Stock Take: The Art of Value Investing

Stock Take is a podcast by the Intelligent Investor analyst team with a focus on value investing and ASX- and globally-listed securities. Whether you’re a seasoned investor or new to the game, our analysts will keep you entertained as they navigate the ups and downs of the Aussie share market and beyond with their unique insights and musings.

Stock Take is brought to you by Intelligent Investor, Australia’s leading value investing research house, get your free trial by heading to intelligentinvestor.com.au. The information in this podcast is current on the day of recording. It is general advice only, does not take your personal situation into account and may not be suitable for you.

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Good morning everybody, my name’s John Addis, I am the Founder and Editor of Intelligent Investor and I have the lads with me here this morning to talk about quite a big subject, actually. It’s Nick and Graham who have kindly decided to devote their time to talk about how hard it is to invest right now as a value investor. Graham, just before we started this podcast, you came up with a nice way of introducing the subject to our members and non-members, would you like to give it a go and explain how for the last 20 years we’ve been urging members to buy high quality companies and now it’s really difficult?

GW: Well, you pretty much just introduced it there so I’m not sure how much I can add, but you said it exactly right. We’ve been pitching the idea since the company’s founding that our investors should be in higher quality businesses. You want to buy businesses that have lots of cash flow, that have clean balance sheets, that have good margins or competitive advantages and the companies that tend to get everyone in trouble are when you’re buying those businesses without those qualities, they’re either over-leveraged or they don’t have any way of beating their competitors to maintain a decent level of profitability and that seems to make sense kind of fundamentally with price being the magic number that can actually make an investment in those companies work. But at its core, we think you should buy higher quality businesses.

Nick, what’s the problem with doing that now?

NC: I think the problem is just everyone is doing that and there’s been this huge herding mentality over probably the last decade or two into these higher quality businesses. Everyone’s aware now that it doesn’t make as much sense to buy the old Ben Graham cigar butts and has followed Buffett into buying wonderful businesses for a fair price, but a problem now is a lot of the prices aren’t fair, they’re expensive. There’s a certain mean revision argument to possibly looking at some lower quality names at the moment. Value investing outperformed in the 70s and the 80s and then growth investing outperformed in the dot-com phase of the 90s.

Then value investing came back between 2000 and the GFC, but now growth and quality investing has outperformed value four-fold over the last sort of 20 years and that’s the largest on record. So, I guess from an opportunity set, it makes sense to look where people aren’t looking and it seems to me, everyone is looking for the same thing, they want all those things that Graham mentioned, higher returns on equity, excellent management, great operating margins, all the rest of it. I think there’s possibly some opportunities now…

Before we get into the areas where we are finding some value, can we just go through the areas where we’re not finding value? I can’t remember a time in 25 years of doing this where I’ve seen every broker have a sell on Commonwealth Bank. That seems astonishing to me, they’re so reluctant to put sales on anything, let alone Australia’s best bank, so that’s clearly one which everybody knows about now, people are saying this is really, really expensive. Also, with the tech stocks as well, like Pro Medicus, unbelievable company, really good, I think we missed that but astonishing valuation could grow into it, we’ve made the case that it might. But still, it’s a very, very hard stock to buy right now. You would say the same of most of the high growth tech businesses like WiseTech and Xero as well.

Are there any other areas of the market where you feel it is quite expensive and also, maybe a comment on the fact that Commonwealth Bank, as it’s such a big stock and it accounts for about 10 per cent of the index, I believe, that because of these high performing companies, the index looks really expensive, but that expensiveness is due to just a handful of really expensive companies?

GW: That’s probably where the opportunity is, there does seem to be kind of bubbles going in the market for particular areas like you said, tech and Commonwealth Bank in particular. But that’s kind of the distraction from a lot of the smaller companies that are just kind of riding under the radar and they’re still doing okay, maybe not the high quality businesses, but they’re still reasonable businesses with reasonable outlooks and just because they can’t achieve a 90 per cent profit margin growing at whatever it is, 50 per cent a year, it doesn’t mean they’re bad businesses or bad investments. And so, that distraction, it could be the opportunity for investors today.

