Sink or swim: Valuation critical in finding future quality

Catastrophe tends to bring out the best and worst in humanity – we’ve certainly seen this in 2020 as pandemic lockdowns of various kinds were instigated around the world to try and stem the contagion. And a similar dichotomy has occurred among economic sectors and the companies of which they’re composed. Some will change forever or disappear entirely; others will emerge stronger than ever.

Iain Fulton, portfolio manager of Nikko AM's Global Equity strategy, alludes to this in discussing the COVID-19 fallout: “Some companies have faced a dramatic fall in revenue unlike anything seen since the Second World War.”

At the same time, those involved in gaming, e-commerce, cloud computing and other online goods- and service-exposed categories are riding higher than ever.

One example is HelloFresh. The meal-kit company landed on the Nikko AM watchlist after Fulton’s family relished its convenience during lockdown, and he figured many others would feel the same. Apart from tasty ingredients, inside the box his team found other treats including a lean inventory; flexible ordering; and cash generation that ticked all the boxes of Nikko AM’s Future Quality process.

In the following interview, Fulton discusses some other well-known global names – including Sony, Nintendo and Amazon – along with some lesser-known companies. A handful of companies his team has sold out of also rate a mention.

You’ve significantly outperformed your benchmark over all timeframes - how have you done this?

The vast majority of our outperformance has come from stock selection. Our risk-adjusted returns have also been strong given positive stock contributions from a wide range of sectors such as financials, health care, consumer, industrials and technology. The key drivers of this outcome are:

1. Sticking to our philosophy. We believe businesses that can attain and sustain the highest returns on capital in the market outperform over the long term. We call this Future Quality. Sticking to this philosophy has helped us invest in firms that are profitably gaining market share in a range of industries based on a sustainable competitive advantage.
2. A culture of teamwork that encourages creativity. We manage our portfolio on a team basis. Having a culture that enables us to collaborate and make the most of the creative insights we have is the foundation of everything we do.
3. A disciplined and repeatable process with an emphasis on valuation. In idea generation, stock research and portfolio construction, we are driven by our focus on finding Future Quality companies regardless of which industry they are in.

Companies must fit our criteria for management quality, franchise quality, balance sheet quality and valuation. By applying a consistent research process and collectively ranking our ideas each month, we aim to construct a portfolio of companies that are profitably gaining market share in their respective industries and where the valuation doesn’t fully discount the future return on capital for the firm.

What have been some of the key lessons learned during the COVID-19 pandemic? Has it led to any shifts in the way you assess companies?

COVID-19 placed a great deal of stress on many industries and business models, while simultaneously offering greater opportunities for others. For example, companies involved in consumption away from home, such as travel and hospitality, faced a dramatic fall in revenue unlike anything seen since the Second World War. In these areas, the importance of having a strong balance sheet has been critical in how these companies have been able to respond.

Looking after employees and key suppliers will help these firms have a stronger competitive position as demand returns but this can only be done with the financial strength to weather the crisis in the near term. There are specific examples in our portfolio, such as Progressive, which is refunding premiums to customers, and Unilever, which is granting €500 million to support suppliers. 

These are companies that are doing the right thing by their stakeholders in a crisis – primarily because they have the required strength of balance sheet and business model.

The opposite has been the case for companies involved in the supply of goods, services and infrastructure that enable people to work and consume at home. In industries such as gaming, e-commerce, cloud infrastructure and health care services, already high growth rates have been accelerated. In some cases, this acceleration has resulted in an expansion of valuation towards levels where it has been right to become cautious about their future prospects.

Going forward, we feel the most important aspects of how we look at companies will remain our valuation discipline, our focus on strong balance sheets and how management are allocating capital to maintain and enhance the competitive advantage of the business to sustain high returns on capital.

How are you positioning the portfolio now into the future?

Some of the changes in the way we work and live brought about by the pandemic have accelerated trends that were already in place. At the time of writing, around 50 per cent of the portfolio is invested in companies where growth has been enhanced by current and future COVID-19 threats. These include companies in the video game industry (Sony, Tencent, Nintendo), e-commerce companies involved in delivery solutions to the home (Amazon, Meituan Dianping and HelloFresh), cloud infrastructure providers (Microsoft, Adobe, Accenture, Amazon) and healthcare solutions companies (LHC, Encompass, Bio-Techne and Danaher). We think the improvement in demand for these companies is likely sustainable as we shift to new ways of living and working, and the increase in share prices has been supported by higher earnings and cash flows.

We’re finding interesting opportunities in companies offering environmentally-friendly solutions in areas such as power infrastructure (SolarEdge and Schneider), improving air quality (Daikin) and environmentally efficient construction materials (Kingspan). As the policy agenda evolves, we suspect these will be interesting areas for the next phase of markets.

