Look for businesses that can compete successfully in disrupted markets.
COVID-19 has brought with it a new set of challenges we think will exacerbate the pre-existing headwinds of an ageing population, high levels of debt, rising wealth inequality, natural resource constraints and technological disruption, including automation and artificial intelligence.
We believe this sort of environment is set to continue for the next decade and have positioned our global and domestic portfolios accordingly to capture superior earnings per share (EPS) growth from the structural leaders.
These are modern businesses with strong value propositions, competitive advantages, large and growing addressable markets, low debt, and high levels of R&D.
Elite companies with these attributes will be able to take market share away from their competitors and be able to grow revenues in the absence of overall economic growth.
Winners few and far between
We believe future returns will be concentrated in a small number of winners and our investment process is focused on identifying these sorts of businesses and the key themes that will deliver alpha (a return greater than the market return).
Among these are the:
- Shift from traditional to online/digital media.
- Transition to Software-as-a-Service (SaaS) and the cloud.
- Move from cash to electronic payments, which has accelerated during COVID-19.
- Transition to sustainable energy and transport.
Within the Australian market, we particularly like healthcare and technology stocks, and the Hyperion Australian Growth Companies Fund has a significant international tilt with many of the businesses, including CSL, ResMed and Xero, having diversified and global revenue streams with large addressable markets.
Taking this approach, the fund has been the best-performing Australian fund in the last quarter and has been able to deliver 9 per cent per annum over three years.
Conversely, we look to avoid average-quality, old-world businesses in industries we believe are in structural decline or are vulnerable to technological disruption.
- Traditional retail businesses.
- Highly discretionary products and services.
- Commodity-based businesses.
- Banks and other highly leveraged lending businesses.
- Capital-intensive and debt-heavy businesses.
As a result, we currently have no exposure to oil or gas and our exposure to the banking sector remains low within the overall portfolio.
The long view
Our investment thesis is long term in nature and focused on fundamental quality and growth at a reasonable price. We take a research-driven approach and think of ourselves as business owners, not share traders.
Our view is that it is difficult to predict short-term movements consistently because share prices are highly unpredictable in the short term.
We do not buy stocks with a particular exit strategy in mind because we want to own them over the long term and benefit from sustainable growth in positive free cash flows.
Over time, the businesses in our portfolios tend to compound their sales at double-digit rates and this strong underlying structural growth also results in double-digit EPS growth. This in turn tends to see share price appreciation.
While some value companies may look cheap compared to growth companies, we think investors need to take a long-term view on the intrinsic value of a company to really determine if it is expensive or not. This is because in an increasingly winner-takes-all environment, beaten-down companies will probably continue to be beaten down in the absence of a growing economy.
Growth not value
History shows that the value anomaly performs poorly in difficult low-growth and low-inflation environments and this is exactly the environment we now find ourselves in and will be dealing with for the foreseeable future.
Average returns on equity have materially declined over the past two decades, but more than that, financial reward is becoming less and less equally shared. Marginal businesses will struggle, and many will not survive.
Although many of these businesses may look “cheap”, investors who get caught in those being disrupted and are sensitive to economic growth can easily lose a lot of capital.
Old-world profit drivers simply do not work anymore – and the companies we believe are set to dominate are those with key structural tailwinds we have mentioned.
Investors should look for businesses that can compete in a disrupted world – where technology has changed the way we work, interact with each other, and pay for goods and services.
For successful and profitable businesses to remain so during weaker periods, the need for structural tailwinds like a strong value proposition, a large and growing addressable market, and a talented and committed management team with a long-term outlook and “skin in the game”, are all required.
Our proprietary investment processes are designed to weed out average and low-quality businesses, allowing the investment team to focus their research efforts on high-quality businesses that are positioned to grow earnings, even in harsh economic climates.
For example, Hyperion’s portfolios have been stress-tested and significantly outperformed through difficult economic conditions such as the GFC and European debt crisis.
In conclusion, good things happen to good businesses and although economic conditions will remain difficult overall, we believe a growth-based investment style will give investors the tailwinds needed to deliver alpha into their portfolios.
Written by Mark Arnold, Managing Director and Chief Investment Officer, Hyperion Asset Management