Rising competitive pressure from superabundant capital and new tech-enabled business models makes franchise durability more vital than ever. Few firms are creating value at a rapid pace, making some value creators intrinsically more valuable. Thus, my investment strategy is to own 20 high quality firms with rapid intrinsic value growth priced at low valuations considering their rate of value creation. I reduce market risk through partial hedges of market ETFs that offer lower rates of value creation but at similar valuations.
In a more competitive world value creators are scarce and worth more
Michael Porter wrote his seminal articles about the five forces that shape competition more than 30 years ago. Considering these five forces – (1) threat of new entrants; (2) threat of substitutes (3) bargaining power of customers; (4) bargaining power of suppliers; and (5) industry rivalry – helps us understand the intensity of competition within a given industry. It’s critical to remember that these five forces not only vary between industries, but also evolve over time, leading to increases and decreases in competitive intensity through business cycles.
Unfortunately for many firms, superabundant capital and new tech-enabled business models are shifting these forces and heightening the competition firms face. First, we live in a world awash with money, which is lowering the capital hurdle rates for companies to enter an industry, remain in an industry, or fund new product launches within their own industry. Second, internet-enabled technological advances that increase the speed and lower the cost of communications have powered a host of new business models that help smaller firms rent scale to compete with their larger incumbent competitors, such as online third-party eCommerce and logistics portals (Amazon’s marketplace and Alibaba’s TMall) and cloud computing offerings such as Amazon Web Services. These new business models are having a transformative effect on the nature of competition in many industries, threatening the profitability of many industry leaders.
The impact of superabundant capital and new tech-enabled business models is best seen if we assess their influence on the five forces: (1) there are more entrants as firms can more easily fund business expansion into a category from adjacent categories; (2) new small-scale niche providers are appearing because they can now rent scale – think of craft beer, craft spirits and boutique apparel lines; (3) customers have more bargaining power as there is better price discovery via the internet; (4) suppliers can more easily understand end-selling prices to sharpen their pricing, or even go direct to the consumer themselves; and (5) industry rivalry intensifies as firms strive to meet their internal growth targets in the face of mounting competitive pressure.
In sum, it is now harder than ever for firms to maintain their leadership, high returns on capital and growth trajectory. It presents a challenge for long-term investors who, like me, look for “value creators” that can grow intrinsic value rapidly over an extended investment horizon. But it also increases the relative rewards from identifying such firms as they will ultimately distance themselves from the competition and create significantly more value over time than the average company.
Value creation over valuation
As a long term investor I look for “value creators” – firms that are growing intrinsic value rapidly and can continue to do so for at least the next three years. I expect to hold these firms in my portfolio for three years or longer, leaving time for them to create more value and grow into the premium valuation that I may have had to pay for them. Valuation obviously matters — it’s always better to pay a lower price than a higher price — but I’m happy to pay a slight premium for firms with better long term prospects rather than compromise on value creation potential, which is just false economy.
These value creators typically have four characteristics:
- Durable sources of competitive advantage from a strong market position and/or better business model, allowing the firm to generate high gross cash flows each year
- Growth opportunities to expand the business through: end market growth; market share gain; and/or pricing power to improve margins
- High returns on capital so financing this growth does not consume too much capital, freeing up annual operating cash flows for further growth opportunities or shareholder distributions
- Leadership that works for the benefit of all shareholders, not just the controlling party if one exists
These value creators can also be called “quality” firms or “quality growth” firms, but one should take care to not lump this strategy in with all forms of “quality” investing. I am not focused on the “defensive quality” that is often seen in low-volatility consumer staples & utilities stocks. I certainly don’t mind it – defensiveness is an attractive trait – but focusing on it exclusively often leads to firms that lack the growth opportunities I seek. Similarly, I do not use balance-sheet focused measures such as Piotroski scores to measure quality. Balance sheet scores focus on a firm’s solvency rather than its long term earning power, and so are best used by “cigar butt” style value investors to increase the odds their “cigar butts” are not about to be extinguished by a flood of concerns about the firm’s bankruptcy. I consider these scores very useful for avoiding “junk,” but much less useful for identifying firms that are creating value through durable growth of cash flows.
