BAEP won in the Australian Equities – Large Cap category and Quay won the Global Real Estate Investment Trust category.

The Awards, hosted by Zenith Investment Partners, recognise and encourage excellence in funds management across all asset classes.

Bennelong Funds Management’s CEO, Craig Bingham, said the awards are a welcome recognition of the expertise and skill of the portfolio managers.

“With significant and ongoing events impacting markets across the world over the past 12 months, the teams at BAEP and Quay are to be commended for delivering such strong returns to their investors during this challenging period.

“It’s particularly pleasing to see their achievements recognised by Zenith,” he said.

Zenith bases its awards selection on long-term criteria derived from its extensive research and due diligence, including fees, portfolio construction, investment team strength, security valuation and selection, risk management and investment philosophy.

The Bennelong Australian Equities Fund, one of the five funds managed by BAEP, is a high conviction ‘core’ fund and aims to grow investment value over the long term via a combination of capital growth and income, through a diversified portfolio of Australian shares.

The Quay Global Real Estate Fund invests in a portfolio of real estate securities listed on stock exchanges around the world, and is relatively concentrated and currency unhedged, with a conviction-based approach.

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The funds are the Bennelong Australian Equities Fund, the Bennelong Twenty20 Australian Equities Fund, the Bennelong ex-20 Australian Equities Fund and the Bennelong Concentrated Australian Equities Fund.

All four funds are run by BAEP’s single investment team, based on a similar active management, long-only equities strategy that uses a fundamental and bottom-up investment process.

BAEP was founded in 2008 by Mark East in partnership with Bennelong Funds Management.

In its reports for each of the funds, Lonsec said: “This rating reflects Lonsec’s high regard and increased conviction for the experience and calibre of Portfolio Manager and CIO, Mark East, as well as the robust and logical investment process and supportive ‘boutique-with-backing’ ownership structure, which ensures a strong alignment of the investment team.

“Notably, the Fund has delivered an impressive long-term track record of outperformance relative to the benchmark and its peers and has successfully met its investment objective over all assessed time periods.”

It also said: “The Manager adopts a comprehensive stock research process with the key drivers being extensive industry and value chain (competitors, suppliers, customers, regulators) analysis supported by a well- resourced company visitation program.

“Lonsec draws significant comfort from the research process, considering it to be comprehensive and able to identify quality stocks.”

The Bennelong Australian Equities Fund has returned 18.01% over one year, 15.54% p.a. over 3 years, 14.20% p.a. over 5 years and 13.97% p.a. since inception*. All four funds are available on multiple platforms, with the Concentrated Fund recently being added to the North platform.

 ——–

*As at 31 August 2020. Inception date is 20 January 2009.

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Julian Beaumont

The Australian sharemarket has doubled investors’ money since the bottom of the GFC – something that seemingly goes unnoticed by many commentators – and investors are risking potential returns by concerning themselves with future economic uncertainty, according to Bennelong Australian Equity Partners’ investment director, Julian Beaumont.

Studies into the psychology of loss aversion show investors feel losses twice as much as gains, and while speculation of a recession or equity market crash is rife, investors are doing themselves a disservice by focusing too much on the unknown, Mr Beaumont said.

“Being fixated on risk is resulting in investors missing out on market opportunities.

“The GFC has left investors with deep psychological scars that are yet to fully heal. In the decade since, investors have mostly targeted low-risk and low-volatility investments, with the obvious example of this being their preference for bonds and real estate.

“When it comes to equities, investors have sought out the safety of defensives, yield and the momentum of whatever has most recently been working, such as AREITs, gold stocks and ‘expensive defensives’, even though not necessarily justified by the fundamentals,” he said.

Mr Beaumont believes the Australian market is currently at its normal, orderly self, and with investors speculating about a potential recession and corrections, the sentiment is invariably making its way into share prices.

“Ironically, where there seems to be the most risk is where it is perceived to be the least. The rush into safety – bond proxies, for example – might prove to be not so defensive given their popularity and stretched valuations.

“At the very least, the current uncertainty in markets is good reason for investors to ensure they are genuinely diversified,” said Mr Beaumont.

Research shows there is little correlation between economic growth – specifically GDP – and equity market returns, and while volatility presents risk of loss in the short term, the risk reduces further out, becoming almost irrelevant over the long term.

In practical terms, this is evidenced by the fact that worrisome economic data post-GFC, which showed signs of a weakening economy, was actually beneficial for both bonds and equities.

“The bad news effectively delivered a greater probability that central banks would come to the rescue with further monetary stimulus, so why did we fear what didn’t bring us any harm?

“Does all the worrying and speculation make us better investors? No. Having some defensive strategies in place in case of a downturn is one thing; but continually anticipating the worst is another. Amid all the doom and gloom, we’ve actually had it pretty good,” he said.

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The award-winning fund, the Bennelong Concentrated Australian Equities Fund, has provided strong returns over time. Since the fund’s inception, it has returned 18.1% per annum compared to the benchmark’s return of 10.6% over the same time period. Over the past year, it has returned 19.6% compared to the benchmark’s return of 5.7% (returns are as at 30 April 2018 and the fund’s benchmark is the S&P/ASX 300 Accumulation Index).

