A focus on the micro trumps the macro over the long-term

August 3, 2023
Investment Updates

We believe that good investment opportunities are those where there is limited downside and significant upside risk. Stocks where a large gap in price and intrinsic value exists i.e. they offer a large margin of safety typically lead to good future returns regardless of whether they are classified as defensives or cyclicals or large caps or small caps.

Incidentally, the Fund is underweight expensive defensives given they are trading at significant valuation premiums versus the broader market and in many cases offering low earnings growth. We are significantly overweight ex 100 companies that have seemingly been forgotten by the market, as assessed by their relative valuations and have materially underperformed large caps despite offering stronger earnings growth.

As is often the case in the business world so it is in the stock market that opportunity lies in adversity. The market from time to time becomes overly fearful or greedy about short-term prospects for a business and fails to give due weight to long-term value. After businesses have passed our balance sheet, cash flow, management quality and sustainability hurdles we seek to identify those stocks trading significantly above or below intrinsic value to take advantage of short-term market inefficiencies or mispricings which correct themselves over time.

For cyclical stocks where profitability can vary a lot year to year we value the business on its midcycle or through the cycle sustainable earnings. In practice we notice the market from time to time will capitalise earnings in a bumper year and hence overvalue the business and also capitalise earnings in a poor year and hence undervalue the business.

We have used this concept of midcycle valuation and keeping a focus on the micro (company specific) over macro economic concerns of the day to make profitable investments over time. For example we started buying BlueScope Steel in the $12s in mid 2020 when steel prices were well below their long-term averages because of a short-term decline in demand driven by the pandemic. Over the next 12-18 months as demand picked up and steel prices rose well above their sustainable level we sold a significant part of our position in the low $20s.

More recently the fund started purchasing McMillan Shakespeare stock in early to mid last year in the $11s when market fears over weaker consumer demand for cars were overblown and the business was trading at a significant discount to its midcycle value. We believe sentiment for the stock has swung to the other extreme currently and we recently exited the position.

Today we think Qantas is a stock where the market is overly fearful about a potential slowdown in consumer spending on travel and significantly undervaluing the business. 2024 earnings per share is c.50% higher versus pre-pandemic yet the stock price is lower. Qantas trades on a price-earnings ratio of c.6x or earnings yield of 16%+ despite having materially lower debt, better industry structure and proven pricing power in a rising fuel price environment. So with limited downside and significant upside of 50%+ (the stock ought to trade 9-10x price-earnings ratio over time) the stock is attractive in our view.

Qantas has a strong focus on sustainability and recognises emissions is a key matter for the company. In 2019 it became only the second airline across the globe to commit to net zero by 2050 and more recently set an interim target to reduce emissions by 25% by 2030. The company is committed to using 10% sustainable aviation fuel (SAF) in its total fuel mix by 2030 and 60% by 2050.  Qantas alongside Airbus is investing up to US$200 million to help establish a SAF industry in Australia. Moreover the company is purchasing new aircraft that will reduce emissions by at least 15% compared to emissions from the aircraft they are replacing.

We believe focusing on the micro will continue to trump the macro over the long-term. This is especially true in an environment where investment horizons continue to become shorter thereby making a focus on the long-term a sustainable way to generate solid returns.

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