Nick, you got any thoughts on that?

NC: I just found it funny that it only took us three minutes to mention how expensive Commonwealth Bank is. [Laughs]

[Laughs]

GW: There’s something funny about this though because, like you mentioned, Commonwealth Bank, Pro Medicus – and these were the exact two names that came to my mind as we were talking as well of the kind of obvious overvaluation. But maybe there’s something there that not actually is overvalued. Pro Medicus, in particular, I think there is a – I mean, the people buying these stocks today, I don’t think they’re totally crazy, they are good businesses that can do really well over long periods, it’s just a matter of how much you’re willing to pay for that and I think that’s the trickiest part of this kind of bubble territory, is that the people buying the bubble stocks, they can always make really good arguments for the long-term, it’s all just down to the valuation and what you’re willing to pay for it or what you expect interest rates to do and some niche ideas.

What about in the US where you’ve got a similar kind of thing going on with the magnificent seven, or most of the magnificent seven, where they’re all investing heavily in AI with the exception of Apple and the valuations are – you might call it a stretch, but you’d also say these are probably some of the best businesses in the world. Is that a similar kind of thing going on there, Nick?

NC: Yes and no. I actually don’t find most of the magnificent seven actually that expensive. I think you can probably justify the valuations of, say, an Amazon and Microsoft and Meta and a Google, Tesla and Nvidia may be a bit more difficult and Apple’s a bit harder as well. But I wouldn’t say that actually the biggest stocks are all that expensive. The bit I struggle with is these quality sort of slower growth, but excellent businesses like Costco and Walmart that have always traded at a premium to the market, but now it’s just got ridiculous. If you look at Costco, it has a growth model where it opens 2-3 per cent more stores each year and typically grows its same store sales at about 5 per cent, so you very rarely get revenue growth over 10 per cent a year, but the durability of the growth is quite good. Previously you were paying 25 to 35 times earnings for that, you’re now paying well over 50 times earnings and the growth is – well, it’s actually now a more mature business and the same goes for Walmart as well. There’s many other examples where this applies and that’s the bit of the market I sort of don’t really get, is why are we paying such big multiples for these businesses that are more mature and further into their sort of growth journeys? The same goes for Commonwealth Bank, no one would argue that it’s not the best run bank in Australia. It certainly has been over the last two decades, but why are we suddenly paying 30 times earning for it? It makes very little sense.

GW: I wonder how much of it is to do with a fair based approach instead of greed, where people know that these businesses aren’t going to shoot the lights out, but there’s just so much disruption these days with AI and with all kinds of other factors that people don’t know where else to invest, they’re just looking for something that’s kind of steady and that they can predict a little bit better over the next 10 years.

I think that’s a large part of it, Graham.

NC: Yeah. The simplicity argument for this quality investing makes a lot of sense, right? If you can buy Costco when it’s got a predictable growth model and they run the business really well, management is excellent, why wouldn’t you do that? Why would you look at an insurer that’s complex and has to make all these changes for you to get a return? But I guess the problem is that everyone’s doing that and it’s pushed these multiples to just very expensive levels.

The same could be said of Wesfarmers which is kind of similar to Costco in some respects, you know, you’re paying a premium for a steady, high quality company. Let’s now turn to the pockets of the market where we are finding value and this is, I think, one of the things that’s important for investors to remember. You might look at the index and go, that’s at all time highs, because some parts of the market are overvalued and that always means that there are other parts of the market that are undervalued. The opportunities often are just as broad, or maybe not just as broad, but they’re pretty common when stock markets are generally perceived to be expensive, as they are when they are relatively cheap.

Now, this isn’t a period like COVID where I think we upgraded 35 stocks in the space of three months, we’re probably not going to see that again in our lifetime, unfortunately, but it’s not to say that we can’t find businesses that are doing well at the moment. So, what kind of areas are you guys looking at and where are you finding opportunities?