The fund is concentrated in BAEP’s highest conviction stock picks, typically holding 20-30 stocks selected from across the ASX. BAEP manages the fund using a research-intensive and risk-focused investment approach that emphasises companies with strong fundamentals.

BAEP’s CIO, Mark East, said the fund’s success came down to a focused investment approach and the discipline, focus and hard work of the investment team in executing it.

“This award pays tribute to the consistent effort of our investment team and the strong returns we’ve been able to achieve for our clients,” said Mr East.

BAEP was founded in 2008 by Mr East in partnership with Bennelong Funds Management. It now manages five Australian equity funds, all employing the same proven investment approach. The Bennelong Concentrated Australian Equities Fund was one of BAEP’s first funds, incepted in January 2009, and will celebrate its 10th anniversary next year.

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Julian Beaumont

The global economy is experiencing synchronised growth creating good opportunities for investors locally and internationally, according to Bennelong Funds Management’s investment partners.

Julian Beaumont, investment director at BAEP, says the upcoming ASX reporting season will be closely watched by the market, but the expectation is that it will be generally positive.

“Despite a strong last quarter, the ASX is yet to regain its highs from late 2007, and only in November regained highs from early 2015.

“While overall the market should provide decent returns, stock selection will remain an important element.

“The biggest risk for markets is a material jump in interest rates, but with Australian 10-year government bonds yields at around 2.8 per cent – the same as the start of 2016 and 2017 – this seems to be some time off.

“As was the case in 2017, the best opportunities will be outside the top 20 stocks. In 2017, the top 20 stocks returned 7.3 per cent, while the ex-20 stocks returned 18.7 per cent.

“Increasingly, risks are appearing in the so called ‘safe’ stocks, such as the banks, Telstra, Wesfarmers and other bond proxies.

“There are promising opportunities in a number of successful Australian exporters and global businesses, but a question mark hangs over whether the Australian dollar will strengthen.

“Globally, however, the economic outlook is strong and conditions are conducive to solid returns for international equities,” Mr Beaumont says.

According to Justin Blaess, portfolio manager at Quay Global Investors, the global outlook for property markets in 2018 is also generally positive.

“Global capital is still actively seeking real estate returns and the global macro environment is conducive to this.

“In the US, supply fears are abating and are constrained by tight labour markets and higher funding costs.

“In Europe, markets are earlier in the cycle and so still have a way to run, while in Hong Kong and Singapore the rental cycle is recovering.

“Generally, global REITs are trading a discount to private market net asset values (NAV), with some market commentators estimating this is by as much as 10 per cent.

“The expected 12-month total return forecast for 2018 is for low double digits, consisting of earnings per shares (EPS) yield of 5-6 per cent and growth of 5-6 per cent.

“Locally, despite prophecy of a looming retail apocalypse, retailers in Australia are still employing and there has been no uptick in retail insolvencies.”

Mr Blaess echoes Mr Beaumont’s view that the Australian dollar is a wildcard in the mix, and says global real estate returns for Australian investors were negatively impacted by a strong dollar in 2017.

Meanwhile, it is onwards and upwards in global infrastructure for 2018, says Greg Goodsell, global equity strategist with 4D Infrastructure.

“Globally, there is a huge infrastructure spend that needs to be financed and traditional government fiscal resources are, quite simply, inadequate.

“Private sector financing will be an essential element of future projects if global infrastructure investment needs are to be met.

“According to the World Bank there is a significant spending gap across both developed and emerging market countries. It estimates that global infrastructure investment needed by 2040 will total $US94 trillion.”

Globally, the increased infrastructure spend required is partially due to the rise of the middle class at an unprecedented rate.

“At a global level we are witnessing the most rapid expansion of the middle class the world has ever seen – particularly in Asia.

“At the end of 2016 there were 3.2 billion people in the global middle class. That will increase by 160 million each year for the next five years. In all, 88 per cent of the next billion entrants into the middle class will reside in Asia.

“Globally, the middle class is already spending $US35 trillion and could spend $US29 trillion more by 2030, accounting for roughly one-third of the global economy.

“This rapid pace of growth will also need a commensurate increase in infrastructure development to keep up with its growth – and private sector financing will be essential to meet the global investment need,” says Mr Goodsell.

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In general, the anonymity of the stock market prevents us from knowing too much about the sellers. However, there are important instances where we do.

Director and other insider selling

It makes sense that investors should sit up and take notice when those in the know are selling. Directors, CEOs and CFOs invariably know more about their company than outside investors. Any insider selling should thus invite questions over what might be implied.

The last year has seen a number of high profile cases of insider selling that have preceded company problems and steep share price declines. These include at Aconex, Bellamy’s, Brambles, Healthscope, Sirtex Medical, Vita Group and Vocus Communications. It is tempting to conclude that investors should assume the worst upon seeing any insider sales. Academic research^[i], and BAEP’s own quantitative analysis, shows that insider selling indeed correlates with subsequent underperformance. However, the extent of this is relatively insignificant, statistically speaking at least. Insider selling is not necessarily a forewarning of troubles ahead. In fact, the ASX specifically warns against assuming as much^[ii]. After all, inside selling is quite common. Over the last 12 months, 47 of the companies in the ASX 100 disclosed insider sales^[iii]. Of course, not all of these stocks have struggled. In fact, some have been among the past year’s best performers, including those in the table across.

