By Vesna Poljak, Australian Financial Review
As markets eye record levels, IML’s Tim Wood is screening out over-earning as COVID-19 super profits fade. The same goes for the float everyone’s talking about: Virgin.
The reporting season under way gets the market another half closer to weeding out the COVID-19 gremlins that persist in company reporting, be they a flair for over-earning, or the final kinks being ironed out of supply chains.
IML Sustainable Future Fund co-manager Tim Wood does not assume super profits booked during the pandemic years in any of the manager’s forecasting exercises.
“We’re literally taking what they [earned] pre-COVID, and what is the normal organic growth that you would expect a business would have achieved for this. And that’s how we should project it going forward,” he says.
So, knowing that when the window for floats reopens, it’s likely to be marked by the initial public offering of Virgin Australia by Bain Capital, that same approach will prove an essential discipline.
“It’s going to be very dependent on what conditions look like and what the feedback is like, as they come and do their initial roadshows,” Wood reflects. “We’ve been involved in a lot of those discussions. And it’s just a question of whether the companies are trying to capitalise on COVID booms – we’ve seen huge profits from Qantas, for example. Virgin’s likely to be seeing the same.
“Are they trying to get us to pay a multiple on record earnings that are unsustainable, or are they willing to let go the business for a more normalised multiple, normalised profit?”
The narrative is similar at another rumoured trophy float, Chemist Warehouse: “That had a phenomenal couple of years selling pharmaceuticals and vitamins.”
Like many Australian managers, IML lost some portfolio positions to privatisations in the great M&A rush of 2022.
The rolling of AGL’s board last year poses a cautionary tale for capital allocators who approach the energy transition passively. But the market is constantly throwing up new ways to trade the green premium, and reward investors who apply a more forensic lens to valuations.
Take the dual ASX- and NZX-listed gen-tailers (generator-retailers) Meridian Energy and Contact Energy. Meridian is 100 per cent renewables and trades on 17 times earnings – “it’s a very high valuation”, as Wood observes. Contact Energy is about 80 per cent renewable supply, but the company trades on 12.5 times – a substantial discount.
Contact is committed to building new geothermal power and shutting down its residual fossil fuel generation so that in about two years, it will also be 100 per cent renewable. And here, in the eyes of Wood, lies the superior opportunity for investors.
“We get a better ESG outcome by supporting companies like this. But also, we think we get a better investment outcome: we’re only having to pay 12½ times for Contact, versus 17 times,” he says.
There are many reasons why the market should assign a higher valuation to renewable companies versus fossil fuel operators, such as the risk of a tax on carbon, which would increase the cost bases of emitters.
“And here’s an example for us where we have an investment in a company that’s going to be 100 per cent renewable in a couple of years’ time, but trades at a significant discount to the peer that’s already 100 per cent renewable,” the manager said.
The Sustainable Future Fund is seeded by Natixis Investment Managers, which five years ago bought into Investors Mutual. It subscribes to the same value mindset that IML has advocated since it was founded by Anton Tagliaferro in 1998 with an emphasis on quality.
“For us, it’s really around predictability of cash flows. It’s great to get amazing revenue growth. But if you’re not profitable, we’re probably not going to invest in you,” says Wood. A good business is broadly defined as an established company with a robust balance sheet, astute management, and operating within an attractive industry.
“And always for a good price,” the fund manager adds.
“The great thing about being value investors is there’s always stocks and sectors that come in and out of favour.”
Quality companies, says Wood, tend to think about the future. “What is the best use of those profits to invest in going forward? How does that tie in to sustainability?” In reality, this means they already have their own targets around carbon, and don’t face a capital shock when policy surprises arise.
“I think any company that’s worth their salt over the last five years has recognised that sustainability is increasingly important, and that they will trade at a discount if they’re not able to demonstrate not just words, but actions.”
Wood says fund managers will never have a problem tipping more capital into a business that is making sensible acquisitions and identifying growth.
One such example is Imdex, which raised $220 million to buy Norwegian drilling technology company Devico last month, which IML participated in. “That will widen that moat for them, and enable them and their clients to be more efficient at what they’re doing.”
The interim profit season beginning this week will be an optimal time to hear how companies are coping with inflation and trying to protect, or grow, margins.
“Remember, it was only 12 months ago where there was a huge shortage of most things. And so companies were perhaps not selling as much, but they were selling at much higher margins because they weren’t having to discount their products. I think we’re in a very different dynamic.”
Inventory is another battleground issue for retailers: “What does the competitive environment look like in terms of discounting or promotions that we might see? That’s interesting.”
Wood recalls the global shortage of ammonia nitrate because of the Russian invasion of Ukraine. Russia was previously one of the biggest exporters of ammonia and ammonium nitrate, the key ingredients in explosives. “So the question for companies like Orica, who sell explosives, is, can their customers negotiate as strong outcomes as they could in the past?”
In forthcoming negotiating rounds, relatively lowly priced contracts up for renewal will have to meet current market conditions. “And we should see that transpire over the next couple of years where we see substantial margin uplift from that disruption that we saw 12 months ago,” he says.
Another sector where the margin outlook is improving is insurance, although the floods in Auckland are a reminder of how quickly adverse weather can reset expectations. Even so, insurers and reinsurers globally have seen such large claims that premium prices have been forced up, and Australian insurers are no different.
“What we think will happen is, as we roll off La Nina into a more benign cycle, we should see claims costs come down. And so we should hopefully see profitability improve for Suncorp and IAG, where we have big positions.”
Hates losing money
IML also owns Steadfast, an insurance broking service to small and medium businesses that need bespoke cover. “So with premiums going up, and them clipping the ticket on every premium, we think profit growth for companies like Steadfast will be very strong as well.”
Wood’s background is financial planning, where he was faced with solving the portfolio needs of small investors. “I spent the first six months of my career writing to investors about how much money they’d lost,” he says, recalling the weak returns of the early 2000s.
He became increasingly motivated to become a buy-side investor, earning a CFA qualification and eventually moving to Hong Kong for a role with JPMorgan Asset Management.
He returned to Australia in 2018 but the lessons of working with mum and dad investors stayed with him.
“I’m a very conservative investor by nature, I can see how bad management teams, bad balance sheets can very quickly unwind a company if you get a few of the risks play out.” He has spent the past four years at IML.
While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (IML) (AFSL No. 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is general in nature and does not constitute personal advice. This advice has been prepared without taking account of your personal objectives, financial situation or needs. Investors should be aware that past performance is not a reliable indicator of future performance. The fact that a particular security may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock. Any reference to a particular security is general in nature and should not be taken as an endorsement by IML. Any forecasts referred to in this article constitute estimates which have been calculated by IML’s investment team based on IML’s investment processes and research.
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