GW: I’ve certainly noticed the turnaround stories, maybe it’s just a trend that I’ve noticed recently in my own stocks, but turnaround stories seem to be something that people are not willing to try out anymore. There’s no great belief in the stock just turning around, it’s always got to be fully fledged, everything’s running perfectly, wonderful outlook. So I do get the impression that the companies that have been through a bit of a rough patch, maybe they’ve turned the corner and management have got their act together and been fired and they’re now working towards something fairly concrete, I’ve noticed that those ones seem to be trading at much more reasonable valuations compared to where they could be a few years from now, if that turnaround continues.

What about you Nick?

NC: Yeah, I piggyback that a little bit and just say that any business that’s suffered a setback, it doesn’t necessarily have to be a turnaround, but maybe growth has come in lower than expected or there’s a division that’s loss making and hasn’t been accounted for in the valuation, things like that are pretty interesting. There just seems to be far less eyes on them, as we’ve already noted, everyone’s chasing these quality stocks. Businesses where a few little improvements can make a massive difference, that’s one area. UK stocks, I know I say it every podcast pretty much, but they continue to look pretty cheap compared to US and Australian businesses, particularly the same equivalent business can be sometimes half the price. That’s some pockets, but look, as much as we’ve banged on about quality investing and how expensive things are, there isn’t many other pockets that I’m finding. I think broadly the market looks pretty expensive and it is hard to find value at the moment.

Where have we had some success then over the past six months or so, maybe past year or so? Is it just in places where other people aren’t looking? You know like say with Eagers which is a second-hand care dealer but also a new car dealer, it’s a very interesting business and I think that’s up 70 per cent since we – and it’s become kind of fashionable, incredibly, over the past few months, six months or so. But that’s just an area where there’s just no kind of narrative in that business that in anyway plays into the technology side of things and the excitement that we see in tech stocks and stuff like that. That’s kind of a neglected part of the area, it’s just really, really unsexy. I think we got a few other examples as well.

Graham, we’re about to upgrade a stock in the health sector – we won’t say what the name is, you’ve got to be a member for that – but if you could just tell us what that story is like and why you think it’s attractive right now when not many people are looking at it.

GW: This is will be tricky to say without giving too much away. It’s a healthcare stock, it earns some money but will be earning more money in the future. This is tricky. It’s a dominant healthcare stock, it is a turnaround stock but it’s got a very established base already and the main thing we’ll be looking at margins. It’s under-earning its competitors by a substantial margin at the moment and through a few different mechanisms and particular cost cuts that management’s outlined, there’s a pretty good case for how they can turn those margins around and if that does play out that way, then today’s share price is definitely undervaluing the company a few years from now, it should be double where it is today. There’s been disappointments in the past, but I think they could probably pull it off this time, it’s a different company to what it was five years ago, it’s already had some substantial changes. So, everyone out there can try and guess which company that is and watch the website for a few days and you’ll see what we’re talking about.

Okay. Nick, we have got one company that we can reveal the name of to listeners, this is Fairfax Financial, another company that is kind of unloved or was unloved, tell us about Fairfax Financial?

NC: Yeah, well it’s one we haven’t really spoken about a lot but kudos to Graham here who recommended it about two years ago and the stock’s up almost three times since then. It’s very much one of these opportunities we were speaking about previously, it was an unloved Canadian insurer, it previously had this amazing track record and it’s run by Founder Prem Watsa, who’s considered the Warren Buffett of Canada. But it had gone through a few tough years and that meant we could buy this business below book value and for a PE under eight, despite them actually looking in higher earnings for a number of years because they bought those fixed income bond-like instruments for pretty much guaranteed earnings for a few years.

That was one opportunity that, again, no one was really looking at this, it was a bit complex in a sort of unloved sector. Financials haven’t been the greatest performers and they’re certainly not as sexy as the tech sector, but one that’s worked out and sort of an example of, if you do look outside the box a little bit, these are sort of the opportunities you can find.

Yeah, that’s right. I think this is an important lesson for investors, like you really have to think about where the crowd is going and then look elsewhere. That old saying about if you want to beat the market, you’ve got to do something different from the market and sometimes that means that you underperform, but when you’re underperforming because you haven’t bought those big stocks that have got all the momentum, is it a sign that you should be looking in areas that other people aren’t? And we’ve done that reasonably successfully over the past few years. Let’s move on now to section two, where we’re going to talk about Virgin and the private equity heist. We’ll be back in a moment.