It is said there is only one reason to buy shares, but there are many reasons to sell. Only if the reason denotes something negative of the company’s prospects should investors be concerned. Determining a seller’s reasons, however, is not always easy. Companies will often point to some innocuous reason, such as to fund the purchase of a house. Investors should, however, treat them with scepticism. Never is the reason given that the insider sees troubles ahead, believes the shares are overpriced, or considers now a better time than later to cash out. The surrounding circumstances of the selling are likely to be far more telling.

A Case Study: Ramsay Health Care

Earlier this year, one of BAEP’s largest holdings, Ramsay Health Care, announced the following significant insider selling on 6 March 2017:

• Chris Rex, the outgoing CEO, sold 400,000 shares at $68.10 per share, with sale proceeds of just over $27 million; and
• Bruce Soden, the CFO, sold 110,000 shares at $68.18 per share, with sale proceeds of $7.5 million.

Following the announcement, the shares traded down about 5% over the subsequent week, to a low of $62.35. We treated the insider selling as a ‘red flag’, something that gave us cause to consider the implications. In doing so, we considered the following factors.

1. The percentage and dollar value of the insider’s shareholding sold/retained

The sales were material, but both still retained significant shareholdings. Mr Rex retained 806,213 shares and 589,181 performance rights (leaving him with more than two-third of his previous holding of ordinary shares). Mr Soden retained 290,791 shares and 254,419 performance rights (leaving him with about three-quarters of his previous holding of ordinary shares).

2. The frequency and extent of previous selling

Both Mr Rex and Mr Soden had previous form in selling material stakes, none of which had preceded troubles for Ramsay.

3. The number of insiders selling around the same time

The more insiders selling, the worse the assumption might be. That both the CEO and CFO were selling was significant. Partly diminishing its significance is that they had sold at similar times before, as shown in the table above, and that there has been minimal other recent insider selling in recent years^[iv].

4. Recent share price performance

If a company’s share price has fallen hard, insider selling may confirm troubles ahead^[v]; if the shares have been particularly strong, insider selling may imply a view they have become overvalued. Ramsay’s shares were broadly stable in the preceding few months. They had traded higher at around $80 six months earlier, but there was no insider selling at these prices, many other ‘defensive growth’ stocks had also been sold off over that time period, and the company had since upgraded earnings guidance.

5. The timing of the sales, particularly around regulatory change, earnings results, etc.

Two weeks before the insider selling, the company reported a strong first half financial result and upgraded full year earnings guidance. This provided comfort at least on the company’s near-term prospects. However, also at the time, the company announced the intended retirement of the CEO, Chris Rex. He was highly respected, and news of his retirements was inevitably taken negatively by the market. The news of the CEO’s intended retirement clearly added to concerns raised by his selling. As a separate issue, we were able to satisfy ourselves of the reasons for the CEO’s departure, which included discussions with him directly. He had, after all, been CEO of the company for eight years and Chief Operating Officer before that for 13 years. Thus satisfied, we were able to get comfort that the insider selling did not imply anything untoward in the context of recent developments. Indeed, those developments offered a justification for the CEO’s selling. We also noted favourably from a corporate governance viewpoint, that the selling had transacted after news of these developments was released^[vi].

6. The stated reasons for the sales

Some reasons given are tenuous and their implication equivocal. These include to diversify (denotes the shares carry risk that needs diversifying from), to provide greater liquidity in the company’s shares (how selfless?), and to fund tax liabilities (possibly only solved by selling shares but it’s impossible to verify). For both Mr Rex and Mr Soden, the later reason was given, specifically, to fund tax liabilities arising from shares they received as part of their remuneration. This is largely unhelpful.

In Mr Rex’s case, it is understandable that he might sell down what is likely his most valuable asset as he nears his retirement and the need to fund it becomes pertinent. As before, his resignation explains his selling. Indeed, the other reason Mr Rex gave for this selling was for “the orderly diversification of his personal investment portfolio following the announcement of his intention to retire”.

7. The company’s future prospects

Based on our research, these continue to look good for Ramsay, with earnings growth supported by a pipeline of high-returning capex projects for hospital expansions, a procurement cost-out program, a retail pharmacy network rollout, and structural industry tailwinds owing to factors such as a growing and ageing population.

On this last point, it is important to realise the extent to which the company’s prospects depend on exogenous factors. For example, selling by an insider at a resource company is less telling given his company’s prospects depend heavily on commodity prices, in respect of which an insider’s view generally carries limited insight.

We were mostly able to get comfort in the insider selling, and accordingly, maintained a position in the company, albeit that it has been reduced. So far, Ramsay’s shares have not moved far from the time of the insider sales. We nevertheless remain vigilant, and willing to change our view if warranted by our continued research and analysis.

The important takeaway is that insider selling is not always a worrying sign. At BAEP, we have over time been invested in a number of stocks that have performed well despite substantial insider selling. A good example is Aristocrat, which is referred to in the table on the first page and whose stock price has risen very strongly.

Initial Public Offerings

Like insiders, the vendors in an IPO typically have an intimate understanding of the company they are selling. This places them at a considerable advantage over new investors. The vendors get to choose the timing of the float, presumably to coincide with when they believe the company looks best and market conditions most receptive. As well, potential investors generally get limited access to historical financials and other information, and limited time in which to assess an investment in the IPO.

