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Airlie's quality test for household blue chips

Glenn Freeman  |  06 Aug 2018Text size  Decrease  Increase  |  
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Obsessed with cash generation and a detailed understanding of business models, this Australian equities fund's management team explains what it loves and hates about these blue chip companies.

Airlie Funds Management was acquired by renowned international equities manager Magellan in November last year, and has since pared back its institutional mandate to also launch a targeted retail portfolio of about 25 stocks.

"We think we're good at picking stocks, so we've honed our process down to a concentrated, active 'best ideas' approach," says portfolio manager, Matt Williams.

A diverse list of value stocks – Reece, Qantas (ASX: QAN), Suncorp Group (ASX: SUN), James Hardie (ASX: JHX) and Link Holdings – are its top five holdings.

Speaking at a recent industry event, co-portfolio manager Emma Goodsell explained the vital role company balance sheet, management and overall business quality have on its investment portfolios.

"It's usually a bad balance sheet, bad management or deteriorating business quality that trip you up.

"The question that we ask ourselves is: 'what is the right financial structure for the business model?'" she says.

The cause of blow-ups

In terms of the financial strength and downside protection, she believes that company "blow-ups" are usually a result of carrying too much debt in a business model.

"We think that the market isn't very good at putting a value on the optionality that a strong balance sheet gives you … we're always very attracted to these cash-generative, asset-rich businesses."

Department store retailer Myer (ASX: MYR) is one well-known company that currently fails Airlie's balance sheet test. This is largely because of its significant off-balance sheet liabilities in the form of leases.

"Even if no customers went into the store that day, they'd still have to pay the rent and keep the lights turned on.

"On the flipside of that is that we've had a very good experience investing in Metcash, where they own the property themselves," Goodsell says.

Business quality is key

Assessing business quality accounts for the majority of the time Goodsell and fellow portfolio manager, Matt Williams, spend analysing companies.

Qantas is also highlighted as a company that has been successful for Airlie. "The important thing to note is that we didn't participate in the early share price gains coming out of the early capacity war [between Qantas and Virgin], but two years ago, it did pass our filter and we invested," Goodsell says.

The business quality it identified at the time was the duopoly industry structure, which she describes as "a very favourable environment for Qantas … with 65 per cent market share but 90 per cent of the domestic profit book".

As a comparison exercise, they also looked overseas, where international airlines trade on higher multiples, but found it was more competitive.

Still, there are companies that tick some boxes but not others, and so are excluded from its portfolio. Harvey Norman (ASX: HVN) is one. "They own the property and have a good balance sheet, but with its corporate governance concerns, you can probably use that as example of a precautionary tale of being a minority shareholder," she says.

Telstra telecommunications mobile telephone

Telstra's perceived advantage

Among Australian large-caps, companies don't come much higher profile for investors than Telstra (ASX: TLS). Yet Airlie has so far shied away from it. It sees financial strength as a key problem, in that "they spend more than they earn".

"If they've made $100 out of the business, they've been sticking $68 back into it … that's an unsustainable situation," Goodsell says.

She describes a "capital intensity pact" Telstra has, whereby customers have traditionally been willing to accept paying higher prices for the service because they get the best coverage network.

"This creates a high capital intensity for management because they can't risk losing that perceived network advantage.

"The implication for us is that when we roll forward not only this capital intensity, but the coming pressure that we see in mobile and the National Broadband Network, that's a balance sheet that increasingly lacks optionality."

Goodsell concedes that Telstra's share price appears cheap when weighed against international competitors, while it looks more  fairly valued in terms of its sustainable earnings.

"So, we're fairly mixed on how it looks … none of this really screams 'value' to us. We keep a watching brief, but for now, it's not really screening particularly positively thorough our process," Goodsell says.

Tick for Wesfarmers, CSL

Wesfarmers (ASX: WES) and specialist healthcare business CSL (ASX: CSL) are companies Airlie likes.

When assessing CSL, they identified five companies globally with higher return profiles, and all trading at substantially higher multiples.

"But to us, CSL's price makes sense given the quality of the business.

"Where CSL had a quarter of the market a few years ago, they'll have a third in a few years' time," Goodsell says.

The fund has held Wesfarmers for two years, over which time "it hasn't really done much" except pay a dividend, until recent outperformance.

Bunnings and Kmart are two of its businesses Airlie highlights as star performers. Airlie has called on Wesfarmers' management to separate from the conglomerate structure.

"We got our next best wish with the spinoff of Coles," says Goodsell. "We attribute the recent outperformance to the fact that our thesis is playing out."

 

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Glenn Freeman is senior editor, Morningstar Australia.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is senior editor for Morningstar Australia

© 2019 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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