SAYING MOO TO THEMATIC INVESTING
Investing in stocks in industries that have good longer term growth prospects can be both rewarding and alluring for many investors. Obvious examples of these themes include telecommunications and internet, ageing populations and healthcare, food and population growth and so on. After all, the promise of structural growth in demand for a product or service over a long period of time seems like a sure way to make money year in year out for many years to come regardless of the vicissitudes of underlying economies. However investors should pause and exercise caution by taking a deeper look at the inner workings of the business they are buying. Not all companies involved in obvious growth areas are going to be successful investments.
To recap, the chances of investment success in the stockmarket are increased by focusing on those stocks that represent robust businesses that is, they are high quality businesses, have favourable longer term prospects and can be bought at a rational price (green lights investing).
So are investment themes still important? The answer is yes but themes are only part of the story. The particular investment being considered still needs to be a robust investment. Where structural themes are relevant is with regard to whether a business has favourable (or unfavourable) prospects. The risk of a stock not being a successful investment is still there if notwithstanding that the business is in the right thematic area it represents a poor quality business either because of high debt levels or low profitability or a myriad of other reasons. The same risk applies if the business appears high quality and is in the right area but is selling for a price well above what would appear to be a rational value. It is common in a bull market for companies operating in sexy or currently fashionable areas to trade well above what appears to be a reasonable value.
Let us look at food related business for examples. After all everyone has to eat. So a food related stock has to be a lay down misere right? Food related stocks cover a wide array of businesses and cover most of the food chain. Just picking on a few names they range from supermarkets like Wesfarmers (Coles) and Woolworths to the cholesterol sector i.e. Domino’s Pizza to suppliers or wholesalers to supermarkets like Goodman Fielder (bread) and Metcash (IGA) to suppliers to agricultural businesses where we have Nufarm (crop protection) to agricultural businesses themselves like Australian Agriculture (beef) and Tassal (salmon).
While not an in depth analysis a quick comparison of these stocks over a number of years shows that their shareholders have had widely varying experiences. Just looking at a few key metrics we see the following:
In this table Q is the quality of the company, ROE is how profitable the stock is (the higher the number the better), eps is earnings or profit per share, div is dividends per share, value is estimated value and price is that figure that flicks up and down from day to day. The figure is expressed in cents so looking at Wesfarmers eps 183 is $1.83 and for price 4450 is $44.50.
Goodman Fielder are no longer listed so the relevant figures for this table are not at hand however the figures are not pretty. Goodman Fielder was a poor long term performer and must have had almost as many takeovers, privatisations, reconstructions, cost cutting exercises etc. as I have had hot dinners.
So identifying a share as being in a food business was clearly insufficient analysis upon which to base an investment decision.
For most of these stocks the range in the figures has been wider and in some cases much wider than is shown. One can see that there is no automatic correlation between investing in a food related company and having a successful investment. There is however a correlation over the longer term between the quality of the business, its profitability, earnings and dividend growth, increase in value and share price.
Those companies that have good or high quality ratings have, as a group, been rewarding longer term investments whereas those companies with modest quality ratings have not performed well over the longer term. Also with the exception of Tassal it can be seen that the better performers have higher profitability (ROE) than the stocks with lower profitability. If you look at earnings per share growth we get the same results.
Where companies have had low profitability it is usually from a combination of factors lack of a strong competitive position being one of them (Metcash). Another is being in capital intensive and volatile industries (Nufarm and Australian Agriculture). If you are a primary agriculture business there are many factors beyond the control of management which makes high profitability hard to achieve consistently. Why anyone would want to invest in Australian Agriculture on a longer term basis is beyond me notwithstanding that beef prices are on the rise.
So identifying big secular investment trends is only part of analyzing a stock (and not the hardest part). The harder part is identifying those stocks that have the potential to position themselves so that they can carve out a competitive position. And to form a view as to what is a rational price to pay for such a business.
If we look at other industries or sectors that have expected long term growth we will find once again (if we dig a little deeper) that some businesses will stack up as potentially rewarding investments and others will not.
Meanwhile back on the Australian Agriculture ranch in some godforsaken part of outback Australia are two Australian Agriculture cattle. The first one says “Moo”. To which the other responds “You bastard I was going to say that”. Well one can empathise with the second beast. You know how annoying it is when you think of something really good to say and someone else says it first.
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