On the other hand, the vendors are often trying to sell a large amount of stock, and need to price it favourably enough to encourage sufficient uptake to get the IPO away. In part owing to this, the track-record of IPOs is actually a generally positive one, remembering of course that all listed companies were once IPOs. Undoubtedly, there is a mix of good floats and bad. The trick, of course, is to identify the former. In this respect, investors should gain conviction as they would in respect of a stock already listed. However, it is also worth considering the position of the vendor.

In some IPOs, the vendors are selling their entire shareholding, leaving them with little concern for the company’s success once listed. Here, the vendors will be motivated typically to maximise the IPO price, and caution is required. In other IPOs, the vendors might retain a significant shareholding. Indeed, in some IPOs, it is only the company itself that raises money, achieved through the issue of new shares, with this money directed back into the company itself rather cashing out some or all of the shareholders. In these instances, it is possible to imply confidence on the part of existing shareholders, and an ongoing interest in the company’s future success.

PE-backed IPOs

Investors have learnt to take extra caution when it comes to IPOs in which the vendor is a private equity firm. PE firms are purely financial sellers, and unashamedly motivated to maximise investment returns and therefore the IPO price. In some cases, this appears to have led them to dress up the business to look more attractive, for example by reducing costs and capex and providing overly optimistic earnings forecasts. There have been many examples that have gone horribly wrong over the years, including high profile IPOs such as Myer. Owing to examples like this, the markets have increasingly required private equity to retain significant shareholdings, forcing them to own the company’s prospects in the first years of its listed life. In some cases however, this has just delayed the inevitable, with the stock’s performance suffering soon after private equity have sold down their stake once it comes out of escrow. Examples include post-IPO sell-downs at Spotless, Dick Smith, Estia Health, Healthscope and iSentia. In this respect, investors should be conscious of the possibility of a post-IPO private equity sell down, and when that might be.

The reputation of private equity has obviously suffered as a result of some notable disasters. This has recently meant some difficulty in encouraging investors to take up PE-backed IPOs. Some potential IPOs have been pulled, such as Zip Industries, and some have found greater interest via trade sales, such as Alinta Energy. Private equity has an interest in keeping open the IPO route as a viable exit strategy for future investments. A poor reputation will rob them of that opportunity.

The reality is that whilst there have been some disasters, there has also been some big winners. Examples include Seek and Invocare. In fact, the results of PE-backed IPOs are better than commonly perceived. The table on the following page looks at the returns of all PE-backed IPOs since the beginning of the current IPO cycle at the start of 2013. A $1 invested in each of these IPOs would have generated an average return of approximately 31% to the end of May 2017^[vii]. Of course, there have been some stinkers like Dick Smith, but there have also been some very healthy returns to make. This recommends against blankly ruling out PE-backed IPOs.

At BAEP, we are admittedly more discerning when it comes to PE-backed IPOs. Even so, we have been able to participate in, and benefit from the success, of the IPOs of MotorCycle Holdings, Eclipx Group, BWX, Bursons, Veda and Mantra Group (some of which we continue to own).

Privatisations

“Whatever the Queen is selling, buy it.”

Peter Lynch, Beating the Street

Certain types of IPOs more consistently offer profitable experiences for investors. One of the best examples is a privatisation, where the Government is selling its wares via an IPO.

There are a number of reasons why it often makes sense to buy whatever the Government is selling:

• naturally, the Government wants to give incoming investors, who are also voters, a happy experience. Privatisations are typically priced accordingly;
• government-backed IPOs tend to be of solid businesses that are industry leaders. Examples include Commonwealth Bank, Aurizon, Telstra, Tabcorp and Medibank;
• government businesses are often bureaucratic, have inefficient cost bases, and lack accountability and entrepreneurism. Once listed, they tend to be run far more profitably, the benefit of which accrues to the new investors. Witness Aurizon’s cost-out programs, and CSL’s ambition in building out a global biopharmaceutical powerhouse; and
• privatisations are not necessarily timed to maximise sale proceeds in market upcycles. Instead, timing is more dependent on the Government’s desire to pay down debt, use the proceeds to invest elsewhere in the economy, or to deregulate industries.

Reflecting these factors, privatisations are generally relatively low-risk and nice returning IPOs to look out for.

Conclusion

The takeaway is that we should not necessarily fear who takes the other side of a trade we are on. This is so even when buying from a director or CEO, or from a private equity firm as part of an IPO or post-IPO sell-down. It should however focus the mind, leading one to understand the reasons for their selling, and to reconfirm one’s own conviction in the company’s prospects. In this respect, research is one’s best defence.

———

[1] See, for example, Insiders’ Profits in the Australian Equities Market, 2016, CIFR, by Berkman, Bradrania, Viljoen and Westerholm
[2]Per ASX Guidance Note 22: “ASX does not believe that directors’ securities trading is necessarily an indicator of an entity’s prospects and discourages any perception that investors should rely on such information in making investment decisions.”
[3] Per disclosures to the ASX, as at 31 May 2017.
[4] An exception was director selling of approximately $565,000 worth of stock in April 2016 at an average price of $62.71
[5] Another possibility is that the insider receives a margin call and is forced to sell his or her shares. This is speculated to have been the case when Estia Health’s found Peter Arvanitis sold his 10% stake in September last year.
[6] Ramsay’s Securities Trading Policy effectively requires prior approval for any trading.
[7] Admittedly, this is the arithmetic average return. It reflects the opportunity set for investors that can be selective in which ones they invest in. The geometric return, calculated as the compound annual growth rate, is somewhat lower.

