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The Morningstar Four: How to spot a well-managed company

Lex Hall  |  05 Sep 2019Text size  Decrease  Increase  |  
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When Morningstar senior banking analyst David Ellis was recently asked to nominate the best chief executive he'd seen during his decades covering the sector it didn't take him long to answer: Gail Kelly. Why did the former Westpac's chief executive name spring to mind? It essentially came down to honesty. "She has the ability to make you feel that she's talking to you as an individual,” said Ellis, “and not to the thousand people that are in the room.”

Nor was Kelly bad at banking, Ellis notes. She was appointed Westpac chief executive in February 2008, only months before the global financial crisis took hold. She not only steered the group through this turmoil but also oversaw the biggest bank takeover in Australian history, when Westpac bought out the bank Kelly used to run, St George. During Kelly’s stewardship, Westpac’s market capitalisation more than doubled, from $50 billion to $104 billion. And the share price rose by 26 per cent. 

On that score, Kelly showed two characteristics that contribute to what Morningstar would classify as “exemplary” stewardship. On one hand, an ability to communicate clearly and honestly with shareholders; and two, a shrewd investment strategy that increases the value of the company.

Stewardship has a special meaning when it comes to the way Morningstar evaluates companies - and understanding this key characteristic can help you when it comes to appraising companies you're considering investing in. 

A search of stocks covered by Morningstar reveals 16 names that carry an “exemplary” stewardship rating. However, when we narrow that search down to “exemplary stewardship” and “undervalued”, only four names make the cut. Ansell, Challenger, Domino's Pizza and Iluka Resources. A mere 4 per cent of the Australian Stock Exchange.

But before we examine these four, it’s useful to determine what makes stewardship “exemplary”. According to Heather Brilliant and Elizabeth Collins, authors of Why Moats Matter: the Morningstar Approach to Stock Investing, stewardship boils down to how a company’s managers behave on behalf of shareholders. In short, how do they use the money/capital they have at their disposal to create value for shareholders - the owners of the company? 

Brilliant and Collins use several benchmarks to evaluate it, which we’ve summarised below: 

Investment strategy and valuation: When it comes to capital allocation, managers essentially have three options: they can reinvest it in the business; save it; or return it to shareholders. “A firm with ‘exemplary’ stewardship will consistently invest in projects that establish or enhance its core business and competitive advantage,” say Brilliant and Collins. Think: Google buying little known software company Android in 2005 for a rumoured $50 million. Since then, Google’s Android operating system powers more than 85 per cent of smartphones around the world, compared with Apple iOS’ slightly below 15 per cent. “Similarly, we look favourably on management teams with a track record of shedding non-core or underperforming assets at good-to-fair prices.” 

Execution: Execution is about making promises and keeping them. Only then will companies gain credibility with investors and analysts. On the other hand, poor execution by management can destroy value. BP is a striking recent example. Almost a decade after the fatal 2010 Deepwater Horizon disaster in the Gulf of Mexico, BP remains on the hook for $23 billion, to be paid over the next 17 years. BP’s “consistently poor safety record resulted in massive legal liabilities and clean-up costs that contributed to significant shareholder value destruction,” note Brilliant and Collins. 

Financial leverage: A mark of exemplary stewardship is the ability to consistently strike the right balance of debt and equity financing. Poor stewardship is taking on too much debt for a company’s line of business. Companies that operate in highly cyclical, capital-intensive industries should avoid carrying a large debt load as it can exaggerate the inherent volatility in the business and put shareholders’ equity at risk. By the same token, a company with no debt but few reinvestment needs may be able to maximise shareholder value by issuing debt as it could lower the cost of capital.  

Dividend and share buyback policies: The ideal dividend policy should be consistent, affordable and transparent. Management worthy of an exemplary stewardship rating will avoid hoarding cash. Nor will it borrow simply to prop up unsustainable dividends or buybacks. Investors should seek a dividend policy that is firmly established and outlined in the annual report and one that is not altered to suit the prevailing business environment. It should leave management with enough cash to reinvest in value-enhancing projects. Australian iron ore miner Fortescue Metals Group, for instance, has returned 78 per cent of $4.4 billion profit in dividends this year, which it says is “definitely sustainable”. At the same time, it is spending $5 billion on new mines.

