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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Julian Beaumont

The ASX was up strongly in February, indicating a positive investor reaction to reporting season, says Julian Beaumont, investor director with BAEP.

“The market mood was somewhat nervous leading into reporting season, with many fund managers perceiving significant earnings risk. Stirring these nerves, the few downgrades pre-announced before February were treated harshly, even when they only mildly disappointed.

“In aggregate, earnings for the full year were downgraded slightly, but only by a level considered typical of past reporting seasons.

“Earnings held up well enough and so stocks were able to gain nicely over the month.

“The consensus is concerned with the domestic economy, and particularly consumer-exposed sectors such as housing, retail and the banks. There were signs of this, though things seem to be getting worse. Management teams quite universally saw weakness ahead, even as some were reporting reasonably solid historic numbers.

“Management teams become all the more important in these uncertain times. For example, good retailers can still perform well even with general consumer weakness, and this season we saw good numbers again from the likes of JB Hi-Fi, Lovisa and City Chic.”

Mr Beaumont pointed out that the ASX is, however, more than just a play on the domestic economy.

“Many of the best performers in recent times are those exporting to, or operating, overseas. These include global tech companies, miners, and global consumer businesses such as Breville, IDP Education and A2 Milk.

“The tech sector has led the market in recent months, and it continued its charge through reporting season. The likes of Altium, Appen and Afterpay all took off, having talked up large growth opportunities. In an environment of slow growth, investors are willing to pay over the odds for disruptive and other structural growth stories.

“The big mining houses BHP and Rio Tinto are benefiting from higher pricing for the bulks, and the broader mining industry has evidently come back to life and is starting to invest again. This is starting to help out the mining services firms, with for example Seven Group’s strong form demanding fund managers’ attention.

“In contrast, some of the blue chips such as the banks,  large supermarket operators, telecommunications companies and energy retailers disappointed. For them, increasing regulatory risks and tougher competition is adding to the weakening economic backdrop.

“Dividend payments were larger than expected this reporting season. Many companies decided to step up the percentage of earnings paid out, while special dividends were more prevalent than normal. These moves were likely motivated in part by the potential changes to franking rules.

“Of course, this largesse for shareholders means less invested back into business. And so we saw a return to our recent past, where dividends took preference over capex and other reinvestment. This might keep shareholders happy now, but inevitably comes with less growth in the future,” Mr Beaumont says.

“In this environment, and consistent with our philosophy, we favour high quality growth names. We’re particularly focused on those stocks with structural growth owing to strong industry growth, gains in market share, or new products or markets. Examples include CSL, Reliance Worldwide and Costa Group, which all sport quite reasonable valuations given their long term prospects.”

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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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Julian Beaumont

While it is wise to be wary in today’s market environment, there is no need for investors to feel overly anxious about the outlook for investment markets, says Julian Beaumont, investment director at BAEP.

“The key thing for investors to keep in mind is that now isn’t the time to panic about things like whether the property market is likely to collapse, what the result of the UK election might mean, or how the political situation in the US might play out.

“Certainly there are a number of unknown and unpredictable factors at play, but there are always risks in the market.

“In our view, the level of systemic risk is currently being overstated, and equity investors should still be able to find opportunities in the market,” Julian said.

He said that an additional concern investors seem to have is that the share market outlook is not currently in sync with the economic outlook.

“Investors should keep in mind that this is not unusual, and indeed in recent years we have seen the economy – both globally and domestically – struggle, requiring government intervention in the form of quantitative easing; yet the share market has continued its solid rise.”

Julian says that while risks undeniably exist, investors can position themselves to avoid them, and continue to take advantage of the opportunities that also exist.

“For example, it is the large cap companies on the ASX that are suffering the most at the moment, but outside the top 20 valuations are looking quite attractive.

“At BAEP we also currently favour healthcare and consumer stocks, which are presently good defensive stocks which are performing well.

“We also see good opportunities in Australian companies that are doing well internationally.

“Our view is that the market continues to offer reasonable returns for long-term investors, especially compared to other asset classes

“However, we also believe it pays to be selective – both in what you choose to invest in, and what you choose not to invest in.

“While there continues to be ongoing discussion about the relative merits of passive versus active investing, the current market environment is one that we believe will reward a selective and research-driven investment approach aimed at identifying the best opportunities and avoiding the worst,” Julian said.

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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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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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The fund is managed by Bennelong Australian Equity Partners (BAEP) and combines a passive, market cap weighted exposure to the S&P/ASX 20 Index with an actively managed investment in a selection of stocks outside this index.

