The five pillars of a quality stock

Key Points

• Michelle’s first investment and her early experiences running a gold fund.
• Five pillars of a high-quality company and how to buy them at a good price.
• A high-quality stock that the market is overlooking.
• The stand out management team on the ASX and what sets them apart.
• The 30% club.
• A painful mistake that made Michelle a better investor.
• The investing lessons that she will pass on to her two young daughters. 

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Transcript

James: Can you remember your very first investment?

Michelle: I was part of a ASX stock picking game and that was in year 12 I believe. And we had to develop the portfolio. I think it was a three month time period. And from that that sort of planted a seed in my mind. So when I was at university my first year and I was legally allowed to open up a trading account, I actually bought ASX of all stocks. And let's be honest here, I didn't give it too much thought. I guess the only thinking behind it was I took the view that this was a monopoly provider and it was absolutely core and critical to the financial system. So that was 2000. And stock price, I'm not sure what it was, but it was a lot lower than here. It was probably $10. And I've just held it.

James: You still hold it.

Michelle: I still hold it.

James: Oh, you've done well.

Michelle: Yeah. I've done well. Done well was a small amount. So that was probably the first, but so many investments stick in my mind. Interestingly, I ran a global gold fund for the Aberdeen at the time, and that was over the period of 2009 to 2015. That was just an incredible experience because it was a global fund, so it wasn't just an Australian gold companies. I was truly fascinated by the industry. So I did a deep, deep dive into it. I wanted to know the history of gold, the connection with currencies. I delved into the US dollar and it being backed by gold, and when they moved into the nix the 1970s and when they disconnected from the gold standard.

So anyhow, for better or worse, I became a bit of a gold bug. I bought a couple of gold stocks. With hindsight everything looks like it was quite favourable. So as you can remember over that period there was a enormous amount of QE. Interest rates were coming down. So I thought, well, it's quite supportive of gold fund, from a macro point of view. And then you start meeting these characters, these Canadian gold guys, South Africans and it really sort of hooked me in. I dare say I lost a lot of money on those, but they've come good.

James: Oh, you still hold them as well?

Michelle: Well, I hold three, but that's a personal trading. That was not so much for the group.

James: Very topical at the moment, gold.

Michelle: It is. It is, yes.

James: From an investment perspective, how do you describe the way that you invest? That the firm invest? What's at the core of what you do?

Michelle: Right. Look, the industry again, the industry has a tendency to really box investment styles into either value or growth. And for better or worse, we don't really fit into either of those. What we focus on is quality, and we are searching for quality companies that are being underappreciated by the market. I'm sure our discussion will go into this in a great amount of detail hopefully because I think it's incredibly important to understand how we run money as well. But at the essence, if a company does not pass our quality filter, regardless of how cheap it looks or it screens, we won't even look at it and it's not investible for us.

Not to say the valuation isn't important because it absolutely is. I mean you can have a very high quality company, however it doesn't mean it's going to a, make you money or b, be a good investment if it's fully priced and then some. But for us, when you think about our investment style and process, first and foremost, it's quality. If we have the conviction that it is a high quality company, then we look at the valuation in detail.

James: Let's get as practical and rather than theoretical as possible. But tell me exactly what you mean. What defines quality for you?

Michelle: Sure. What defines quality? Quality is such an obvious term in our industry, but we are very clear around what it means for us and what we're looking for. And we break it up into five key characteristics. So I'll go through these in some detail, but probably not as detailed as we go through practically. But first is the business prospects and strategy. So what we're looking for here are attractive industry characteristics, a strong competitive advantage or competitive moat. And the final piece is really how they're positioned within the industry. Are they price takers? Are they price makers? Do they have leading market shares? What's the trajectory of that share? So that's the first one.

The second one's management. So we spend an inordinate amount of time speaking to the management of the companies that we're investing in. So that's the CEO and CFO, but it's also the next level down because we feel sometimes the conversations can be a little less scripted and what we get from that level. Why is management important? Probably three things, and three things we look for within management. So it's execution, experience, and track record. It becomes particularly important when they're navigating through rough waters as well. And it's not just management of the companies that we're looking for, but also management of when we're doing our checks. So customer suppliers, value players within the value chain.