Compensation: In short, is the amount the chief executive of a company is being paid having a positive or negative effect on capital-allocation decisions? If the CEO’s pay dwarfs that of his or her immediate lieutenants then it could indicate that power is too concentrated. When Westpac looked to Californian banker Bob Joss in 1993 to mop up the damage from its $1.6 billion loss - the largest in Australian corporate history – Joss’s starting salary of $1.9 million nearly eclipsed the combined salaries of his rival CEOs at the three other big banks. Joss reversed Westpac’s woes, but his salary set off an explosion in exec pay, which even he questioned in a book he co-wrote called Managing in Australia. For Brilliant and Collins, exec pay must be based on metrics that motivate the leadership team to invest in value-enhancing projects and which incorporate long-term performance. 

Management backgrounds: Factors such as relevant and sufficient experience, as well as a manager’s track record in previous jobs and other factors that may have played a role in the leader’s previous successes or failures. Alan Joyce’s ability to take Qantas from a $2.8 billion loss to a $900m profit in a single year was no doubt helped by his experience at Aer Lingus, Ansett Airlines and later Jetstar. Similarly, Treasury Wine Estates chief executive Michael Clarke is an apt fit given his more than 20 years' experience in senior roles at various global food and beverage companies and extensive experience of consumer brands and fast-moving consumer goods, which he gained at Kraft, Coca-Cola, and Premier Foods. 

Communication with shareholders: Just as important as relevant background is management’s ability and willingness to be frank with investors. But while it’s easy to nominate cases where executives took credit for a success, it’s a harder task to identify cases where they showed contrition for a mistake. In 2017, BHP’s Andrew Mackenzie BHP chief executive Andrew Mackenzie revealed plans to sell US onshore shale assets. Mackenzie admitted the miner's entry into the industry was poorly timed and that it had overpaid for the assets. Analysts welcomed the move, which occurred after the miner came under pressure from an activist investor. The decision coincided with a decision to more than triple the final year dividend. “We appreciate when executives own up to strategic missteps and are forthcoming about the challenges the company faces,” say Brilliant and Collins. “Being communicative with shareholders when times are bad can also make management’s words more believable when times are good.”

The Morningstar Four: undervalued companies with exemplary stewardship

Ansell, Challenger, Domino's Pizza and Iluka Resources are both undervalued and well run. Here our analysts outline why these companies stand out.

Ansell (ANN)

Sector: Healthcare | Moat: Narrow | Fair value: $32 | Price: $27.10 

Ansell is a global provider of health and safety protection solutions, employing more than 10,000 staff in the Americas, Europe, and Asia. The firm designs, develops, manufactures, and markets a range of surgical, medical examination, industrial and household gloves, and protective clothing. It is a global leader in several product categories.

“Ansell has successfully morphed from a poorly performing conglomerate to a focused manufacturer and marketer of protective clothing products. This has been characterised by strong shareholder returns, in part driven by a strong balance sheet that allowed share buybacks (issued shares fell by almost one third during the decade) and value-accretive acquisitions. However, management also successfully expanded the business in niches where the firm enjoyed particularly strong brand positions (such as surgical gloves), moved manufacturing to low-cost jurisdictions, and successfully integrated value-accretive acquisitions.

CEO and managing director Magnus Nicolin joined the company in these roles during March 2010. He is an executive with high credentials, previously worked for consumer products conglomerate Newell Rubbermaid as president of its Europe, Middle East, Africa, and Asia-Pacific divisions. Nicolin successfully guided Ansell through the recession that followed the 2009 financial crisis.” (Nicolette Quinn)

Challenger (CGF)

Sector: Financial Services | Moat: None | Fair value: $8.20 | Price: $6.41 

Challenger’s core business is selling annuity products in the Australian retirement market and, since November 2016, selling Australian-dollar-denominated annuities into Japan's large retirement market. The firm’s annuity products provide investors guaranteed regular payments over an agreed term for an up-front lump sum investment and is designed primarily to protect investors from the longevity risk of outliving their savings.

“Despite the inherent characteristics of the core commodity-like annuity business not lending itself to having sustainable competitive advantages, Challenger nevertheless has been able to generate strong returns for shareholders for an extended period. We believe senior management has effectively allocated shareholder capital and has positioned the company for future strong earnings growth.

