Quality stocks have nothing to fear from inflation
“The only thing that I think gets confusing is that this correction, especially for high-priced stocks in the market, has nothing to do with the outlook for the national economy. For us, it’s very positive.
Inflation does not affect all companies in the same way: some will benefit from it and will show their quality. Others, the consumers of capital, will have a harder time.
“It’s not rocket science,” he said. “It’s about finding companies that have proven to be high quality companies. And basically you have a bit of a cheat function to determine if something is a high quality business, and that’s go take a look at its statutory ROI, or return on investment.
“Everyone talks about moats and competitive advantages. Well, if they have a demonstrably higher ROI than their peers, there’s obviously something to that.
BHP Group “just got better deposits”. REA Group has “such a dominant position in this online property portal space”.
“A good business isn’t a popular business, it’s not a business that gets a lot more users,” says Carleton. “To its owner, a business has value only to the extent that it generates cash flow that the owner can earn from the business.”
Auscap’s strategy emphasizes the benefits of capitalization, the so-called eighth wonder of the world – “it’s extraordinary” – but also the discipline of distancing oneself from tired narratives and adopting a patient approach .
The Australian equity fund Auscap Long Short returned 43.2% in 2021, after fees. As of January 2022, including a 7.2% decline that month, it has an average annualized return of 17.4% since inception, ahead of the All Ordinaries’ 9.6%.
The strategy topped Mercer’s survey of Australian equity managers last year with a return of 50.6% (measured on a gross or before fees basis), beating 140 other managers.
“Opportunities don’t arise all the time, as good companies should trade at a higher price than the broader market,” says the fund manager. “But there are several reasons why you should expect to have such opportunities, throughout the cycle.”
Sometimes it’s the result of a company with little institutional awareness, like MA Financial, the former Moelis Australia, which was arguably relatively unknown until a few years ago.
And “sometimes you can have an opportunity because something is very well known”, like the Macquarie band. Its returns are consistently higher than those of the big banks, “but there were times when you certainly couldn’t have predicted five or 10 years ago when the majority of profits would come from today.”
“So if you have the ability to buy them at a market multiple, you’re buying something that’s likely going to generate well above market returns.”
Winners and losers
Auscap detects some opportunities arising from the dominant narratives of winners and losers from COVID-19, and the assumption that these trends are reversing. “I think you’re seeing that right now with some of the retail stocks,” Carleton speculates.
JB Hi-Fi’s interim earnings, which sent shares jumping 5.4% and recovering further on subsequent brokerage upgrades, represented “a very, very strong result.”
“Probably the most impressive thing was the January negotiation; they delivered similar positive lineups, both for JB Hi-Fi and The Good Guys.
But the popular bear thesis was that electronics spending would plummet as the economy normalized. “And so, as a result, this stock is trading at a very steep discount to the rest of the market, despite being a very high quality, very, very well run retailer that is generating a truckload of cash and has a very strong capital position.
Nick Scali seems to be fighting the same narrative: “You have a business that should benefit from this big real estate cycle that we’re in right now, that has some really exciting opportunities in terms of what it wants to do,” says Carlton.
Most Underrated Trends
“Their online business has EBIT margins in the mid-50s. And yet it trades in low double-digit earnings multiples for a company that has probably one of the best management teams in the market.
“It’s run very conservatively. They don’t do dilutive things. There are the same number of shares outstanding today as there were at the listing.
A substantial investment opportunity that the strategy has realized comes from the fact that, over a long enough horizon, most trends tend to be underestimated.
“With an S-curve, the adoption rate, once you start to see an acceleration in adoption, it’s usually underestimated by the market,” says Carleton. “The demand and supply outlook for lithium, for example, is extremely favourable.
“We suspect everyone might know there will likely be a supply shortage, but people are underestimating what that means for price and therefore profitability.”
He remembers when iron ore traded below US$20 a ton in the early 2000s when the commodity was tied to long-term contract prices. Although again in a bear market, futures for the benchmark 62% ore were trading around US$130 per tonne last week.
“We went from a situation where the mining companies with the best resources were getting a reasonably attractive rate of return on their investments to a phenomenal return,” says Carleton.
The main reason was the exponential growth in demand from the Chinese steel industry.
What has become evident in lithium is the need to be selective in supporting operators capable of producing successfully, as some projects never see the light of day. In Auscap’s view, these are mineral resources.
“They’ve partnered with probably the two biggest or most experienced lithium players – Albemarle, Jiangxi – and they control very high quality deposits and they’ll make sure they’re extracting the most value down to the product. final.”
As a value manager, Carleton admits that a consistent focus on earnings has made things difficult over the past five years because the market has been gripped by “the biggest growth cycle we’ve probably ever had. seen “.
“Many of the best performing companies in the market haven’t made a profit,” he says. “The number of companies that have a market capitalization north of $10 billion and are losing money right now must be unprecedented.”
But, just like sticking with stock for the right reasons, consistency in the process tends to pay off.
“If you get a reasonable rate of return on your capital over time and hold it long enough, you’ll do very, very well,” he says, whether that comes with a growth bias or valuable.
“The reality is that the Australian market, the US market, most markets have scaled the walls of worry over the past 100 years and consistently provided the best returns across different asset classes.”