Why resilience and uniqueness spell sustainable competitive advantage (and two stocks that meet the brief)

“I'm looking for resilience and uniqueness. So, when I say resilience, I mean a business that can maintain margins, returns on capital, and cash generation through ups and downs of the economic cycle. And uniqueness, what I want to see is a value proposition that's very difficult to be replicated,” he says.

Exploiting the herd

Hill believes that looking for high-quality companies experiencing short-term stress, that are being unduly punished by markets, can spell the difference when it comes to making a profit over cycles.

In this edition of Expert Insights, Hill discusses the WaveStone investment strategy, exploiting the herd and two stocks he has identified that meet his criteria.

Edited transcript

What are the key elements of your investment strategy?

We prefer higher quality businesses over a long-term time horizon. We generally think about businesses in a three to five-year time horizon, which I think insulates us a bit from market noise. We do prefer companies that are growing, although we won't just buy a business because it's higher quality and growing, we are quite valuation focused. 

I think the way that manifests in portfolio construction is that it's a relatively concentrated book. It's usually only about 30 or so stocks, and very low turnover, which you would expect on a longer term time horizon. And we are quite conservative, so uniquely I think, we don't invest in unprofitable companies. That can be an issue in years like 2020, but it can also protect you on the downside. And I do think it stops you from having to worry about a company having to be reliant on external financing to grow. So you mitigate that dilution risk.

WaveStone’s cornerstone is identifying companies with a sustainable competitive advantage. What does this mean in practice?

Sustainable competitive advantage is one of those terms that gets thrown around a lot, but nobody really has a great answer for. For me personally, I'm looking for resilience and uniqueness. So, when I say resilience, I mean a business that can maintain margins, returns on capital, and cash generation through the ups and downs of the economic cycle. And uniqueness, what I want to see is a value proposition that's very difficult to be replicated. 

I think the best way to generate exceptional returns on capital and high margins is to offer a product or a service to your customer that is unique, as long as they get value from it, but cannot be replicated by competitors or the customer itself.

You also look to exploit the herd. How does this manifest in your process?

Buying a company with a sustainable competitive advantage is not in and of itself going to be a profitable strategy. To make money in the markets, you do have to think differently. 

One thing we know about the markets is there is a propensity to extrapolate, and I think that's been very evident for the last three years during COVID. The last data point seems to be that's the way the business is going to go on the upside and on the downside. 

If we take those two things together, how we think about making money is finding a good business that is high quality and resilient, but is having some short-term stress. The market has now said this short-term stress is a structural issue and has discounted that into the valuation moving forward. 

So, if you can get comfortable that this issue is temporary and you like the business, I think that's the best way to make money on the long side.

Firstly, the earnings revisions will typically be positive as they manage their way through the temporary issues. 

And secondly, the multiples should re-rate as people start to realise that that structural issue that they were pricing in was actually just a temporary issue.

Can you talk about some examples of stocks that have the characteristics discussed above?

One stock we've been adding to in the last six months has been PEXA (ASX: PXA). 

PEXA is an electronic conveyancing platform that was established by the banks and the land registries about a decade ago. It's a monopoly in Australia, with very high margins, and very low incremental capital needs, so it generates a lot of cash flow. But the market's been worried about a few things and that's: 

• A) housing volumes have been quite weak recently. 
• B) I think there was, in the last result, a bit more investment in the data business than they would've liked, and 
• C) it did look like there was a little bit of slippage around the timing of their UK strategy. 

I went to the UK last year, and I've spoken to participants all up and down the value chain, and I think that the PEXA platform solves real issues in the UK market. I think that would be successful. A few months here and there of customer slippage shouldn't really matter in the long term. The housing market in Australia has been soft, but I think that's just a temporary weakness. It will rebound, and you've got a very high-quality underlying business there. 

And the data business, while yes, costs are elevated, the fact that management has set some targets around revenue and profitability, I think that makes it more of a free option than people are pricing in. 

The second business that fits that bill that we've been taking a look at recently is the ASX Limited (ASX: ASX).

Again, another monopoly, a very good business with high margins and high return on capital, but they've had some very well-publicised issues.

1. The issues with Chess, which we think ultimately is noise despite what the media says.
2. They've had some revenue issues due to low interest rates. So, that's really forced down trading of their most profitable business, which is the futures volumes, which we've actually started to see come back more recently, and
3. There have been some concerns about costs in that business. Some of the costs are elevated now as they get a bit more focus on that business. But if they can ride through that, you've got a very good business that looks like it's at a cyclical low point in revenue, and is certainly, in terms of sentiment, as negative as it's been in a long time.

Learn more

WaveStone aims to provide capital growth over the long term and tax-effective income by investing in quality companies with a sustainable competitive advantage. For further information, visit their website or fund profiles below. 

Managed Fund

WaveStone Australian Share Fund

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Managed Fund

WaveStone Dynamic Australian Equity

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