Its active investment in ex-20 stocks leverages off the same strategy employed by the team in the very successful Bennelong ex-20 Australian Equities Fund. The Bennelong ex-20 Australian Equities Fund has been able to generate a return of 13.72% per annum since inception, which compares favourably to the benchmark’s return over the same time period of 6.2% (both calculated up to 31 March 2016).

Zenith believes the combination of an indexed exposure to the S&P/ASX 20 Index and an actively managed ex-20 component provides investors with an attractive exposure to Australian equities.

In its report, Zenith said that the fee structure was attractive. The management fee is 0.39% (plus a Performance Fee if applicable). The Fund therefore provides an efficient way to gain all-cap exposure to Australian equities.

Julian Beaumont, investment director at BAEP, said “There has been an ongoing debate about whether active or passive fund management is best for investors. We believe that both have a place in the Australian market, just in different parts of the market.

“We believe there is a strong case for paying fees where there are genuine prospects for outperformance. Passive investing has its place; in Australia, that place seems to be within the top 20 stocks where the prospects for outperformance are limited. Combining active and passive provides the best of both worlds – lower overall fees whilst retaining the potential for outperformance,” said Mr Beaumont.

He added “appetite for the Fund has so far been very strong”.

The fund has recently been included on the Federation Managed Accounts investment platform.

Zenith believes the Fund is an innovative product managed by a highly experienced investment team with a demonstrated track record of outperformance.

“Although the Fund was launched in December 2015, the strategy has a strong track record that dates back to September 2012,” said Zenith.

BAEP has been managing a mandate on behalf of an institutional client since September 2012 that employs the same passive-active concept as the Fund.

The Fund represents a practical solution for retail clients who are increasingly focused on costs, but who do not want to lose the prospect of market-beating returns.

The Twenty20 Fund is the latest addition to BAEP’s suite of funds which includes the Bennelong Australian Equities Fund, Bennelong Concentrated Australian Equities Fund and the Bennelong ex20 Australian Equities Fund.

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*The Zenith Investment Partners (“Zenith”) Australian Financial Services License No. 226872 rating (assigned April 2016) referred to in this document is limited to “General Advice” (as defined by the Corporations Act 2001) for Wholesale clients only. This advice has been prepared without taking into account the objectives, financial situation or needs of any individual. It is not a specific recommendation to purchase, sell or hold the relevant product(s). Investors should seek independent financial advice before making an investment decision and should consider the appropriateness of this advice in light of their own objectives, financial situation and needs. Investors should obtain a copy of, and consider the PDS or offer document before making any decision and refer to the full Zenith Product Assessment available on the Zenith website. Zenith usually charges the product issuer, fund manager or a related party to conduct Product Assessments. Full details regarding Zenith’s methodology, ratings definitions and regulatory compliance are available on our Product Assessment’s and at: http://www.zenithpartners.com.au/RegulatoryGuidelines

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Julian Beaumont,

Australian share market investors are increasingly focused on unsustainably quick gains rather than long-term growth, says Julian Beaumont, investment director at BAEP, in his recent paper entitled: A long story told short.

“We no longer own equities, we rent them. Three decades ago, the average holding period for Australian shares was more than six years. This has now declined to just one year. In aggregate, investors can only suffer from this increased activity, owing to the additional costs of trading and taxes which can be considerable.”

He says it is not just retail investors who are at fault, but that many professional investors also yield to the short-term temptation.

“The pressures of closer client scrutiny mean short-termism can be even worse for professional investors. Fund managers are required to report their performance on a monthly basis, a timeframe that is at odds with the long-term nature of equities.

“As well, many clients, both retail and institutional, very often look to short-term performance in determining whether to invest in a fund. For managers, significant short-term underperformance comes with the risk of losing clients, so they become overly focussed on short-term results.

“The risk of client loss also forces many fund managers to become risk averse. And standing out to make a difference comes with the real risk that you fail miserably and, worse still, that you do so alone.

“In an attempt to avoid this many fund managers will hug the index closely, with similar portfolios that are designed more to avoid failure than to add value.”

Investors’ short-termism can also permeate to the corporates themselves, he says.

“Corporates feel significant investor pressure to deliver on short-term expectations and to avoid risk that might jeopardise this.

“To the extent that CEOs have long-term incentives, the performance period over which they are determined is typically just three or four years, a time period that is too short to see through the full lifecycle of corporate planning.

“Thus, a CEO might choose to put off investment in research projects, product development or other long-term projects that come with additional costs today but could add material value further down the track. These CEOs then fall into the same myopic and low-risk strategy that many professional investors fall foul of.”

