnings resilience’, meaning the ability to grow earnings organically on the back of a strong value proposition, a track record of profitability, low gearing and a high return on equity.

“When these factors are present, earnings growth is strong, and evidence shows that strong and sustainable earnings growth is what really drives share prices higher over the long term.

“At Hyperion we are long term investors. This doesn’t mean that results from individual earnings seasons are not important, but we assess short term performance measures in the context of long term business fundamentals, which can put us at odds with the market on occasion.

“This is because the market tends to over-emphasise temporary themes and short-term factors, so it’s not unusual to see quality companies undervalued in the short term.

“In our eyes that can be a buying opportunity, it is exactly the kind of market inefficiency we look to exploit,” Mr Arnold explained.

Mr Arnold then gave the example of some of Hyperion’s major long-term holdings, including Cochlear, Domino’s Pizza and the REA Group as highlights of winners in the February reporting season.

“Cochlear had earnings per share (EPS) growth of 91%, Domino’s Pizza of 46% and REA Group of 36%, far in excess of the market as a whole, and industrials excluding banks, which had EPS
of -2% and 8% respectively.

“These earnings results are excellent and contributed significantly to the performance of our Australian Growth Companies Fund, which outperformed the ASX 300 by an average of 5.8% p.a. (after fees) over three years. However, the most important thing for us is our belief in the quality of these companies’ underlying business models, and their ability to continue to grow earnings over time,” Mr Arnold said.

Mr Arnold went on explain Hyperion’s aversion to resources and banking at the moment, describing these as the ‘losers’ in the current economic environment.

“Resources companies lack pricing power and competitive advantage, and their earnings are unpredictable as a result. Banks have run their course in our view, the credit environment is very subdued and likely to remain so, interest margins are tight, capital requirements are rising, bad debt levels are very low and likely to be a drag on profits going forward.” Mr Arnold said.

Banks may have run their course, but according to Hyperion, non-bank financial companies are on a growth trajectory, as is healthcare. Consistent earners, like REA Group and Seek, both showed good earnings momentum in the first quarter of the year, and are likely to continue to grow earnings consistently.

“Within the non-bank financials sector, we like the Henderson Group and Veda Group, among others, and Ramsay Healthcare and Healthscope are our picks in the healthcare sector,” Mr Arnold said.

Mr Arnold concluded by saying that reporting season results are always revelatory, but that the real lesson to be learned is that quality fundamentals, rather than short term results, are what will consistently deliver. And the real skill lies in identifying companies with these quality fundamentals.

“There are no guarantees in investing, but the probability of future performance emulating past success is much higher with a disciplined investment process and stable team in place.”

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