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Julian Beaumont,

Despite recent talk about ‘disruptors’ and the impact that new companies can have on traditional marketplaces, investors shouldn’t assume that ‘innovation’ necessarily means disruption and fear the worst for their portfolio.

“Innovation and disruption are part of capitalism, and have been happening for a long time,” says Julian Beaumont, investment director at Bennelong Australian Equity Partners (BAEP).

“Investors therefore shouldn’t get too carried away with the idea that all innovation is disruptive, and is going to turn markets on their head and force incumbents into the gutter.

“Companies such as Uber have perhaps led to the idea that new approaches will lead to the destruction of traditional operators.

“Certainly new and innovative companies can have a significant impact on an industry, but the subsequent demise of existing companies isn’t inevitable.

“Nor is it a new phenomenon. Seek, the job search company, could be described as a disruptor, and has without question had an enormous impact on the newspaper companies and their employment classifieds revenues. But it was founded 20 years ago and is hardly a new company.

“Likewise, there are many established companies innovating for better and better products, not necessarily replacing old ones. CSL, Cochlear or ResMed are extremely innovative in advancing product capabilities, user-ability and other features.

“Therefore ‘new’ or ‘innovative’ does not automatically mean ‘disruptive’,” he said.

He said that one of the least risky ways for investors to take advantage of the theme is to find the companies that are benefiting from the new ways of doing old things.

“We search for the companies that are beneficiaries of innovation, who are leveraging innovation to build on existing revenues streams, improve efficiency and reduce costs, and push further their competitive advantages.

“We believe it is preferable to invest in proven businesses with an existing strong competitive position and scalable base of earnings.

“A good example is Dominos, which has just started trialling robotic delivery drivers and drones to deliver pizza.

“At this stage, it seems gimmicky, but if successful, it has the potential to excite the customer, take out wages and other costs, and speed up delivery times. Ultimately, whether it works or not, Dominos is thinking about continuous innovation to improve its offering and competitive position.

“Another example is Rio Tinto which has recently started using driverless trains. It might be tongue in cheek to say, but they beat the likes of Google and Tesla to driverless vehicles.

“In both cases, these are existing strong businesses that can take advantage of innovation.

“We tend to be cautious of new businesses formed out of new innovation that have yet to prove profitability. Just as they might have disrupted an industry, so they may easily be disrupted themselves,” Mr Beaumont said.

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The Fund is managed by Bennelong Australian Equity Partners (BAEP) and has been rated ‘highly recommended’ consistently since 2011. It provides investors with an Australian shares portfolio that invests in companies that lie outside of the top 20 ASX listed stocks. In its latest review Zenith said the fund is an appealing offering owing to its highly capable portfolio manager and demonstrated track record of outperformance.

In its latest review Zenith said the fund is an appealing offering owing to its highly capable portfolio manager and demonstrated track record of outperformance.

The fund is placed in Zenith’s “Australian shares – mid-cap” sector, which it says can potentially be used by investors seeking a lower volatility exposure to ex-20 Australian Shares, versus a more volatile dedicated small companies fund. Over the longer-term, it says active management in this sector has historically demonstrated an ability to outperform a passive index.

Portfolio manager Mark East said: “The Fund leverages some really promising companies outside of the large-cap names that everyone knows of.

“In comparison to the typical domestic core equity portfolio, the Fund offers genuine diversification and greater exposure to the rich opportunity set outside of the largest 20 stocks,” Mr East said.

BAEP is a boutique fund manager established in 2008 as a joint venture between Bennelong Funds Management (Bennelong) and BAEP’s principals.

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Julian Beaumont

Companies on the cusp of achieving a turnaround in their fortunes can offer savvy investors the opportunity to invest in quality that may not be readily apparent to others; however successful turnarounds are rare and often difficult to identify in advance, says Julian Beaumont, investment director at BAEP.

“The idea of identifying opportunities that are underappreciated by the market is very appealing in that it usually comes with undervaluation.

“A turnaround can be defined as a company changing from a poor quality company to a good one. This doesn’t mean companies whose improvement relies on the cycle, such as a building materials company benefiting from a housing construction boom, but rather a corporate change that is more structural and enduring.

“Certainly in the current market environment, there are an increasing number of companies who recognise that they can’t rely on the economic cycle to boost their fortunes, and are looking for structural changes to improve performance and deliver better outcomes for shareholders.

“Successful turnarounds can often give rise to an investment ‘double play’. Firstly, the company materially improves profits – often dramatically so. Secondly, this then leads to a change in investors’ perceptions, leading to a re-rating of the company’s shares through a higher valuation multiples. This double play compounds returns for shareholders nicely.

“In addition to the potential outsized returns, turnarounds can also offer diversification benefits. Turnarounds represent upside that is generally stock-specific and, as a result, performance has far less correlation with the rest of the market. The ups and downs of the share price depend more on what is going on within the company rather than the broader stockmarket.”