The third part is financials. So again, we spend a lot of time scrutinising annual reports. So balance sheets, cashflow statements, and the income statement, all the notes that go with that. And what we're looking for there are obviously strong balance sheets. A lot of the companies that we are invested in not only have low gearing but also a net cash. And that's the type of company that we feel are much better placed if conditions turn for the worst. But also looking at things like return on capital and margins.

The fourth factor is transparency. And this takes on a number of aspects. So firstly transparency. By that we mean a clean company structure. So understanding whether earnings are being generated. The other part is around transparency of earnings. So again, can we see where the earnings are coming from? Are they recurring? Are they one off? And then the final piece is the cashflow conversion. So again, being very clear and transparent around the conversion of those earnings into cash flow.

The final piece and the final factor is stewardship and ESG, so we spend again a lot of time around governance of organisations and ensuring that they've got the proper frameworks in place and that the company is being sustainably run.

James: So the quality filter I understand, I can see the appeal of it. But sure, if it's appealing to me that means it's appealing to other investors. And the attributes that you've listed, I know are probably on the wishlist of plenty of fund managers. Doesn't that make it pretty hard to find the other part of the equation or the other important part of the investment that you talked about, which is finding it at the right price? Is quality not the most crowded place to be hunting?

Michelle: Look, I have a slightly different view to that and we've been able to demonstrate that through a history of performance across a number of our funds as well. For me, what I consider the differentiating factor or the edge, it's actually very clear to me. Firstly, it's the depth, at the core of the fundamental research that we do. When I sit down and the insights that that has generated for us. We've really been able to exploit marketing inefficiencies. I can get into the depth if you'd like to go there.

The second part is our network of investors. So we actually have 180 equity investors globally and that really rivals a number of our larger global peers. Our small cap, large cap companies have either operations off shore, customers off shore, competitors off shore. The value chain that they're playing in majority is offshore. We have investors on the ground that not only speak the language but also understand the cultural nuances, and that in itself has provided us with a significant edge.

The third part's ESG. It's been embedded in our investment process for many, many years. And the data that we go to directly engaging with the management teams, again for us has... I dare say that there's not many others that go to the extent that we do. So that's where for me it's quite clear how we do things slightly different. And with the edges... Your question around valuation, though. Again, back to the point around we're not value and we're not growth, we're quality investors. It doesn't mean that we buy every quality company out there. We're very specific around when there are high, well higher valuations on companies. The level of conviction that we need to have around their meeting growth expectations and there has been much stronger than a company that is not fully factoring in.

So as an example, you know tech stocks, you can't get away from speaking about them at the moment. We own a couple of tech stocks. One of them, which is part of the WAAAX’s is Xero. And Xero is a company that again questionable whether how much... And it's quite polarising in the view from a valuation point of view. We actually still feel that there is significant value in the stock taking a five year view as we do. And how we get to that position is a, understanding where growth assumptions are coming from. So where we have concerns, which is the US, which is also their greatest opportunity if they can crack. We have done significant channel checks. We've used expert networks to have conversations with people participating in that part of the market to understand what isn't working for them, what is working for them. Likewise in the UK, a market we don't know that well. However, again we tap into the resources that we've got there.

So we've got a greater level of conviction that they're able to deliver the growth expectations, very different to a number of other, a couple of other WAAAX names that were not invested in. So again, it's really differentiating, and a, we want to ensure that company, the product itself is embedded in workflows and is mission critical for businesses to operate. The barriers to entry are high. The competitive moat, as I mentioned before, is still going to be there in 10 years time. So when we take that into account, we still feel that there's value to be had. And that the return expectations are still well above market.

James: Xero's a well known stock is... It's been one of those growth stories that people been following for a time. Is the something else that may be a bit overlooked from that quality perspective? Something where you feel like maybe a recent addition where you feel like you've used your edge to identify something that the rest of the market is missing?