Can you nominate one or two standout stocks that you’ve added to the portfolio recently (or a position you’ve increased substantially), and explain why you made this call?

Being cooped up at home for several months led to changes in daily routines we could never have predicted even at the beginning of 2020. In March, just getting supplies for the family seemed like a major ordeal with many UK supermarkets selling out of products and online delivery slots booked up weeks in advance. Our family found the convenience, variety and flexibility of HelloFresh’s meal kit delivery model very useful. As the importance of food to our daily routine rose during lockdown, we wondered if others might be experiencing the same thing. This prompted us to take a deeper dive into the business model and investment case.

We were pleasantly surprised at the high return on capital nature of the business and believe HelloFresh has an ability to address consumer demand for health and wellness, concern around food waste, and a desire for convenience. 

These trends are unlikely to disappear in the coming years, making HelloFresh an appealing long-term investment.

With very lean inventory and flexible ordering, the profitability and cash generation of the business meant the company had the Future Quality characteristics we look for. First-quarter results provided proof of concept as the company acquired a record 1.2 million new active customers whilst driving margin expansion.

We believe the total addressable market is underappreciated. Management are rolling out new price points to address different market segments and the marketing spend required to attract and retain customers will decline as a percentage of sales allowing margins to stay high. We added HelloFresh to the portfolio in April and have recently added to our position.

What sectors are you particularly bullish on – or actively avoiding?

We think more about stocks than we do sectors, although we do think companies that can reduce the cost of healthcare delivery while improving outcomes for patients will have very favorable long-term prospects. This area represents the most significant overweight within the portfolio given the attractive balance of good long-term growth, sensible valuation and strong returns on capital.

We have also been finding opportunities in the financial sector on a very selective basis. Companies like Palomar (earthquake insurance) and Progressive (auto and home insurance) are applying their technological advantage and direct-to-consumer business model to gain share profitability in niche markets. With larger and more flexible databases than their peers, the companies’ early investment in cloud infrastructure is enabling them to offer better pricing to customers with better underwriting outcomes than the competition. This is resulting in profitable market share gains with improving return on capital, which is exactly what we are looking for. All at attractive valuations.

FAANG stocks seem to be a key driver of performance in global equity markets. What are your views on this?

The FAANG stocks have been important as they have become a very large part of overall benchmarks people are compared against. The rise in value of these companies has been supported by the fact that their increase in revenue, profitability, cash flow and return on capital have been amongst the very best in the market. Where rising share prices are supported by sustainable improvements in profitability and returns, we are not too concerned.

But there are several high growth companies outside the FAANGs where recent share price gains appear to be driven by valuation expansion alone and based on very distant hope of high profits and good returns at some far-off point in the future. 

We are very wary of these ‘jam tomorrow’ investments. As a result, we feel valuation discipline will be very important in the coming years.

Explain how valuation is part of your process at times when markets have had a good run, like now.

We constantly look at the degree to which the return on capital, cash flow and growth we are forecasting for a business is reflected in the price we are paying. This has caused us to take profits and exit some positions in companies we believe to be excellent quality but where prices discount too much.

Companies we have sold since March include ResMed, Rentokil, Gentex and Ecolab. The result of this is that the headline valuation for the portfolio is the same today as it was at the start of 2020, as the performance we have seen has largely been supported by growth in cash flow and profitability.

Looking back over fiscal 2020, how would you sum it up in a single sentence?

Characterised by uncertainty, 2020 has been a period where the best and worst aspects of trends within society have been exacerbated, and we are hopeful that as things normalise, many of these social and economic imbalances can begin to be addressed.

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Disclaimer

This material was prepared by Nikko Asset Management Australia Limited ABN 34 002 542 038, AFSL 229664 (Nikko AM Australia) who is the responsible entity and issuer of units in the Nikko AM Global Share Fund ARSN 092 026 269 (Fund). The information contained in this material is of a general nature only and does not constitute personal advice. It does not take into account the objectives, financial situation or needs of any individual. For this reason, you should, before acting on this material, consider the appropriateness of the material, having regard to your objectives, financial situation and needs Investors should consult a financial adviser as well as the information contained in the Fund’s current Product Disclosure Statement (PDS) and the ‘Additional Information to the PDS’ which are available at www.nikkoam.com.au/pds or by calling Nikko AM Investor Services on 1800 251 589 before deciding to invest in the Fund. An investment in the Fund is not a bank deposit and distributions and the return of capital are not guaranteed. Past performance is not an indicator of future performance.