But Mr Beaumont warns that investors need to be cautious about investing in turnarounds as there are significant risks.

“After all, a turnaround may not succeed. Worse still, considerable costs may have been wasted in the attempt and underlying profitability may have deteriorated further or additional harm inflicted. It will also dispel any hope that investors had that things will improve. As a result, the stock price may well falter, or at least remain depressed.

“From an investor’s point of view, it pays to stay close to the company in question. We tend to wait for genuine evidence that a company is in fact turning, most often through the company’s report financials, as head fakes are common in this game. As a result, we’re happy to give up the first 20 percent or so of returns if it means greater certainty on the progress of the turnaround. Invariably this still leaves plenty of upside as the market slowly recognises what the company is turning into.”

Mr Beaumont says the reality is that it is far more common for turnarounds to fail than succeed.

“There is often a fine line between success and failure in any turnaround situation, and the trick is identifying which turnarounds will in fact turn.”

There are a number of common attributes of successful turnarounds that investors should look out for:

• The existence of a strong underlying business or assets to work with – a business with good bones will find it much easier to successfully turn
• A new CEO (often from outside the company) carrying none of the company’s historical baggage and who can drive the turnaround strategy
• A corporate restructuring, generally aimed at building up the higher quality businesses and exiting unprofitable ones
• Industry rationalisation, particularly as part of an attempt to beef up profitable businesses, with the added benefit of improving industry structures
• An accommodative industry, in which a struggling company is allowed to re-emerge, or where the industry, as one, works towards higher pricing and therefore profitability
• A recapitalisation, with the effect of addressing an over-leveraged balance sheet, which affords the financial flexibility to get through any difficulties that emerge during the turnaround, and which allows investment into profitable growth opportunities.

“These factors don’t ensure the success of a turnaround but their existence improves the probability of success,” says Mr Beaumont.

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A bias towards high quality companies naturally comes with the question of how to define quality. The answer is not straightforward and there is no simple textbook definition. This contrasts with other investment styles such as value and growth that can be assessed objectively based on a few select quantitative measures. Value is characterised as cheap, typically by reference to a low price-to-earnings or price-to-book ratio; whilst growth is characterised by fast growing sales and earnings. Defined this way, there is generally near universal agreement when it comes to identifying the typical value or growth stock. Not so in the case of quality.

Trying to quantify quality

The concept of quality is inherently imprecise and subjective and, as a result, it can mean different things to different people. Unable to deal with this ambiguity, quants and the like have attempted to simplify quality down to a few quantitative measures. The issue then becomes deciding which metric or metrics best define quality, and in this respect, there is no uniform agreement[1]. A few select measures, however, are more commonly referenced and arguably do most of the heavy lifting, with probably the most popular being the return on equity, or ROE[2]. These are summarised in the design of the MSCI Quality Indices, which identifies quality stocks as those ranking in the top 5% in terms of return on equity, levels of financial gearing, and stability of earnings growth. Definitions like these in fact do a reasonable job of approximating quality, particularly in their effort to group stocks into quality ‘buckets’. Indeed, the MSCI World Quality Index is made up of the type of high quality stocks one would expect to see, including for example Microsoft, Johnson & Johnson and Nestle.

As much art as science

However, purely quant-based tests have limitations. These limitations are most pronounced at the individual stock level. Quant-based tests invariably rely on accounting-based metrics and this means they are necessarily backward-looking. They assume the past will carry on into the future, which is reasonable enough at a general level but ignores the possibility of change at any particular company. To gauge this, it is necessary to look at the softer issues that lie behind the numbers.

Until recent years, Woolworths Limited was considered one of the highest quality ‘blue chip’ stocks on the ASX. It dominated the supermarket industry with scale advantages and a compelling customer offering, which in turn allowed it to nicely grow sales, earnings and dividends. On its own admission, it then began late last decade to ‘put profits ahead of customers’, including pushing grocery prices and shaving in-store service. This manifested in profit margins that grew well above historic and global norms and evidenced a business that was over-earning. Soon enough, competition intensified, in particular with a new low-cost proposition from Aldi and a rejuvenated Coles. Somewhat arrogantly, Woolworths maintained a short-term profit focus, and these competitors were able to steal sales and chase down its lead. Meanwhile, a maturing profile saw it stretch for growth. This included heavy investment in new stores of questionable profitability and, helped along by a healthy dose of hubris, a misguided $4 billion investment in the Masters start-up. This year, the company will report asset write-downs of over $4 billion, a further decline in sales, and margins below Coles. It now finds itself facing a difficult turnaround that even on the company’s reckoning will take as long as five years.

Woolworths is a good case study in showing how an assessment of the qualitative factors – including the increased competitive intensity, deteriorating customer offer, poor capital allocation, and cultural concerns – are important in uncovering quality issues that the numbers alone may not reveal for some time.

A few other examples will suffice.

