Picking the eye out of innovation
Stock markets are good at normalising returns and humbling investment managers – especially those who exhibit even a hint of hubris. We benefitted in November in particular from our participation in two IPO’s (Pacific Smiles Group – a dental clinic roll out and IPH – Australia’s only listed patent attorneys) both of which performed well from their issue prices. Whilst the IPO market has been running red hot, we have generally been running cold preferring to take advice from Elsa in ‘Frozen’ and “let it go” ... the cold never bothered us anyway. We recently analysed our participation in IPOs over the past twelve months and found that we participated in less than 10% of new issues. We expect that to be the high point.
Although many investment commentators focus on GDP growth forecasts and imply a linkage with subsequent stock market performance we feel the best future indicator of likely performance are stock valuations. There have been numerous studies demonstrating a lack of correlation between a country’s GDP growth rate and stock market performance but nonetheless the myth appears to live on. We believe that other things are more influential on returns. Things like industry structure, a business’s return on capital and the corollary, its capital intensity and, of course, valuation relative to other investment opportunities (typically long term bonds adjusted for equity risk). Whilst it’s true that good businesses can survive poor managers, a manager’s ability to allocate capital is also an extremely important driver of long term returns.As Buffett pointed out, “I’m a better investor because I am a businessman and a better businessman because I am an investor”. An excellent book entitled “Outsiders – 8 unconventional CEO’s and their radically rational blueprint for success” by William Thorndike Jr. spent a lot of time analysing how good capital allocation by CEOs can drive radically different outcomes between companies in similar industries. Correspondingly, poor capital allocation can destroy a lot of shareholder value. This is commonplace amongst smaller companies when acquisitions are made at full multiples to justify earnings per share growth targets written into the performance contracts of managers. A number of these roll up style businesses are likely to come into some turbulent territory as organic earnings growth becomes more anaemic and balance sheets become too stretched for further “accretive” acquisition opportunities. One of our jobs is to avoid them.
Whilst we focus largely on bottom up investing, a view on economic growth is important to frame our thinking on likely earnings growth for companies. The sum total of earnings growth having to relate somehow back to the total size of the economy in which those earnings are derived. Many macro indicators including commodity prices – the historical bellwether of inflation – have trended down all year. Oil has recently followed. Oil is the most important commodity due to its size and non-discretionary nature in many instances. We can debate whether the selloff in oil is fundamental or politically motivated but either way its importance to the global economy cannot be overstated. The world consumes around 90 million barrels of oil per day. At US$110 a barrel, this equates to US$3.6tr per annum of expenditure or 5% of global GDP. Simply put, a 30% decline in the oil price saves the world economy 1.5% of GDP in annual energy costs. So who benefits? Over 60% of oil consumed is for transportation purposes so consumers are winners, trucking and transport companies and agricultural users are also winners. Whether the effect is globally stimulatory or not probably depends where you live and whether your country is an exporter or importer. Oil’s fall does however help keep inflation low which probably means interest rates continue to stay low’ish for some time. This in turn implies growth rates are likely to be
If we are right about the macro environment earnings then growth is going to be tougher to come by. We have found when things are more difficult companies usually behave in one of two ways. The usual way is to falter, blame the tough environment and then restructure. The alternative, and one we’ve seen with many better companies over time, is to innovate and win new business through market share gains or by growing a category. Let me give you some examples to illustrate. When an industry or category has no innovation, consumers do what comes naturally – they start using price as a means to differentiate offerings. This leads companies to focus more and more on lowering costs and squeezing efficiencies out of their operations in order to be able to lure more customers with better prices. This works for a period of time until an industry commoditises and returns shrink. Businesses in this situation are offering low value at low cost. Innovation is hard. No one has done it quite that way before which is why it is interesting to customers. Innovation gets easier when it becomes habit and involves two models; high value high cost or high value low cost. Either way, the consumer feels like they are getting a good bargain.
We’ve all experienced innovation that provides high value with high cost. Some good examples of high value high cost innovation are Apple iPhones and Dyson vacuum cleaners. Dyson innovated the humble old vacuum cleaner and drew new consumers into a stale category persuading them to part with close to $1000 for a cool looking vacuum cleaner. Of course, they weren’t just cool looking they were more efficient too. Dyson taught consumers that there could be something interesting in dual cyclone vacuums that didn’t require a bag. They also invented the air blade hand dryer – brilliant – they actually dry your hands. Competing hand dryerstend to blow lukewarm air at slow speeds with deafening sound to no effect! A case of good innovation closer to home is Godfreys the vacuum retail specialist who are in the process of listing.
Godfreys have licensed the Hoover brand in Australia. They quickly emulated Dyson with some innovations at Hoover, stimulated growth through their own stores and also innovated their business model by vertically integrating the supply chain. By this I mean they have created and licensed a number of brands and do their own design and global sourcing. Eighty percent of Godfreys’sales are now derived through their owned or licensed brands giving them greater margins to work with and greater control over their product line-up. This successful business innovation has enabled Godfreys to take market share from competitors. Other businesses we own which have similarly innovated giving them substantial competitive advantage are Beacon Lighting and Reece.
Beacon Lighting is a relatively recent addition to the smaller companies fund. Their ability to source directly from factories has given them a margin advantage and, like Godfreys, an ability to reinvest in brand building. Beacon devotes a substantial amount of money toward marketing and outspends all the other independent lighting retailers put together - now that is a tough proposition to compete against.
The other end of the innovation spectrum is the low cost high value offer. Some businesses offer enormous amount of value to the customer for relatively little cost. The advent of the digital age has given rise to this. The ubiquity of broadband, both fixed line and mobile, as well as the creation of digital rights and data compression techniques has enabled some very successful business innovators. Consider Netflix. They offer a vast amount of all you can eat video content for $8.00 a month (only if you are a US based consumer). Spotify offers access to virtually all of the world’s music for $11.99 a month and Google offers – free search, free maps and free Gmail for the ancillary benefit of being able to charge advertisers who want access to internet searchers. Each of these models has given a huge amount of content or value to their customer base for a relatively small amount of money. In Australia, 3P Learning is a good example of this. 3P Learning owns the Mathletics and Reading Eggs apps. These are virtually ubiquitous apps for primary school children.
They offer a vast learning opportunity for children with feedback to teachers for a comparatively low price. Each year the
apps improve as do the learning diagnostics available to teachers (and hopefully to parents eventually).
The last business category of course is the high cost low value one. Any business ending up in this quadrant will be a headline in the business obituaries section.
With the market now in negative territory for the year, a slowing domestic and international economy and relatively full valuations we continue to have a cautious outlook. In smaller company investing you can’t rely on the stock market to be ‘open’ for capital raisings if you get into trouble. Consequently, we are more focussed than ever on cashflow generation, sound businesses and valuations. We also prefer managers who continue to use the power of innovation and capital management to be able to inch out advantages over their competition.
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