How to identify rising stars

Photo of Stuart Jackson, Montgomery Investments By Stuart Jackson, Montgomery Investments

min read

Watch the trends and understand industry value chains.

Montgomery’s focus is on identifying high-quality companies with bright prospects, combined with a disciplined and patient approach to buying at a discount to fair value. We believe that in the long term, these companies provide an attractive combination of stronger returns with lower-than-average risk.

In assessing the prospects of company, we look at the potential for growth in its industry. There are many macro-economic factors that provide a good starting point.

One example is the impact of long-term demographic changes. Most developed economies are grappling with an ageing population as a result of the combination of increased longevity and the large baby boomer generation heading into retirement.

This trend that will continue to affect industries over the long term and throughout future economic cycles.

Having identified some broader trends and drivers, we need to identify the beneficiaries.

As people age, healthcare companies will benefit from stronger demand growth. There can also be opportunities in companies that support the core healthcare industries, such as insurance.

In financial services, the needs of retirees are different to people at an earlier stage of their working life. Retirees are more focused on income rather than wealth accumulation. There is a likely to be a shift in demand away from traditional superannuation and mortgage products in favour of interest and other income-generating assets such as annuities.

Demand for providers of leisure time activities that suit an older demographic are also likely to benefit from a combination of strong growth in the number of older people and an increase in their available leisure time in retirement.

The broader macro environment provides the potential for superior revenue growth, and identifying the company that is best positioned to benefit and deliver the most attractive investment characteristics is a function of quality.

Understanding company quality

The quality of a business is affected by a number factors. An important measure of quality is the ability to generate a high return on the capital the company has invested in its businesses.

This can be measured in several ways, such as including or excluding the impact of balance sheet gearing through debt financing, or in looking at the return generated on tangible or total capital employed in the company. Different measures of returns provide slightly different pieces of information.

The very best companies can retain a high proportion of their profits and reinvest them at high rates of return. The compounding effect of this sort of reinvestment on earnings growth is extremely powerful in driving increases in shareholder value.

However, the key component of this equation is the return the company generates on the incremental capital it invests. For example, assume a company retains and reinvests 50 per cent of its earnings back into its business. If the company generates a 10 per cent return on the incremental capital reinvested, its earnings would increase by 5 per cent. If instead it reinvested its capital at a 20 per cent return, earnings growth would be 10 per cent.

This seems like a simple thing to look for; just find companies that have generated a high rate of return and have a low dividend payout ratio.

However, it is not the historic or average rate of return that is important. Rather, it is the return generated on the incremental capital invested. This can be significantly different to the average return on capital generated by the company in the past.

First, historical returns based on the reported earnings and balance sheets can be distorted by accounting policies and decisions. A classic example is large asset writedowns that are taken as “significant items”. These reduce the book value of the capital invested by the company as set out in the balance sheet statement.

This reduces the denominator in the return equation, artificially boosting the return on capital in future periods. The writedown does not improve the company’s rate of return on incremental capital reinvestment, but it can materially impact the historical return calculation.

The other problem with historical returns is that they are based on historical industry conditions. An extreme example of the dangers of assuming historical returns are a good proxy for future incremental rates of return on capital are the mining and mining services industries.

If we looked at the average return on capital employed by the big iron ore miners in Australia over the past 10 years, it would indicate average returns in the mid-to-high teens on an after-tax basis.

Jackson - return on capital chart

However, historical earnings and returns were buoyed by extremely high iron ore and other commodity prices in the previous decade, which resulted from China’s strong economic growth and the lags in bringing new mining production capacity online.

Since then, global production capacity has ramped up due to heavy reinvestment by mining companies, and at the same time China’s rate of economic expansion has slowed.

Consequently, the peak commodity prices that delivered the miners high returns historically are unlikely to be repeated in the foreseeable future. As a result, the return that miners can be expected to generate on future capital reinvested in their businesses would be lower than their historical rates of return.

One of the hallmarks of a high-quality company is that it is able adjust its business model to mitigate the impact of any external influences.

Understanding the overall industry value chain and the competitive position of those within that value chain of the industry is vitally important in assessing the robustness of a company’s margins and return on capital employed in the face of changing market conditions.

Know the risks

Understanding the competitor set and substitutes can identify risks to the investment case.

For example, a vertically integrated competitor that covers more than one segment of the value chain can signal a risk to the returns generated by a company that operates in just one part of the value chain. This is because it can redistribute pricing, margins and returns from the segment with more competitors to another segment with less competition.

An example would be a company such as Telstra raising wholesale network charges while maintaining retail prices. Resellers of Telstra’s network would then incur higher access costs but receive no relief from margin pressure through higher retail prices in the market. The result is lower margins in the retail segment but higher margins in wholesaling.

In understanding the company’s position in the value chain, its competitive advantages relative to other players in the market, and supplier and customer power, an investor gains insights into the pricing power of the company and barriers to entry to its market.

Pricing power reduces the risk that an external shock or change to the market causes a structural change in the company’s margins and return on capital. Barriers to entry protect the business from increased competition that can dilute margins and return on capital. Consequently, these key attributes of a high-quality business reduce the investment risk.

The final element in identifying a good investment and minimising downside risk is buying the stock at an appropriate price. This requires the investor to determine an appropriate value for the company.

The incorporation of an appropriate margin of safety is important to ensure downside risk is limited, and this will depend on the risk characteristics of the company.

Once all these factors have been assessed, the final and often most difficult factors are patience and discipline.


About the author

Stuart Jackson is a portfolio manager at Montgomery Investment Management.


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