Where to mine for new blue chips

Finding those emerging blue-chip companies that offer the prospect of lower risk, higher growth and a safe haven to escape volatility isn’t easy. 

But as Elston portfolio manager Leon de Wet  points out, digging a little deeper to understand a company really isn’t enough. You’ve really got to keep chipping away to unearth all the obstacles, and discover the bedrock of future success.

We asked de Wet to provide his view on the characteristics most likely to make a leader. Based on his experience with the Elston Australian Large Companies A  portfolio, Leon was also able to identify a stock that he believes is overvalued – and nominate two interesting blue-chip picks for 2022 and beyond.

Standing the test of time

Defining an emerging market leader can be hard, but for de Wet the characteristics for any emerging blue-chip are clear:

• a track record, importantly through various business cycles, of stable revenue and profit growth;
• if not an industry leader, then at least amongst the major participants;
• a balance sheet that allows it to weather the headwinds of economic downturns;
• strong cash generation that enables both reinvestment in the business and consistent growth in dividends over time; and finally
• a proven management team focused on all its various stakeholders, not only the shareholders and customers but also employees, service providers and regulators, among others. Balancing the often competing requirements of these various parties is critical to ensuring a sustainable long-term business model.

"In essence an emerging ‘blue-chip’ company is one expected to be able to ‘stand the test of time’, to adapt to the changing competitive environment and grow earnings faster than the broader market in the years ahead." 

He cautions that while such companies often appear less risky, making them look like a sound choice for more volatile times, there is no such thing as a sure thing in equity investing - as his picks make clear.

Not so COVID normal anymore

A case in point for de Wet is Fisher & Paykel Healthcare (ASX:FPH), which has underperformed the market this year despite making gains from its two product groups (hospital and homecare), leaving the business at what he calls an 'unreasonable price'. 

On paper, FPH appears well placed to deliver strong revenue and growth over the next decade owing to the characteristics mentioned - including its "proven history of profit growth, net cash on balance sheet, and strong EBIT margins (c.29% pre-pandemic)."

FPH has also had the advantage of a large addressable market for its hospital and homecare products (which includes everything from humidifiers and ventilation machines to consumables like masks), giving it a leading position in the current environment. 

So why does de Wet think this stock is overvalued? As for many healthcare companies, FPH benefitted from the demand for oxygen devices during COVID's height, but that scenario may be short-lived.

"To their credit, management has done an outstanding job of ensuring supply of the lifesaving equipment – the result, in FY21 the hospital segment’s revenue increased by nearly 90% and group profit margins expanded well above management’s medium-term target given the benefits of operating leverage. For some context, hospital operating revenue grew to what we expect will be a 6-month peak (for the next few years at least), of $817.1m in 2H21 from $353.6m in 1H20."

And while it's clearly too early to make a call on Omicron's long-term impact, the latest 1H22 result for FPH - $670.2m from hospital operating revenue and lower sales across the US and Europe - illustrate the predicted slowdown in hospitalisations and acute care as vaccination rates rise. 

"Over the next 18-24 months we expect both sales and margins to drop further as vaccination levels improve globally, and that FY24 will deliver a profit still below that enjoyed in FY21. Trading at a little over 40x our expected FY24 earnings, FPH looks overvalued."

It's the season for giving

de Wet points to two companies that have what it takes to become future leaders.

The first is Cochlear (ASX:COH), another well-known healthcare provider which has already taken a clear market leader position in implantable hearing solutions. According to de Wet, Cochlear has a long reach in providing both better quality of life measures and societal benefits from increased productivity. 

"The addressable market is certainly underpenetrated with estimates suggesting less than 5% of people suffering from severe to profound hearing loss have a hearing implant currently – so a very long runway supporting future growth. 

Additionally, the Services business segment which provides sound processor upgrades and other accessories to existing implant customers has very high switching costs, providing growing long-term annuity-style revenues as the installed base increases. Also, as noted, it is the industry leader and with its annual investment in R&D materially higher than key competitors (typically around 13% of revenue), we expect it will continue to lead in innovation and product development." 

Finally, in terms of financial metrics, it currently has a historic high net cash balance, strong EBIT margins (FY22 c. 22%) and operating cash flow sufficient to fund investing and capex requirements."

The second (and more contentious) choice from de Wet is Amcor (ASX:AMC). 

While Amcor's Flexibles division generated "around 68% of group revenue in FY21 (the balance being from Rigids and cartons)", an increasing ESG (environmental and social governance) focus from investors provides some pause around the company's future decisions on plastic packaging. 

Much depends on management's choices going forward, says de Wet. And there is no easy choice - plastic packaging is critical for many industries, including healthcare, and Amcor uses plastics for 95%+ of its product streams.

"Following the Bemis acquisition in 2019, Amcor has a truly global footprint and enjoys market leadership and operating scale – it is the largest packaging company in both Europe and the US. 

With a continued focus on R&D we believe Amcor is well placed to deliver a first-mover advantage in cost-effective responsible packaging, an enormous opportunity if management can execute on their pledge to develop all packaging to be recyclable or reusable by 2025.

Despite low-to-mid single-digit revenue growth (excluding bolt-on M&A), strong operating cash flow (FY21 delivered c.US$1.45bn) allows not only for a consistent dividend, but also ongoing capital management (buybacks) that is ultimately EPS accretive."

As ESG measures become more important, de Wet believes we shouldn't discount Amcor's prospects when change is achievable.

Managed Fund

Elston Australian Large Companies Fund

Australian Shares

View

Never miss an update

Enjoy this wire?

Hit the 'like' button to let us know. Stay up to date with my content by hitting the 'follow' button below and you'll be notified every time I post a wire.