Michelle: Rather than a recent addition, there's a stock that we bought initiated two or three years ago, but we've been adding to in quite a material way. And that's Vista Group. I'm not sure if you're familiar with Vista. So Vista is a provider of software services to the cinema industry globally. So again to the points that I was making earlier, this is a piece of software that is mission critical. The company the cinema cannot operate without it. It's a POS. So it does all the ticketing, it does all the scheduling, it does all the customer feedback, engagement. They have 40% global market share. And if you strip out China, it's closer to 50%, although they are now participating in China as well. So when you think from a quality perspective, now this is a business that mission critical software, strong recurring earnings, absolute leader in the industry, and the other player, which is in the industry is actually pulled out capital and they're not gonna invest any further. So they are the leader and will continue to be.

I'll go through the financial side in a sec, but really that's the cinema part. There's a part of this business which is called Movio and this is where we feel the market is underappreciated or doesn't really get what they're trying to do here. And Movio is a data analytics company. So essentially they're aggregating movie goers data. So any point of contact anonymously of course. And that gets stored into a central database. So when Vista Cinema has almost 50% global market share, you can imagine the depth and the value of this data. So what Movio and Movio Media is doing is going to the actual film studios and they have signed contracts with the major film studios that they can tap into this data. And what that helps them is pre production assessment of customer behaviour but also with their digital advertising.

James: So customising the films that they're producing, making based on investor tastes using this data?

Michelle: Using it. And again, that's at very early stage, but again, when you think about the size of the digital advertising market, it could be huge. And it's a very small part of the business, but we feel that it could actually be as large as the core of the business, which is the cinema software.

James: And the valuation?

Michelle: So its margins are in excess of 30% and have consistently been so. It's gotten ROA in meetings but actually expanding because the Movio part is this huge amount of operating leverage there. And then it's been profitable, which not many of these tech stocks have for 10 years. And the other piece of it pays a dividend. Very small one, but it pays a dividend, and has consistently done that. So when you look at it on EV to sales and it's trading on four and a half times, EV to sales, on a 12 month forward PE of 34 times, 35 times. To us, that reflects given what we know and where there's that latent upside that isn't being factored in, we still think represents value.

James: Great. One of the things that you talked about there in your list is the quality of management, and you've sort of talked about how you really enjoy that ability to interrogate, to speak with, to understand management and their track record. Is there a particular management team that you think stands out? And I'm sure you could say there's lots of good management team, but is there a recent conversation or recent meeting or is it someone, a team of one of these ASX listed companies that stands out that you think is doing an exceptional job?

Michelle: You know, the one that stands out for me is Cochlear. So Cochlear is an incredible company, is a standalone company as well. And it's global leader and what they do. But when you sit down with management, there's probably three things that keeps striking me about them. So at first it's their thinking, their strategic long-term thinking. When you consider the market for Cochlear implants and the fact that they've got close to 80% market share, you wonder a, how did they get there? How have they been able to maintain that. And can they maintain that? So when you approach management with that, they're very humble about how they got here. But when you start to dig into it, really the value that they ascribe to the R&D of the business is huge. And you have not seen them cut R&D, even though... And to put this into context, 12% of sales, which is their R&D spend, is more than all their competitors put together.

They had a really tough time at one time when they had the product recall. And they a, did not cut. They did not cut R&D spend. They did not cut the dividend, even though they were working through quite a difficult period because they had no earnings. So they really do take a longterm view, and want to ensure that the current positioning is maintained. The other part of it is that they're not sitting on their hands. They're constantly thinking about disruption. They've got this little sort of start up tech business going as well. And it's all centred around implantables. So what other industry could implantables disrupt? So that's going, and they put a bit of money into that. And then the humbleness of it, as I mentioned, they're not aggressive people. You can sit down, you challenge them. They appreciate being challenged rather than get defensive about it. And I think this is part of the DNA, the culture that that business has been able to develop.

James: Yeah, great. The 30% club. Can you introduce the 30% club explaining why it's you think it's so important and why you're passionate about it?

Michelle: Sure. Right. So the 30% club is a group of Chairs and CEOs that are committed to bringing gender diversity onto the boards of listed companies. So it originated back in the UK in 2010, and since then it's expanded to 12 countries, I believe. And Australia is one of them. So we joined in 2015. The objective, the sole objective as the name suggests, is to get women on board at that 30% representation. For context, when it started in 2015 we were at about 20%, and you've got to be mindful that board refreshment and renewals take time. So we're connected to this group in a number of ways.