Short-termism is also apparent at the board level of listed companies, he says.

“In Australia, as elsewhere, boards have acquiesced to the desires of shareholders to maximise dividends. This calendar year, ASX-listed companies are expected to pay out dividends representing an average of 75% of earnings. With the addition of buy-backs, these companies will be returning to shareholders approximately 85% of their earnings. This is a multi-decade high, well above an average of approximately 50% in the 1980s, and obviously leaves very little for investment.

“The ability for companies to reinvest and grow makes equities quite a unique asset class. It is in fact one of the main attributes that allows equities to offer investors capital growth. Reinvestment can add to earnings and create shareholder value.

“As highlighted recently by the RBA, prioritising dividends over investment has broader economic implications. In Australia, as in most developed countries, a lack of corporate investment has been given as a reason for the insipid economic growth. Corporates are apparently too generous with dividends and are left with little to spend on new plant and equipment, hiring and training, and research and development.

“In our view, the Australian share market is systemically short sighted. Its value bias means that it is very often overly focused on PE multiples and dividend yields that rely on just the next year’s estimate of earnings or dividends. Ordinarily, either of these will account for less than 10% of a company’s total valuation.

“This market’s focus on the short term can very often undervalue earnings that are reliable and growing strongly over time, where compounding is left to work its magic.

“Fundamentally, investment is about giving up current consumption for potentially greater consumption in the future. Within this context, and by their very nature, equities represent a form of investment that provides for retirement and other long-term goals.

“Focusing on the constant noise of real-time quotes and never ending news flow is to forget about the goals most use equities to achieve,” Julian says.

A copy of the full version of the paper can be found here.

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Julian Beaumont,

Equity and property markets are continuing to adjust to changing economic drivers, meaning investors must do their research carefully if they are to manage risk, according to Bennelong Funds Management’s boutique managers.

Julian Beaumont, portfolio manager at Bennelong Australian Equity Partners (BAEP) said reporting season was largely as expected, but there were signs of challenges for investors ahead.

“Consumer exposed stocks are performing well, particularly housing as well as housing-related retailers such as Adairs, Beacon Lighting, JB HiFi and Bunnings.

“Likewise, the old stalwarts offering defensive growth, such as infrastructure and healthcare, continue to perform well operationally.

“However while such companies are still lifting dividends, current market conditions show that investors are increasingly concerned with their delivery.

“An example of this is BHP being bid up despite a big dividend cut, and investors no longer chasing the banks despite tempting yields.

“All companies are cutting costs to get earnings growth despite sluggish top lines; however margins are at highs and the cost-cutting efforts are puttering out,” Julian said.

John Campbell, portfolio manager at Avoca Investment Management, pointed out that reporting season saw some extreme volatility in stock prices at both ends of the spectrum.

“Daily price movements throughout reporting season were extremely volatile both for stocks that disappointed – such as Cover-More, Super Retail and Billabong – as well as those that exceeded expectations, such as Breville and Primary Health Care.

“This was primarily triggered by the confused global macro environment, combined with the dominant passive style of investment management.

“As a result, many extreme-priced quality growth names are struggling to sustain lofty (indeed generationally high) valuations, regardless of the fact that most met expectations,” John said.

Both Julian and John saw some positive news for the resource sector.

“Commodity prices may be bottoming – the risks for commodity stocks are now mainly skewed to the upside,” John said.

Julian added that the driver for the resources sector is clearly commodity prices rather than operating results, and this will continue to be the case.

“While reporting season saw savage cuts to earnings for the sector, and estimates for next year were also heavily reduced, the resources sector remained the best performing overall, lead by gold equities,” he said.

Global property markets are also displaying some mixed signals, and are heavily influenced by ongoing attempts by governments to trigger growth through interest rates.

Chris Bedingfield, portfolio manager at Quay Global Investors, said that the global property market is looking strong in a number of areas but the impact of interest rate decisions are still playing out.

“Despite the fact that any economic benefits from central bank policies are still to be fully realised, it seems that the quantitative easing approach is not yet done and we are still seeing countries such as Japan cutting rates, while in Australia the Reserve Bank of Australia is keeping rates at historical lows.

“Interest rates are likely to be lower than expected around the world, but despite this, capital markets are still finding it difficult to obtain cost-effective funding.

“One impact of this is the limited supply in a number of property sectors, particularly in the multifamily and storage sectors.

“In addition, new drivers for industrial property demand are underwriting good rental growth.

“On the other hand, fundamentals in the office property sector are weakening in a number of key markets, such as the US, UK and Hong Kong, as supply catches up with demand,” Chris said.

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