How to find quality at a reasonable price

-- | 28/11/2019

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Lex Hall: Hi, I'm Lex Hall and welcome to another edition of Morningstar's "Ask the Expert." Today, I'm joined by Ned Bell from Bell Asset Management. We're going to be talking about quality at a reasonable price, what that means and how investors can take advantage of it.

G’day, Ned.

Ned Bell: G’day, Lex. Thanks for having me.

Hall: Nice to see you again. Now, talking about QARP or quality at a reasonable price, I wanted to begin with a quote by Warren Buffett who in 1989 said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Is that we're sort of talking about when we talk about QARP?

Bell: Yeah, I think it is and it's really – it's generating this distinction between the valuation risk that comes with quality investing and growth investing but also the earnings risk that comes with some of the growth investing we're seeing now. So, where we are now is, we're at a point where growth stocks have performed extremely well. But they're now the most expensive they've ever been. And value stocks have obviously lagged considerably. They've had a little bounce in September or October, but the earnings risk is very much so still in the value cap. And I think it's pertinent because we're moving into 2020 where the risk environment is picking up somewhat. The macro backdrop has a habit of accentuating the valuation risk and the fundamental risk in the value cohort.

Hall: And so, what distinguishes a company – if I can put it that way – that you would consider fits the QARP criteria?

Bell: Yeah, it's a good question. So, first of all, they have to get over a quality hurdle. That's the first point. So, when we think about quality, we're thinking about companies that have got great management teams, strong franchises, consistently high levels of profitability, strong balance sheets and good business drivers. So, they need to get over those hurdles first before they're even considered for QARP. And then, at that point, you need to think about what you're willing to pay for it. So, typically, we tend to look at companies that are generating it, for example, return on capital in excess of 10 per cent, 15 per cent as a starting point, but then you don't want to be paying over the odds for those companies. So, you want to be typically paying less than, say, 25 times earnings for those types of companies. So, it's that balance between quality and value that's really important.

Hall: So, for a retail investor, what sort of tips would you give them if they were applying this strategy? What should they be looking out for in particular?

Bell: Yeah. So, really, the only way to implement this type of strategy is via active management. I mean, there really is no ETF or passive implementation of this because the passive and ETF are products you can find out there that are either – they're either value or the growth or the quality that you simply don't find them where there's a combination of those factors applied at a stock specific level. So, what I would say is that investors should look for active managers that apply this type of philosophy, that have got a balance within their portfolio between high levels of profitability and sensible levels of valuation and make sure that those attributes have been consistent through a long period of time.

Hall: What about – let's just pick a stock out of the air, say, Tesla, for example. Is that a tricky one? Is that deceptive?

Bell: There's a few issues with Tesla.

Hall: Yeah.

Bell: Yeah. So, the first one, from a quality perspective, profitability is not generally synonymous with Tesla. So, it doesn't pass our quality test, for example. So, again, it doesn't make that 15 per cent return on capital threshold. And because it's not generating much profit, it's very difficult to value that company on an earnings level, because the earnings are always still to come, still to come, still to come. And then, the other issue I suppose with Tesla is because that's a very capital-intensive business, they're always rolling out new models, which means the profitability is always two years away.

Hall: Yeah. Seems like there's a few companies here in Australia that fit that bill, like, you think of some of the buy now pay later companies, they're not profitable, they won't be profitable until 2021. So, that's certainly something to keep in mind, isn't it?

Bell: Yeah, I think some of those things are probably more in that – they're good example of stocks in that growth cohort, where there's a lot of momentum, money chasing them, valuations are just not even really considered. And as much as the performance of them have been phenomenal. There always comes a time when the market tends to bring those stocks back to back to worth a bit. And we saw that in Q4 last year. And that was really the first test of the risk that we saw in value stocks and growth stocks, because to some degree, there was underperformance at both ends of the spectrum. So, a lot of those really well owned growth stocks underperformed because they were too expensive, and some of the value names underperformed because the macro was deteriorating.

Hall: Let's finish on a few names that you think fit the QARP strategy.

Bell: Sure.

Hall: One that you've highlighted is

Bell: Yeah. So, is a stock we've owned for a number of years. So, they are a leader in the online travel business. Most importantly, it's a really high return on capital, asset light business. They generate 25 per cent plus return on capital. The stock trades on a P/E of about 17 times earnings and it's growing its earnings at 10 per cent plus going forward. So, the combination of those three things is really, really powerful because it means that we can make money through the P/E rerating, plus earnings compounding and that's really the Holy Trinity is to get the combination of those two.

Hall: OK. Another one on the list is Home Depot.

Bell: Yeah. So, Home Depot is one of the few brilliant U.S. retailers in what's been a very turbulent period for retail in the U.S. But Home Depot, Costco, maybe one or two others have been the real leaders. They've led that category for a number of years. I think, really interestingly, the reality is that the U.S. consumer is unbelievably strong right now. And so, as a play on the U.S. consumer in the tight labor market, I think Home Depot is a great way of playing that. And again, it's not that expensive. It's only trading at 20 times earnings. Again, 20 per cent plus return on capital, will grow its earnings at least 10 per cent going forward.

Hall: Great. And finally, Broadridge Financial.

Bell: Yes. Broadridge Financial is an interesting small/mid-cap name. It's a financial name, but what they do is, they do a lot of the back-office work and almost like the plumbing, if you like, for some of the big banks. So, the back-office work that they don't want to be doing, they will outsource to companies like Broadridge. So, in effect, what tends to happen is, when the banks come under a bit more pressure, when things are a bit more volatile, they're looking for cost savings, outsourcing some of their back-office work to Broadridge is a logical way of saving money. So, to some degree, there's a countercyclical element to the earnings drivers for Broadridge.

Hall: Sounds as though they might have some work in Australia.

Bell: They might. They might do a little bit of work (with Austrac maybe).

Hall: Thanks for your insights.

Bell: Great. Thanks Lex. Appreciate it.

Hall: I'm Lex Hall for Morningstar. Thanks for watching.

This report appeared on 2021 Morningstar Australasia Pty Limited

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