[Recording] 

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[End recording]

And welcome back. Nick, this is your show from now on, I’m always fascinated from now on. I’m always fascinated by airlines. I’m not amazed that a private equity company bought Virgin out of Bankruptcy, but as listeners might know, I did a big sort of 5,000 word expose on the private equity industry which has grown at an incredible rate over the past few years and also without much evidence it can really do much better than the market overall. But Virgin has been an absolute star performer for Bain Capital that bought it. Let’s see, take us through how Bain managed to turn this around and how much money did they make out of this?

NC: So far, if you include their remaining stake, it’s about $4 billion dollars.

Just $4 billion for a crappy airline?

NC: Yeah, actually I think that figure’s $3 billion, they’ve made five times their money, roughly.

GW: All in a day’s work.

Yeah.

NC: Just a massive home run. If we rewind, Bain bought this business for $3.5 billion dollars out of voluntary administration during COVID, but that $3.5 billion dollar figure includes all the liabilities that Bain assumed, so the actual equity cheque that Bain wrote was only $730 million dollars and that went to the unsecured creditors. If you remember, Virgin had bonds on the ASX, I think about $1.9 billion worth and those bond holders got around 10 cents in the dollar so they were pretty much completely wiped out with the equity holders during the restructure. Bain essentially put in place what I’ve termed a four-step sort of PE playbook and those steps are – step one is to cut the cash outflows or stem the losses; step two, is to delay major investments; and then step three, is to pay yourself; and step four, is to get out and sell it to someone else.

Right, let’s go through each one of those stages, because they’re quite interesting.

NC: Yeah, step one, it shouldn’t be underestimated here how much the pandemic actually helped Bain, because a lot of the cuts they were able to make would usually get backlash in the papers and on the news and all the rest of it, but they didn’t suffer that because the sector was in existential crisis. And so, Bain, what they did, they came in, they let go 3,000 people, so Virgin’s workforce went from 9,000 to 6,000. They exited 500 onerous contracts and that saved about $300 million dollars. They then restructured the operations, so they shutdown Tiger Air, that was burning $45 million dollars before the pandemic and Virgin should have done that years ago.

It’s incredible that they didn’t do that beforehand. Same with the fleet, for a small airline to have so many fleet types is just crazy.

NC: Yeah and that’s the other big change. Before COVID, they were flying six different types of aircraft and now they’re flying three types, but really it’s a one-way bet on the Boeing 737. Bain also favoured leasing for – I’ll explain that in step two – rather than ownership as well, so they were the main changes. They also exited long-haul flying so the furthest they’ll take you now is Bali, they won’t get you to Japan or Hong Kong, some of the previous destinations – and this all really stemmed the cash outflows from the business because when they assumed control, Virgin was burning about $200 million dollars a month which was unsustainable. The other big helping hand they got in step one came from the Government and that’s just all the money that was given out through JobKeeper, there was domestic aviation schemes and all the rest of it where essentially Virgin and Qantas were paid to fly ghost flights on key routes so they were ready when borders reopened.

So that was step one and that saved Virgin. If we move onto step two, this is where it gets interesting and something you see pretty often in private equity and this is delaying large investments…

Let’s just make it clear that when they say delay large investments, that means you delay it until after the float, right?

NC: Yes…

GW: The shareholders need to make the investments.

NC: Yeah, exactly right. The two items you want to look at here in financial statements are capital expenditures and maintenance provisions. Capital expenditures were running at about $500 million dollars a year before the pandemic. During Bain’s ownership period from about FY21 to FY24, they only spent $600 million dollars in capital expenditure, so massive cutbacks. Some of this could be attributed to the pandemic and less flying, but if you look at Qantas and an American Airline like Delta, their capital expenditure was low in FY21 and FY22 as expected, but then it was some of their largest years ever in FY23 and FY24. At Virgin, that didn’t happen.

