Quality shines through

Articles 3/03/2022

Following an extraordinarily volatile January, February's corporate result season couldn't come soon enough for markets: dragging the eyes of investors back to fundamentals. Events in Ukraine didn't arise until very late in the month which meant the market was afforded the opportunity to digest the flurry of information and activity. However, the market's reaction to the results were somewhat muted given the broader macro and geopolitical uncertainties.

Two issues dominated our focus heading into the month: cost inflation and COVID-related disruptions.  Underlying inflation is at multi-decade highs in the US (well above the Federal Reserve's target) and is accelerating (albeit more modestly) in Australia. How would businesses respond? The latter half of 2021 included both the delta and omicron COVID-19 waves on the east coast, resulting in vast portions of workforce sitting in isolation. How was this impacting supply chains?  

By month's end, it was evident the majority of companies in our portfolios were demonstrating impressive earnings resilience in the face of these issues. This outcome was not unexpected reflecting the stringent focus on business quality that is ingrained in our investment process. In tough and disruptive times, high quality businesses shine through, as was the case yet again this February.

Below we discuss these themes along with a broader economic dynamic starting to play out:

  1. Cost inflation continues to run rampant but it can be managed.

    As was evident in the last result season six months ago, elevated input cost pressures continued to run rampant across a variety of industries. Unsurprisingly, raw material producers like BHP and Woodside delivered significant earnings (and dividend) growth on the back of elevated global prices for their commodities. However, the market was anxious to what degree this was impacting the bottom lines of companies further down the value chain. As we highlighted last August, those with true pricing power excelled.

    Consumer product packager Amcor saw a material lift in the price of resin and other key inputs.  Thankfully, it's contracted pass-through mechanisms drove an 11% lift in its own prices to customers, fully offsetting these pressures. Timber pallet owner and manager, Brambles, experienced an extraordinary spike in the cost of lumber. Where a typical market cycle will see the price of lumber lift anywhere between 30% to 50% (refer below), prices had recently lifted by over 200% (including incidents of spot market prices jumping up to 500%)! Yet underlying earnings and the dividend grew by 9% and 7% respectively. How? A focus in previous years to restructure customer contracts to include input and freight cost clauses saw the company successfully pass-through these pressures.

    Source: Brambles 1H22 result presentation

    To reiterate, these businesses were able to successfully pass on these cost pressures due to the essential nature of the product or service they deliver to their customers. Looking forward, this provides us with confidence in their ability to continue generating earnings growth, even in the midst of accelerating inflation in the broader economy.

  2. COVID drove significant supply chain disruptions and labour availability constraints but that didn't necessarily result in lost earnings.

    Much of the east coast was crippled as the delta and omicron COVID waves swept through last year. Many worried about the impact employee absenteeism (due to isolation requirements) would have on the broader supply chain and as a result, profitability. Thankfully, the foresight of a number of our companies' management teams put themselves in a strong position to navigate this environment while others leveraged their competitive advantages.

    Four wheel drive accessory manufacturer, ARB and specialised automotive cooling solution producer, PWR were classic examples. Both consume significant quantities of steel and aluminium, typically sourced from offshore. Given the global shipping delays that were already being experienced in other countries, both acted proactively and swiftly to source larger-than-usual quantities of raw materials to stay 'ahead of the curve' with PWR's Managing Director stating so eloquently "we would rather look at it than have to look for it". This meant both businesses didn't skip a beat, continuing to manufacture at full capacity to meet their ever-expanding order books.

    National logistics provider Qube, commented its fully-integrated logistics service ('port-to-warehouse') offering was finally viewed as a key competitive advantage by its customers. Why try to coordinate multiple parties in your supply chain when just one can provide it all for you?

    Private hospital operator Ramsay not only had to navigate the dramatically reduced availability of nurses due to isolation requirements, but also had to contend with government-mandated restrictions on elective surgeries both here and abroad. While the business isn't quite out of the woods, we remain confident in its medium to longer-term outlook as the waiting list for surgeries has reached record levels and continues to grow every day!

    Even Australia's largest funeral provider Invocare, demonstrated exceptional operating leverage in a period where many of their funeral directors were forced into isolation while social restrictions meant funerals were commonly restricted in their size. As these restrictions start to ease, larger funeral gatherings are taking place and the company is once again able to offer its full suite of services, driving both average price and earnings growth.

  3. Following two years of restricted travel, the 'goods-to-services' switch in consumer spending is underway.

    After being major beneficiaries during the lockdowns of the last two years, we were interested to see to what degree retailers are being impacted by a mean reversion in consumer spending patterns back towards services such as travel and eating out. As seen below in the latest Australian GDP data, services spending remains below the pre-COVID trend, while goods consumption remains at risk of further mean reversion. At the corporate level, the evidence of this shift has been mixed to date.

    Source: Macquarie Research

    Bunnings, Kmart and Target owner, Wesfarmers has indeed started to see the transition play out.  Bunnings' underlying sales grew less than 2%, a material deceleration from the near 28% growth experienced this time last year. Crucially, sales remain 26% above their pre-COVID level as we continue spending more on improving our homes. Meanwhile core sales at both Kmart and Target fell by 10% and were now 5% below their pre-COVID level.  However it's worth highlighting that almost 25% of the business' store trading days in the December half were lost to government-mandated store closures. A return to full operating hours should see sales recover this year.

    Meanwhile, retailer and supplier of automotive parts to mechanics, Bapcor, continues to demonstrate its resilience. While revenues only grew 2% and earnings fell 6% in the period, compared to pre-COVID levels, sales and earnings are 28% and 29% higher. The company prides itself on its speed of delivery, a key competitive advantage given the last thing mechanics want is to have to wait for parts to arrive. It also goes to show that (unfortunately) you can't defer that car service forever!

There remains a number of uncertainties in the global macro landscape. Our unwavering focus on owning only the highest quality companies has helped shield our portfolios from some of the broader market volatility. Following the generally solid set of results and increasingly attractive valuations, we'd ordinarily be tempted to invest further in our preferred companies. However, we still believe there are bigger issues to play out, namely rising interest rates in an attempt to combat accelerating inflation along with the geopolitical uncertainties associated with the Ukrainian/Russian conflict. We believe it prudent to continue closely monitoring events, waiting for clarity before acting.

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