Finding quality companies, at a reasonable price

The Australian share market is heavily concentrated amongst the largest companies both in terms of market capitalisation and industry sector. The top 20 stocks dominate the share market with the S&P/ASX 20 stocks amongst the most widely held and researched companies in Australia.

Given the large concentration of the ASX top 20 to sectors such as the Banks and Resources, we believe the ex-20 segment is worth a closer look as it offers greater opportunities as a result of identifying companies which can generate above average long-term earnings growth and can pay sustainable, regular dividends that can grow over time.

IML has a long track record of investing in mid cap and smaller companies and investing with discipline. We stay focused on the long term even while sharemarkets gyrate through highs and lows, and many short-term investors chase the latest trends.

IML has always sought to invest in companies with the following characteristics:

• Companies that in our view have a sustainable competitive advantage
• Companies that generate fairly recurring and predictable earnings
  
• Companies run by a focused and honest management team
  
• and which in our view are trading at a reasonable price.
  

The last 5 years has been quite a challenging period for many investors, like IML, who buy value stocks. The environment has tended to favour investors that are prepared to chase short-term trends and to invest in the sectors of the market which look fairly risky such as the Resources and Technology sectors.

Where should investors be exercising caution today’s market?

While Australia boasts many of the world’s best Resource companies with long life reserves, such as BHP, Woodside and RIO, these stocks can be extremely cyclical in nature given the unpredictability and volatility of the prices of the underlying commodities that they sell. In addition, Resource stocks outside the top 20 stocks in Australia tend to be of lesser quality and many are in fact highly speculative. For this reason, the QVE portfolio (ASX:QVE) managed by myself and Simon Conn, has only had a minimal exposure to this sector and will likely do so until we are sure that the downside risks are fully captured in the valuation of the Resource stocks we purchase.

Our caution towards the Technology sector requires further explanation as this sector continues to grab the limelight amongst many sharemarket investors and commentators.

While the US technology sector currently boasts several hugely profitable, cashed up, global technology leaders such as Microsoft, Apple, Google and Facebook, the truth is that the choice of good quality technology stocks in Australia is extremely limited. In fact, the majority of popular IT stocks in Australia are in our opinion very risky, either because they are loss making or because their business models are yet unproven.

Thus, if we look at the profitability of what are now referred to in Australia as the WAAAX stocks (Wisetech, Appen, Afterpay, Altium, Xero), you will see from the table below that not only do these companies not make a lot of money, but their valuations are, in our view, at an extreme level.

Many today are arguing that all of these companies have an extremely bright future because the world is changing so quickly that the valuation one pays for them is irrelevant. However, we would point out that this perceived rosy future appears to be more than captured in these companies’ current share prices and valuations.

It is well proven that when buying any shares on the stockmarket that the price and valuation for the company is always relevant to the ultimate long-term returns that an investor can achieve on the stockmarket. For those investors who believe that this not the case should remember Sir John Templeton’s famous quote:

The boom, and chase by investors, of the IT sector can also be demonstrated in the chart below which shows the trend in new floats in the US where loss making ‘new age’ companies like UBER are currently being floated at huge valuations - despite losing billions of dollars. The chart below shows that almost 80% of all new floats of companies (mainly IT companies) in the US in 2018 have been floated off despite being unprofitable. This sort of percentage hasn’t been seen since the 2000/2001 tech boom – which as many remember ended in tears for investors who had invested in the IT sector.

IPO's with negative earnings

So how do investors build a diversified portfolio of well-established, profitable companies in today’s market?

In essence, the QVE portfolio is invested in sound Industrial companies that have a strong franchise and that we believe have realistic growth plans over the next 3 to 5 years.

Given the patchy economic outlook we are also attracted to companies that we believe are on a path to grow over the next 3 to 5 years, with a defined plan as to how best to create value for shareholders.

The table below highlights companies, that QVE owns, which are focused on executing company specific initiatives to deliver long-term earnings growth for their shareholders:

We are also selecting companies with solid and sustainable dividends, thus providing investors with a reliable and consistent source of return:

Source: IML; FY19 estimates as at 2 April 2019. Past performance is not a reliable indicator of future performance

The ex 20 sector is relevant for investors today

IML continues to maintain a disciplined focus on ‘quality’ and ‘value’, which is key to ensure that QVE’s ex 20 portfolio is underpinned by a well-researched, diverse range of sound industrial companies which we believe are trading on reasonable valuations and which, in our view, have good prospects to grow their earnings and dividends over the next 3 to 5 years.

Access growing companies at attractive valuations

QV Equities Limited (QVE) is a listed investment company that provides investors exposure to a diversified, carefully selected portfolio of quality entities outside of the S&P/ASX 20 Index. To find out more, click the 'contact' button below. 

Investors Mutual Limited AFSL 229988 (IML) has prepared this information, as the Investment manager for, and on behalf of, QV Equities Limited ACN 169 154 858 (QVE).This information has been prepared for the purposes of providing general information only and does not constitute personal financial product or investment advice as it does not take into account your investment objectives, taxation situation, financial situation or needs. An investor must not act on the basis of any matter contained in this presentation in making an investment decision but must make its own assessment of QVE, conduct its own investigations and analysis, and seek independent financial, taxation and legal advice. Past performance is not a reliable indicator of future performance.