One of the big reasons is maintenance was pushed out. Usually, you have to do major maintenance on engines and the aircraft before you return a plane to the leasor or renew a lease, this usually happens in the final two to three years but it can happen anywhere in there, it’s a wide window. And so, maintenance provisions went from $300 million before the pandemic to $700 million and that’s what Virgin shareholders now are going to have to stomach because capex is forecast to go to $900 million dollars next year which is just a massive jump pre-pandemic on a larger fleet too. So, Bain did a lot there and that meant they had more cash to distribute to themselves and repay themselves essentially. That gets us to step three, find ways to pay yourself…

[Laughs] So many ways…

GW: This is their favourite part.

NC: Yeah, this is the juicy bit. In step three, they essentially wrote a $730 million dollar equity cheque to begin with and then when travel came back in FY23, there was people paid essentially before they go and then they used that money and some bridging loans to repay that initial $730 million dollars so that made them sort of whole or breakeven on their investment. Then they got a bit of luck. You probably remember the Government blocking Qatar Airways, the slots in Melbourne and Sydney?

That’s right, the Government for Qantas blocking Qatar.

NC: Yeah, exactly. Anyway, this worked in Bain and Virgin’s favour. The workaround was Qatar actually bought a 25 per cent stake in Virgin off Bain for $750 million dollars, which is actually a valuation that was higher than the float valuation, so Qatar willing to pay overs to get this arrangement. What that arrangement is, is essentially that Virgin is going to wet lease planes off Qatar – and wet lease, this means that Qatar will provide their aircraft, the pilots and the crew, so pretty much everything…

It’s a Qatar flight.

NC: It’s a Qatar flight but Virgin is sort of the operator of them and they’ll fly now 28 flights a week to Qatar and then presumably onto Europe. That was a little workaround that worked in Bain’s favour massively. They also used the cash flow that was saved from lower capital expenditures to pay themselves some quite chunky dividends. Then I guess brings us to step four which is the IPO…

Let’s get rid of it, baby!

NC: Yeah, let’s get out! About two months ago, they sold 30 per cent of the business. They still hold 40 per cent of the business, so they still got about a billion dollar stake in Virgin. The IPO was made a little bit easier and Bain deserves a chunk of credit here, they actually have improved Virgin a lot. Capex aside, operating margins are now rivalling Qantas, they were loss making pre-pandemic. They’ve also managed to take market share, probably just because they’re focused on domestic routes, I think that’s about 90 per cent of their business. So I think market share is now about 33 per cent up from 31 per cent. This is a much better airline than it was and on much shorter financial footing.

Net debt has fallen from about five times before the pandemic to I think about one-and-a-half times now, so it’s a much better business and that really helped them sell this float and they sold it at 25 per cent discount to Qantas. Qantas’s share price was up 80 per cent in the 12 months before the float, so a lot of things worked in their favour and they were actually able to get out and I guess that’s the round up of the four steps that private equity typically rolls out in some of these investments.

Yeah. Can I just make a couple of points about this? Because I’m not a big fan of private equity, but I don’t have any issue with this. I mean, the Government stuff annoyed me during COVID. Lend these businesses money, don’t just give them a loan of money. But overall, I don’t really have a problem with this, I think it’s a fine thing to do, they seem to have done a good job of it, I fly with Virgin regularly and I was just struck by how poor the management was before Bain came in. There was Jayne Hrdlicka, the prior CEO who was involved in it – was she involved in the turnaround? I think she was, wasn’t she?

NC: She was, yeah.

She was the one who was there doing all the stuff, but before her it was John Borghetti who was a former senior executive with Qantas, he just did an awful job of running that airline and really set this up for private equity to come in and make a motza from it, because there were just some fundamental errors. There was a kind of empire building there at that airline that was just completely unnecessary and they’ve just done some really smart things, I think, especially that deal with Qatar, which is kind of what Qantas did with Emirates about 10 to 12 years ago, just gives you access to a global marketplace through Qatar, or mainly European, but also North American, without having to buy your own 777s or whatever, it seems very sensible.

