In our recent investor webinar, we discussed 3 issues that are challenging investors in today’s market and how we are managing these issues in the Fund.
1) Low-interest rate environment & inflationary risks.
More than a generation of investors in today’s market have experienced nothing other than a falling interest rate cycle, which has created a tailwind for long-duration assets. With long term rates now at all-time lows (and near zero), we see limited scope for further downside, suggesting at best an end to The Great Tailwind. Furthermore, with inflation now rising ahead of long term rates (and with further inflationary pressures in the system), real interest rates have turned negative, raising the question of the sustainability of interest rates at these all-time low levels. What happens if interest rates start rising…?
To manage this dynamic, we look to business models that have elements of inflation protection (such as Telstra’s NBN income stream), pricing power in their value chain (such as Woolworths) or business models that perform well in a rising rate environment (such as NAB). These businesses do not require an inflationary or rising rate environment to perform well, but in the event that one does materialise, should provide the Fund with, not only protection but hopefully additional upside as well.
2) Elevated forecasting error associated with COVID and ongoing lockdowns.
In order to accurately forecast or predict future cash flows, we establish financial models which aim to provide us with a reliable base. As we stand today, the past 2 financial years have been heavily influenced (positively and negatively) by the COVID pandemic and this has continued in the current period with extended lockdowns in Victoria and NSW. The result is that forecast risk remains extremely high as we attempt to accurately distil what a ‘normalised’ or underlying earnings and cash flow trajectory looks like.
As a result, we lean more towards our core investment methodology of focusing on defensively characterised transparent business models. That’s not to say that such businesses have not experienced a variation in their earnings through COVID, but more so that the underlying drivers are clearer, less volatile and more predictable, such that we can more accurately predict a new trajectory of earnings post-COVID. Examples again include the likes of Woolworths, CSL, Ryman, Ramsay Health, and Mirvac Group.
3) Supply Chain / Inventory Disruptions.
One of the enduring impacts of COVID is the substantial pressure it has put on global supply chains. In the first instance, the availability of raw materials or components has been severely impacted (eg computer chips). Second, manufacturing and assembly lines have in many cases ground to a halt given lockdowns and staff shortages. If an importer has been able to secure inventory, freight and logistic availability have also become scarce and costs have skyrocketed. As a result, aside from the inflationary element, lead times have blown out making inventory management very difficult and, in many cases, resulting in a supply limitation to revenue growth.
The key to managing this dynamic is twofold. First, a company needs to have a balance of power, not just domestically but globally, in their value chain to elevate themselves up the pecking order when scarce inventory is allocated globally. A good example of this is Rebel Sport within Super Retail Group – Rebel is a leading customer of Nike (and other sporting brands) globally such that, during the pandemic, the global brand manufacturers were re-allocating stock from lower-tiered customers/regions to Rebel in Australia. The second key factor is to have the balance sheet strength and integrated supply chain infrastructure to be able to ‘go long’ on inventory. Again using Super Retail Group as an example, the company was able to make use of its debt-free balance sheet as an enabler for management to build elevated levels of inventory well in advance of key sales periods. Furthermore, global manufacturers who typically rely on 3rd party logistic providers increasingly used Super Retail Group’s substantial distribution centres and supply chain network in order to get their goods into and throughout Australia. Other examples of businesses that are well-positioned in this respect include Aristocrat, Accent Group and JB Hi-Fi.
To be clear, managing these (and other) issues has not required a change in our investment approach, rather adhering to it has focused our attention on what we characterise as ‘hard assets’. We think of hard assets as business models with long-term contractual arrangements at favourable terms with strong counterparties; owning unique or scarce assets; being the lowest-cost producer, or owning superior non-trivial intellectual property.
With an average after-tax cash earnings yield of approximately 7% across a portfolio of largely toilet paper and toothbrush-type stocks, we think that we can accumulate 7% in value on a fairly reliable basis, with opportunities for management teams to leverage generally under-geared balance sheets to create additional value from accretive M&A or capital returns.
We are pleased with the Fund’s performance in the first quarter of FY21 and remain focused on our primary objectives of capital preservation and generating a reasonable real return for our investors. We continue to believe this is best served by a disciplined approach and consistent investment methodology. A variety of good businesses run by honest and competent management teams at the right price will create a well-diversified portfolio of ever-growing cash earnings streams.