The 2020-21 company reporting season has just wrapped up and, overall, it was a very good year. The positive results were reflected in AFIC’s portfolio of companies. Portfolio Managers David Grace and Kieran Kennedy outline what the results mean and consider some of the issues at hand.
With COVID prevalent at the start of the 2020-21 financial year, most companies cut their costs in anticipation of difficult trading conditions. However, as the economy rebounded, revenues were much stronger than anticipated, including the benefits to the economy of government stimulus at the time. As a result, at the end of the financial year, lower cost bases coupled with better revenue has meant balance sheets and income are in better shape than they were 12 months ago. Many companies have reported very positive earnings. Off the back of these results, dividends and share buybacks have been strong, so more cash has gone back to investors.
AFIC’s long-term and diversified approach to investing has meant returns were strong across a broad base of companies in the portfolio, many of which produced very strong results and returns for the year.
“Self-help” drivers key to company success
Companies with “self-help” drivers ‒ those companies that can reinvest and capture more market share – have performed well. Those companies have been able to grow their earnings regardless of the economic cycle.
Some examples of companies in AFIC’s portfolio with “self-help” drivers are building products supplier James Hardie and supermarket operators Coles and Woolworths.
James Hardie, which is a large holding in the AFIC portfolio, has spent a lot of capital over the years improving its supply chain, and given the high quality of its products, the company has been able to materially grow its market share. James Hardie has boosted its manufacturing capacity, streamlined operations, and has benefited from its strong marketing. Consequently, it has reported strong earnings growth, and we believe there is further upside to come.
Coles and Woolworths have taken advantage of the accelerated shift to online retailing and home delivery resulting from COVID lockdowns. Although the shift to online retailing isn’t new, this reporting season is the first time we’ve really been able to quantify the level of investment in the supply chain needed to capture this shift. The large capital investment required favours the largest players in the industry – Coles and Woolworths – and we expect they will be able to increase their market share over the medium to long term.
Among AFIC’s investments in smaller to mid-cap companies, a number spoke about their elevated inventory – goods loaded on ships that are just sitting on the water because of COVID-related congestion at ports, or the inflated number of goods in transit as companies try to keep up with strong demand. Motor vehicle parts supplier ARB is a good example. Elevated inventory can have some temporary effects on cash conversion, but we are confident that will be resolved with no long-term harm.
Freight and logistics provider Mainfreight is another good lens on these issues. Mainfreight has gained market share across all its markets. Mainfreight’s customers are always searching for the best price, which is typical where transport is concerned. But in the current environment, customers primarily want a reliable freight and logistics provider, which has enabled Mainfreight to demonstrate the value of its premium service offering.
Are valuations too high?
In the wake of reporting season, everyone is closely watching valuations and direction of interest rates over the long term.
Selectively, there are some companies that may struggle to deliver the earnings growth that justify current prices. Companies that have had a free kick throughout the COVID pandemic may be unable to repeat performance and may struggle to maintain these high valuations.
But companies with “self-help” drivers will be better able to continue to grow earnings, which may mean their valuations look to be more reasonable.
Generally, with the large amount of cash and stimulus in the system now, share prices appear well supported unless a change occurs in economics circumstances. This may change with rising interest rates, but this is unlikely to occur in the more immediate term.
What impact will higher costs in supply chains have?
Increased costs in the supply chain, arising from COVID lockdowns and COVID-related staff shortages, is one of the key issues facing many companies. Those increased costs can temper growth. However, our expectation is that it will be a short-term issue.
Some smaller players are going to struggle with the increased supply chain costs. But larger companies with a higher-quality business and the advantage of scale are likely to be better positioned to be able to pass on the rising costs to customers. Companies that are in a market leadership position should weather this storm better than their competitors.
As an example, consumer goods business with branded premium products are likely to be better placed to either absorb higher costs or pass them on to customers. In contrast, companies shipping low-margin, low-value products with increased freight charges, which represent a significant percentage of the sale price of their goods, will face reduced margins and earnings.
Fortunately, we don’t expect the increase in supply chain costs to disrupt the investment thesis for any of the companies in AFIC’s portfolio in the medium to long term.
Companies that have the financial capacity to invest in their business and the ability to generate higher returns even against the economic cycle are the companies that typically perform better. Challenging times like these favour quality companies. That’s what AFIC invests in.