NC: Yeah and I think if you just look at it from a consumer point of view or a frequent flyer point of view, how bad would the situation be if we were just – I mean, I guess subject to Qantas – without Virgin? If Virgin went the way of Ansett, essentially Qantas would have a monopoly. I mean, Rex has since collapsed, Bonza didn’t get off the ground really. It would be horrible if we just had a Qantas monopoly more than we already do. I think Bain did a really good job here and obviously they got their just rewards which was…

GW: Or in-just rewards…

NC: Yeah, exactly.

Yeah. So this is a great expose of how PE operates, a good local example. What do you think about Virgin’s stock as a private investor, Nick?

NC: Look, I’m not interested… We’ve said before, we don’t really love the airline business and there’s lots of reasons why. I mean, you don’t control one of your biggest costs which is fuel; there’s typically, except in Australia, lots of competition and it’s just a tough business. To make it work, you’ve got to fill up the last 10 seats on a plan and that’s usually your profit margin. It’s really, really fine lines, you can’t make many errors. Airlines typically aren’t the best investments and that’s sort of been proven throughout time. Buffett said, I think, if an investor was a Kittyhawk, he would have shot them down.

Shoot them down, yeah.

NC: Yeah. No interest in Virgin, the price compared to Qantas, it is at a discount but probably deserves to be.

I think one of the interesting things about this is that you can look at it from another angle and say, okay, Bain are good at this, what other good operators are there out there? And you mentioned KKR, that’s one of the better ways to own the managers and we actually did buy KKR, do you want to tell us about that, Nick?

NC: Yeah, my initial interest in private equity was a couple of years ago these companies were being valued like fund managers and there’s a number of differences that make private equity businesses actually far better businesses than fund managers, despite them both being investors. Those are essentially, private equity, you lock up the capital, so because these investments like Virgin might take five years, might take 10 years, people can’t pull out money as readily as they can or as easily as they can with a fund manager. That makes the outflow risk is a lot lower, almost nil in some cases. KKR for example, 50 per cent of their capital or close to 50 per cent is perpetual capital, forever, which this makes it a far better business than a regular fund manager.

The other one was they use debt as well, so when they’re buying a business, there’s equity and debt component and typically they only charge fees on the invested capital which is sort of the equity component. That just means as these investments get re-valued, really, these become recurring revenue streams because rarely does the investment fall so much that you start cutting into the equity, so they’re able to charge fees and those fees tend to grow over time. Performance fees tend to be a little bit stickier than fund managers as well, but they can be volatile. But they’re typically far better businesses and KKR we bought at a multiple of about 10 times earnings, so roughly the same as Magellan, but now trades at close to 20 times earnings and that’s probably a much fairer multiple. So we’ve got a hold on that stock at the moment just for valuation reasons, but we’d love to upgrade it if it were to fall and the market pulled back, we almost got the chance in April.

Yeah, I think when we bought in at was about $52 dollars and it’s now $145, so that was a nice pick and it tells investors that sometimes you can look at a consumer business like Virgin and you see somebody like Bain do a good job and that might be a sign to go and look at that industry in more detail and maybe find some opportunities, which you did, Nick, so congratulations on that. Graham, you must be happy not having to fly Virgin or Qantas most of the time, you can confine yourself to Air Canada and Spirit over in Vancouver.

GW: Yeah, well I’ve got to say, Air Canada has something to learn from Qantas, I suppose. It’s not a top tier airline, but it’s got a nice maple leaf and a good design.

It does, the design is beautiful, I love Air Canada planes.

GW: Yeah, they have pretty planes, if nothing else.

That’s right. Okay, well I think we’ll call it quits there. That was an interesting conversation, thank you both for attending, we’ve got reporting season coming up, I know you two are going to be very, very busy, we’re all going to be extremely busy during reporting season. If you are thinking about subscribing, now is a good time to do so because results are coming thick and fast and we’re hoping to get a few upgrades and a few buy recommendations to add to our existing buy list. If you do feel like joining, visit www.intelligentinvestor.com.au to sign up. Thanks very much and we’ll see you in a couple of weeks.

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