“Challenger has had a stable senior management team over a long period. However, more recently, group managing director and CEO Brian Benari, who was appointed CEO in February 2012, retired in January 2019. Benari was an internal appointment, having been with the company since 2003, previously holding the roles of group CFO and COO. Benari has been replaced by another internal appointment, Richard Howes, who also joined Challenger in 2003. Howes has held a number of senior positions at the company, including CEO of its core life business as well as being chief investment officer, and we believe he has the requisite skills and experience to manage Challenger. The succession to a new CEO also appears to have occurred in a seamless manner.

“The company is reaping the rewards of its senior management team implementing its successful long-term strategy. This includes the strategy of integrating its annuity products in all aspects of the wealth management ecosystem, making it the dominant annuity provider in Australia. Challenger has effectively invested in its brand via successful advertising campaigns increasing its recognition as a leading provider of retirement products.” (Chanaka Gunasekera)

Domino’s Pizza (DMP)

Sector: Consumer cyclical | Moat: None | Fair value: $52 | Price: $42.53 

Domino's Pizza Enterprises operates fast-food pizza outlets and a franchise service. The company holds the exclusive master franchise rights for the Domino's brand and network in Australia, New Zealand, Japan, Germany, France, Denmark, Belgium, Luxembourg, and the Netherlands. It entered the German market via a joint venture and acquisition. The Domino's brand is owned by NYSE-listed Domino's Pizza, Inc.

“The current management team, which includes managing director Don Meij and CFO Richard Coney, has worked together for over 20 years and is integral to the success of the business, which listed in 2005. Don Meij has 30 years' experience, starting as a delivery driver and working through the ranks to become the CEO in 2002. He has won numerous awards, both domestically and internationally, for excellence in management and entrepreneurship. Under his tenure, earnings per share has grown threefold and return on equity has doubled. Through a strategy of innovation, digitisation, and supporting the franchisee network, the company has grown from less than 400 stores at the time of listing to over 800 stores today. It also expanded its overseas business model by purchasing master franchise agreements in Europe and Japan.

“Chairman Jack Cowin was appointed to the board in March 2014. He is a very strong addition to the board, with close to 50 years' experience in the Australian quick-service restaurant industry. He is an industry doyen, owning Hungry Jacks, which is the Burger King franchise in Australia, and he previously owned the KFC franchise rights in Western Australia. Aside from the managing director, the others are nonexecutive members, with strong experience in food retailing and entrepreneurship, which is highly relevant to Domino's.

“Executive remuneration is reasonable and combines base salary with short- and long-term incentives. Base salaries are arguably low, relative to peers and considering the success of the company. Short-term incentives are driven by key performance indicators based around EBITDA and net profit after tax targets.” (Johannes Faul)

Iluka Resources (ILU)

Sector: Basic Materials | Moat: None | Fair value: $10.50 | Price: $7.02

Iluka Resources is a leading global mineral sands miner. It is the largest global producer of zircon, and the third-largest producer of titanium dioxide feedstock (rutile, synthetic rutile) behind Rio Tinto and Tronox. Low zircon costs are underpinned by the high-grade Jacinth-Ambrosia mine in South Australia, but reserve life is less than 10 years. The Sierra Rutile operations in Sierra Leone lack a cost advantage but expansions should bring some scale economies. A royalty over Mining Area C brings high-quality cash flows and gives Iluka some financial flexibility from reliable cash flows.

“We rate Iluka's stewardship as Exemplary. This reflects the company's focus on shareholder returns, a history of value-additive investments, sound execution of development projects, the strong balance sheet and a track record of paying a large slice of free cash flow out as dividends.

“David Robb was managing director between 2006 and 2016. He brought Wesfarmers' famous focus of returns on capital to Iluka. Under his leadership, the company invested counter-cyclically. The strongest examples were development of the Jacinth-Ambrosia mine during the global financial crisis and the decision to acquire Sierra Rutile towards the end of his tenure in August 2016. Tom O'Leary was appointed managing director in September 2016. O'Leary is also ex-Wesfarmers, previously leading their chemicals, energy and fertilisers operations. Prior to that he was the general manager of business development at Wesfarmers. We expect the strong financial, operational and management discipline brought from Wesfarmers to Iluka by David Robb to continue under Tom O'Leary's leadership. Any deviation from the strategic path will be scrutinised and material strategic changes could have negative implications for the stewardship rating. However, since 2017, evidence suggests the company is being managed similarly with a consistent strategy and culture. We also regard the next level of management below the CEO highly and are pleased with the continuity in many of those executive positions.” (Mathew Hodge)

is content editor for Morningstar Australia

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