20 value creators to own for 2020
I’ve selected 20 firms whose business models are strong enough, in my view, to meet the challenges posed in this competitive environment. These firms also should be creating value rapidly over the next three years, based on sell-side estimates. My list of firms is more focused on the tech & consumer sectors where I have done much of my investment, and on Asia as I live in Hong Kong and follow stocks in this region more closely.
While I expect each firm to perform well through 2020 I recognize that not all will. Some will lose out to established competitors or to new challengers, and will not meet the expected returns outlined below. However, I expect these strugglers will be a small minority, and that the outperformers in the portfolio will offset them. The overall portfolio should perform well in both absolute terms and relative to the market indices I am using to reduce market risk.
The best evidence I have for this view is that my chosen firms already have a head start relative to market indices. In the charts below I compare the sell-side consensus earnings estimates for each of my companies with those of the companies in the ETFs that I use to hedge out some of the market risk. All data below uses Factset estimates. The 20 firms for 2020 portfolio is equal-weighted, and the ETF shorts are 50% IWM (Russell 2000); 25% IEFA (MSCI Core EAFE) and 25% EEMV MSCI Min Vol. Emerging Markets. Within each ETF the firms are weighted in proportion to the holdings.
On consensus estimates the 20 firms I selected are growing intrinsic value by 20% p.a., 10 percentage points ahead of the market hedges. Most of this higher valuation comes from faster earnings growth, supplemented by more efficient use of cash (due to higher ROIC) but offset by a slightly lower dividend yield.
The real benefit comes when we consider valuation: these 20 value creators are only 7% more expensive on EV/EBIT multiples for the next 12 months, meaning they will “grow into” their multiple within a year. Already these value creators generate higher free cash flows with yields of 3.8% vs. 3.0%. These statistics are also before considering any alpha at the stock level, and I believe that my stocks are better placed to meet or beat estimates than the average firms in the market indices.
In sum, my strategy is to own 20 high quality firms that are creating much more value than the average company, and yet are priced at a small premium they will grow into within a year. I’m confident they will outperform the market indices.
I believe it’s up to each investor to decide the level of market risk that he/she wants to assume. As a reference point, for this part of my overall portfolio I have 50% net long exposure, roughly 100% long and 50% short through the ETFs.
List of 20 value creators
Alphabet is one of six tech titans on my list of preferred firms. Alphabet is one of two firms that dominate the internet advertising space through its leadership in search (Google), video (YouTube) and Maps. Google has over a billion active users, even before counting users of Android, the world’s most common mobile operating system, and is expected to capture 40% of US digital ad revenues in 2017. Alphabet has been growing rapidly and consensus estimates are for EBIT to grow 15% p.a. over the next 3 years. Alphabet has also shown increased financial discipline since creating the Alphabet structure, and this bodes well for better monetization of assets such as Android, Waymo (self-driving cars) and others.
Amazon continues to grow at a rapid rate (sales 20% CAGR, EBIT 50% CAGR) driven by the twin engines of consolidation of online distribution and Amazon Web Services (AWS). Both divisions are clear leaders in their markets, and in these markets leadership is important to help built trust with customers and for lowering per-unit operating costs. While GAAP earnings are low due to Jeff Bezos’ famed long term focus at the expense of near-term accounting profitability, I believe operating cash flow better shows Amazon’s potential as an investment. Operating cash flow should be $20bn in 2017 (Factset consensus estimates), meaning that with Amazon’s Enterprise Value of $400bn EV/OCF is 20x, which is very attractive given Amazon’s expected 20% annual sales growth over the next 3 years.