• Most investors today will quite rightly identify CSL Limited as a high quality global biopharmaceutical company. This was not always so. In the early 2000s the company struggled with uneven profits, sub-par returns on equity, and relatively high debt levels[4]. It was then in the process of consolidating the plasma products industry, first with the acquisition of ZLB Bioplasma in 2000, and then Aventis Behring in 2004. These acquisitions brought it scale and consolidated the industry, enabling it to build a strong competitive position in an attractively structured industry that underpins the strong returns and growth it enjoys today. Its share price has reflected the transformation, rising from below $4 in 2003 to now almost $120. As another example, TPG Telecom went from losing money in 2008 to a highly efficient, low cost provider by consolidating the broadband industry.
• Companies can restructure into higher quality franchises. Earlier this decade, Caltex was largely characterised by a very volatile and highly capital intensive oil refining business. In 2012, the company set about a restructuring which involved shutting its problematic Kurnell refinery and refocusing the company back to its quite stable and high returning fuel distribution business. Its share price almost tripled from the time the restructure was announced until the time its higher business quality came to be reflected in its financials. The reorganisation of Amcor last decade, in which it shed weak business and scaled up strong ones, is another example of quality improving as a result of internal restructuring.
• Companies materially exposed to regulatory risk can have their businesses or profitability upended. This regulatory risk is typically not evident in the financials. As an example, the lucrative Victoria pokies duopolies of Tabcorp and Tatts were literally taken off them by the Government in 2012 without compensation. Some industries that rely on Government licenses or funding, including gaming, healthcare and education, are particularly exposed to regulatory risk.

Earnings risk and upside potential

Fundamentally, we believe company earnings are the ultimate source of shareholder returns, both to the upside and downside. In this context, the quality of a company is that which defines its earnings risk and upside potential. In assessing quality, we employ a research-intensive approach that investigates all aspects of a particular company and its earnings prospects, including the qualitative and quantitative factors listed in the adjoining table, and in fact many more.

Contrasting examples

Superficially at least, Ramsay Health Care and Primary Health Care run quite similar businesses. Ramsay is the largest private hospital operator in Australia, while Primary is the second-largest operator of medical centres and pathology labs. Both companies provide healthcare services that are economically resilient and for which demand continues growing strongly. The two companies, however, provide a useful contrast in terms of quality.

Ramsay Health Care

Ramsay has a very strong competitive position through its ownership of a strategic portfolio of 70 private hospitals across Australia. These hospitals gain from significant barriers to entry. It requires considerable capital and time to set up a new hospital, and it is generally uneconomic to do so especially when it means competing against an existing hospital that already has scale. Owing to the popularity and scale of its hospitals, Ramsay is able to achieve very high occupancy levels, procurement and operational efficiency savings, and negotiate better rates with the private health insurers who are largely responsible for paying for their members’ hospital visits. Ramsay’s strength is evident in its Ramsay’s ROE of 23%, which in fact has been increasing in recent years.

Ramsay’s business is very well positioned to profitably take advantage of industry growth, which it does by
incrementally expanding hospitals to soak up the increasing demand. This involves considerable investment at high returns, which reflects and supports the high ROE, and which underpins strong growth in earnings per share (EPS) that has averaged 19% per annum over the last seven years. Fortunately, it has a large pipeline of similar investment opportunities, including over $1 billion over the next five years.

Ramsay has an enviable industry reputation. This is underpinned by strong relationships particularly with doctors, who are free to choose where to treat their patients. Top management shares a similar reputation. They are of high calibre, all long time employees of the company, consistently over-deliver, and have significant shareholdings of their own in the company.

In contrast to most healthcare service providers, Ramsay arguably has less exposure to regulatory risk. Its business receives a relatively low percentage of its revenues as direct funding from the Government, relying largely on private health insurance and private co-payments. To the extent that the Government retards the private hospital sector – for example by discouraging the take-up of private health insurance – it must take up the burden themselves. This seems unpalatable in the context of current fiscal constraints and forecasts of massive healthcare demand to come. Ramsay’s efficient operating model and willingness to invest reduces the risks of adverse regulation.

Primary Health Care

Primary’s market positions are more tenuous. The success of its medical centres business is largely determined by its ability to attract and retain doctors to work at its clinics. Primary’s main ploy is to ‘buy’ doctors, which has historically involved large upfront payments and tying them up with five-year lock-ups, minimum billing targets, and restraints of trade, all of which the company would aggressively enforce through the Courts. Understandably, this resulted in a strained relationship with doctors. In contrast to Ramsay, Primary has been unable to take advantage of industry growth, its doctor numbers have in fact been in decline for some time. The company is now looking to embrace more flexible working arrangements, including less focus on upfront payments, but it has little to offer a doctor that is truly unique, which in itself explains the previous need for large upfront payments.

Primary’s other large business in pathology is arguably a stronger one. The pathology industry operates with high barriers to entry, with the scale of the largest players ensuring their centralised labs are run more efficiently. However, the benefits of scale also mean heavy competition for the referrals of their client doctors. This has historically involved paying exorbitant ‘rent’ to the doctors to house collection centres at their practices, a practice which may now be regulated away. However, if margins are not competed down, they may very well be regulated down.

In fact, Primary is very exposed to regulatory risk. It derives the bulk of its revenues from GP visits and pathology tests and these are largely paid for by the Government through Medicare. As seen earlier this year with Medicare cuts to lab and imaging services, the Federal Government can and will restrict reimbursement on which Primary’s earnings primarily rely.