So firstly, if I take the group, our chairman Sir Douglas Flynn, he's on the CEO club in the UK. And then locally we sit on the... And we participate on the 30% club working groups. And what those working groups do literally sit around a table like this and representation of fund managers like myself that feel strongly about this issue. And it's very well reflected both female and male in the working groups as well. So a number of my male peers are quite vocal about it. And we sit around and talk about the challenges with what has been the feedback from boards, from management, how can we break through this? So pleasingly and AICD, so the Australian Institute of Company Directors, the most recent numbers that they've put out, we've hit the target.

So ASX 200 companies are at that 30% representation, which is great. The Australian chapter of the 30% Club has now put out a new target, which good on them and we're absolutely backing. And that's to get the next level of companies at the 30% mark. So initially the target was for the ASX 200 companies, and now it's the 30% target for the ASX 300 companies by 2021. We've got three years, or two and a half years to see if we can do that.

From my perspective why I think this is very important. Firstly and foremost, it's diversity of thought that we need more of in our industry. So gender is an important issue that needs to be raised, but it's part of a bigger governance framework, if you wish. It makes absolute sense for me as were doing it already. We are engaging directly with the chairs, with the boards of the companies that we're invested in. We're having these conversations already, and we've got real case studies of companies that we've been engaging with behind closed doors. And the impact that we've been able to have, it takes time. But we've done some really good work around this. So by joining and by really promoting the 30% club, we're doing it already. So it makes a lot of sense.

James: I want to get a little bit of a pain story now and everyone that comes in for a chat has to go through this process.

Michelle: Oh, there's many there.

James: Well, the more... We only need one, but it needs to be graphic.

Michelle: Graphic? All right.

James: Yeah. Biggest mistake you've made or a really painful mistake that you've made, and the lesson that you learned that makes you a better investor today.

Michelle: Okay. I can't go past QBE.

James: Buying other people's problems.

Michelle: Yes. That's just a story of what was a very high quality Australian focus business originating out of Queensland. We knew that business very well. It was run very well. However, when they went on this big sort of shopping spree, what we didn't realise is a, probably buying other people's problems, but what they were buying had had no scope, sorry, had no one scale. It within insurance there are part times of the market that acquisitions make sense when interest rates are coming down. And QBE had the philosophy that if we acquire we can get scale. But what they're acquiring were businesses that couldn't just add on to others. So the US, there was a lot of acquisitions in the US, in Latin America, in Asia.

And the other part of it is the cycle. My big lesson learned here is don't bet against a cycle. We had interest rates coming down quite materially and a big part of an insurer's earnings and portfolios are the investment book. When you've got a big chunk of that in bonds and insurance coming down, then earnings are getting crunched at the same time that your balance sheet is looking a bit stretched because you've done all these acquisitions. Now that I think back and I think about our quality filters, number one lesson learned is the cycle. Number two also is you need to really cross check management. And there's management teams that are very reassuring and you leave meetings thinking, okay, they've got this under control, when in actual fact perhaps they don't. And we were supporters of that company for a number of capital raisings as well. And in the end we just... And we sold out I want to say three years ago now. However, it was a very painful journey.

James: Good story. Last question for you. You have two young daughters.

Michelle: I do.

James: What advice are you going to give them about investing?

Michelle: Wow. Look, for me, I wish I was given this advice, so I'd like to impart it to my daughters, and that's just make as many mistakes as you can as early as you can, and importantly learn from them. So we have a motto at home and it goes along the lines of, sometimes you win and sometimes you learn. And I think that's a really important philosophy to live by, whether it's just life generally or investing. We're not going to be able to get it right all the time. So you really got to learn when you do stuff up.

So yes. And from that, investing is one of those things that you need to live and breathe it. It's not something you can impose on anyone if you don't have that natural curiosity to just get in there and just discover unhidden gems, or just like we were saying, those conversations with management. That's got to come from inside. You can't really impose that on anyone. But yes, I would love them to learn a lot of lessons really early on. Take risks. There'll be plenty of time for risk aversion.

James: Yeah. Great. Thank you very much for coming in.

Michelle: It was my pleasure. Thank you.

James: And congratulations on your new appointment at Aberdeen, and I wish you all the best.

Michelle: Thank you.