Why old-school analysis may pay off in 2017

To take advantage of volatility, investors are expected to refocus on diligent research to determine a company’s value, writes Natalie Tam.

Australia’s central bank is stuck in a holding pattern. It dare not cut interest rates for fear of inflating a housing bubble. Nor is it likely to raise them given how excess capacity in the economy is stymieing the local labour market.

It means rock-bottom domestic rates and low inflation are likely to persist. 

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This contrasts with the US, where inflation is rising and rate normalisation is underway. Stasis at home and divergence with the US leaves Australia vulnerable to imported volatility. Heightened price moves is what we expect in 2017, with markets susceptible to uncertainty about US policymaking and geopolitical unrest. 

Of course, volatility is fertile ground for active stock-pickers to capitalise on mispricings. To do so they need a sound grasp of company valuations. That’s why we anticipate a return to the sort of grassroots company analysis that used to be relied on to uncover relative value until its effectiveness was watered down by years of artificial monetary support. 

We expect rate normalisation to herald a return to investor rationality and a renewed appreciation for active investing over passive. 

At Aberdeen we have always carried out first-hand research. We want to know what makes companies tick, to look management in the eye when they answer our questions about strategy. It’s part of the fabric of our firm. 

How else can we be confident they will provide value to us as shareholders? In this article we offer insight into how we think about investing, citing five stocks that we own as working examples.

Intuitively these five share common traits. They are conservatively run by management teams with a clear vision, and they benefit from multiple sources of earnings. As we search for company value we target businesses with a dominant market share or competitive advantage. Evidently they need to be profitable. But more than that, they must be able to generate recurring revenues to sustain their growth. 

We don’t want them to be indebted; they should earn more than they borrow. A net-cash position enables firms to spend on research and development to drive product innovation or to make acquisitions to boost growth. Companies need a strong handle on costs, too.

Research

Diligent research requires patience. Some fund managers may not have heard of Millennium & Copthorne Hotels New Zealand (MCK) because so few brokers cover it. Taking the time to understand how this company operates and how its management thinks we believe was time well spent. 

MCK’s share price has risen more than 500 per cent since we first invested in 2012. This is the only hotel owner/operator listed on the New Zealand Stock Exchange. It also has a majority stake in property owner/developer, CDL Investments, which buys land in a depressed market and sells it when conditions improve. A simple model, but to do it well requires discipline and a long-term perspective, which aligns with our interests as an investor. 

Good research is about more than crunching numbers. Before we bought a stake in Bapcor – which distributes automotive parts, accessories, and services across Australasia – we wanted to be sure its pricing would not suffer from rising import costs during Australian dollar weakness. As a result we spoke to its customers, who are mechanics. Not only did we learn they could pass currency spikes on with few consumer complaints, but also that their businesses often expand amid economic adversity as customers seek to avoid comparatively expensive car dealerships. 

So, too, before we invested in Vista Group – which comprises of nine businesses providing software solutions to the global film industry – we wanted to check its product quality. By visiting its customers we found its software was both superior to rivals and, once embedded in an organisation, tended to become entrenched.

This creates recurring revenues. The firm has averaged 30 per cent revenue growth over the past three years, with scope to grow existing and new product sales. Its earnings profile is diverse, spanning cinema management, film distribution, analytics, and business intelligence.

Earnings diversity

Earnings diversity certainly bolsters the balance sheet of Auckland International Airport (AIA). The company owns and operates the nation’s dominant airport, handling the majority of international travel. Growth in population and tourism are supportive of its core operation. But it also derives revenues from retail shops, car parking, hotel and property businesses. It has NZ$141 million ($98.5 million) in projects under construction and 281 hectares available for development. We would expect more airlines with new routes and rising seat capacities to continue to drive AIA’s growth, alongside expansion opportunities for its non-aviation assets.

Growth potential

Growth potential is a key consideration. Technology One’s software powers 1,000 corporations, government departments and statutory authorities nationally and internationally, with offices in six countries. It owns the intellectual property and operates with a licence fee structure that generates recurring revenues. But this was not always the case. 

Founded as an accounting software firm in 1987 and listed in 1999, it relied initially on partners to develop and implement the software it sold. But use of third parties clouded business visibility and complicated customer communications, leaving it at a disadvantage to integrated global rivals such as Oracle and SAP. By changing its model to develop, sell and implement the software itself, it took full responsibility for the value chain and became much more customer-centric. Moreover, founder and chief executive Adrian Di Marco invests heavily in research and development to upgrade products and systems. 

Its focus now is on cloud computing, which is where we see this industry’s future. Vista has a similarly clear growth strategy. It has handed full distribution rights to its joint-venture with Tencent affiliate WeiPiao in appreciation of the fact that China is the world’s fastest growing cinema market. We expect Vista’s cloud-based product to be well-suited to China’s vast array of small cinemas. 

A combination

Each of these elements on their own doesn’t make a good company. But combined they form key building blocks for a sound, long-term investment. However, this will matter little if an investor overpays for the stock – which is why it’s important to employ strict valuation criteria. By doing so, investors can take advantage of attractive entry points that volatility should throw up in 2017.

Provided, that is, they have done their research and know which companies to invest in to begin with.  

Natalie Tam is senior investment manager at Aberdeen Asset Management.




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