Like its industry reputation, Primary’s corporate reputation has struggled. Primary has historically been run more like a family business than a listed company. For example, the founder’s sons ran the company’s two main businesses from an early age and sat on the Board. An effort is now being made to improve governance with, for example, the two sons displaced from the Board and only one left as a business head. However, clouds remain, with for example the CEO currently embroiled in a corruption scandal relating to his time as CFO at Leighton Holdings.

Primary’s accounting has been particularly aggressive. The most obvious example has been in its capitalisation of the cost of acquiring doctors’ practices and in failing to amortise this cost over time. This has left its reported earnings overstated. Indeed, the real cost of these practices has drained cash flows and ensured high debt levels that are only now being addressed through asset sales. Including the goodwill for its ‘ownership’ of doctors’ practices, as well as for overpriced acquisitions along the way, its ROE is just 5%. Indeed, its market value is worth less than what has been invested into it. Excluding this goodwill, the company has a deficit of shareholder equity.

Having your cake and eating it too

The chart below shows why it was worthwhile paying up for Ramsay’s quality instead of being sucked in by Primary’s apparent cheapness. Ten years ago Ramsay’s shares traded at $9.60 and are now almost $80. This performance has been underpinned by a quadrupling of EPS over that time. Primary’s shares traded at $8.40 ten years ago and have halved since to about $4 today, with its EPS a quarter less over that time.

The experience of Ramsay and Primary is quite common for high quality versus poor quality stocks. Research covering both global and local markets[6] shows quite consistently that quality outperforms over time, and perversely for those that still think the two are inversely correlated, the better returns come with less risk. Indeed, Jeremy Grantham of GMO fame went as far as to say that in quality he had finally found a ‘free lunch’[7]. Interestingly, for those that insist that the ‘quality rally’ of the last five or so years explains the free lunch, Mr Grantham’s analysis, which relied on a similar definition to that used for the MSCI Quality Indices discussed earlier, is based on a period starting in 1965 and ending in 2009[8].

Quality’s happy combination of generally higher stock returns and lower risk reflects BAEP’s view of quality as defining the upside potential and downside risks of stocks. Of course, this is not an argument to buy high quality stocks at any price. The Nifty Fifty days of the 1970s is evidence against that, as seen in the steep peak down in the graph above. However, over time, quality is typically underappreciated and therefore undervalued. Quality works, it seems, because the market systematically undervalues the type of boring but reliable growth in earnings and valuation seen from the likes of Ramsay, and underplays many of the risks that threaten the earnings of the likes of Primary.

Conclusion

Our goal as fund managers is to maximise investment returns over time. We seek to achieve this by selecting stocks on the basis of their upside potential and downside risk. We view this risk-return dynamic for any company through the prism of earnings prospects, and in turn through a focus on the quality of a company. In assessing quality, we do not work to some narrow but easy-to-apply definition. Instead, we apply judgement based on quite a broad understanding of quality, which involves weighing up a great number of relevant factors. Unfortunately, the outcome is less clear cut than afforded by a quant-based definition, but we would rather be vaguely right than precisely wrong.

By Julian Beaumont, Investment Director

[1] To give you a taste from academia, there are two very different tests that have gained prominence: the first is the Novy-Marx measure that relies on the gross-profits-to-assets ratio (see Quality Investing, 2013, Robert Novy-Marx); the second is the Piotroski F-score that calculates the total of a binary 0 or 1 score on each of nine metrics such as ROA, asset turnover, and earnings quality (see Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, 2002, Joseph Piotroski (University of Chicago Graduate School of Management).

[2] The return on equity or ROE is the most commonly used measure of a company’s productivity. It reflects the extent of a company’s profitability in relation to the investment made in its business and is calculated as the profit divided by shareholder’s equity. The intuition behind its use is that only a few privileged companies can achieve, maintain and invest at high ROEs. Capitalism is such that high returns tend to be competed away and it takes a company with special qualities to fend off capitalist attack.

[3] Source: Company accounts, BAEP estimates. Note that write-offs have been added back into shareholders’ equity.

[4] In 2003 financial year, CSL Limited earned approximately $70 million in post-tax earnings, had approximately $500 million of net debt, and its ROE was just 5.5%.

[5] Source: IRESS, for the 10 year period to 30 June 2016

[6] See for example “Investing in Quality” (UBS, P Winter, 17 April 2014)

[7] GMO, “Friends and Romans, I come to tease Graham and Dodd, not to praise them.” (On the potential disadvantages of Graham and Dodd-type investing.), April 2010

[8] Likewise, the MSCI World Quality Index has outperformed since devised in 1975 by 1.36% per annum, and over the last 10 years by 3.44% per annum.

[9] Source: GMO, “Friends and Romans, I come to tease Graham and Dodd, not to praise them.” (On the potential disadvantages of Graham and Dodd-type investing.), April 2010

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This information is issued by Bennelong Funds Management Limited (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Bennelong Australian Equities Fund, the Bennelong Concentrated Australian Equities Fund and the Bennelong ex-20 Australian Equities Fund. The information in this document is current as at 4 August 2016. The information provided is general information only. It does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (each a Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388. BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Bennelong Australian Equity Partners (ABN 69 131 665 122) is a Corporate Authorised Representative of BFML.

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