Facebook has a large (>1.5bn monthly active users) and sticky user base that provides enormous potential for monetization via digital advertising. Facebook should capture 39% of the US digital display advertising in 2017, according to eMarketer, after growing 32% from their 2016 level. Facebook can drive further growth through assets such as WhatsApp, Instagram and Oculus. Consensus estimates are for 26% p.a. EBIT growth over the next three years.
Mastercard and Visa operate the world’s largest firms to connect consumers with merchants. Mastercard has close to 2 billion cardholders globally as they offer cardholders wide acceptance, access to financing, reward programs and fraud protection. This offer is difficult for alternative payment providers to replicate, and the card processors can often insert themselves into mobile payment ecosystems such as Apple Pay as their total revenues average out to c. 20bps per transaction processed. Base (assessment) fees are closer to 10bps. Mastercard still has a large growth opportunity as digital payments take share of wallet (literally) from cash payments, and earnings are expected to grow 14-16% p.a. over the next 3 years.
Cognizant is an IT consulting & outsourcing company that has customer relationships with 50-75% of the leading companies in most industries. Cognizant has a great track record of delivering value to these customers, and has grown EBIT by 15% p.a. over the past 5 years. Consensus estimates expect this growth to slow to c. 10% over the next 3 years, but this will continue to generate significant shareholder value. Cognizant has recently established a more shareholder friendly capital management plan including regular dividends and accelerated share repurchases. They have committed to returning 75% of US FCF to shareholders from 2019; Cognizant is currently priced at a 6% FCF yield, and has 12% of the market cap in net cash. Potential changes to the US H1-B visa program would have a negative impact, but as H1-B visa holders are c. 7% of global workforce the impact is likely to be manageable.
Starbucks is the world’s largest coffee shop operator. Most of the profit is derived from the US business, with c. 65% of total from North American stores and a further c. 20% from consumer packaged goods & licensing. China & Asia-Pacific contributes 10% of total and EMEA & other the balance. In the past 3 years operating income and EPS have grown at 19% CAGR. Long term growth targets from their recent investor day are stores c. 5%, revenue c. 10%, EPS 15-20%, with higher EPS growth due in part from cost discipline and operational leverage driving EBIT and in part from share buybacks. Consensus estimates are in line with these targets. Starbucks’ share price has been flat over the past 18 months over concerns that star CEO Howard Schulz’s move from CEO to Executive Chairman may lead to diminished performance. However I believe these concerns are unwarranted (or at least easily priced in), given the breadth of the business’ success in recent years and the depth of talent within the current management team.
Marriott is best considered as the marketing network of the world’s largest hotel group. Their brands include JW Marriott, Ritz Carlton, W Hotels, Sheraton and Westin. The vast majority of their business is conducted through brand & licensing arrangements; Marriott typically does not own the hotel property (reducing capital requirements) and often they do not operate the hotel directly (reducing operational complexity). Marriot does manage the brands, booking systems & loyalty rewards program. This business model makes margins high & stable, and results in high levels of free cash flow. Marriott expects c. 8% revenue and operating earnings growth through 2020, translating to 15-20% EPS growth due to buybacks. This is attractive given the current 4.5% FCF yield that the stock is priced on.
NVR is a US homebuilder focused on the mid-Atlantic region near Washington DC. NVR’s business model is unique in the industry, as they do not own their land bank (lowering risk and capital intensity), and they focus on manufacturing efficiency by focusing on one region of the country and offering a smaller range of potential floor plans than competitors do. NVR has very strong track record of capital allocation, buying back stock regularly since 1994.
Shire has built a diverse portfolio of drugs across across Hematology, Genetic Diseases, Neuroscience (including Vyvanse) and Internal Medicine. In 2016 they acquired immunoglobulin firm Baxalta. Baxalta complements their treatments portfolio and provides more long term stable cash flows than the pharma business, and yet this is not reflected in Shire’s multiple (Baxalta peer CSL trades on 27x NTM PE, whereas Shire is on 11.4x). Consensus estimates are for 12% EBIT growth over the next 3 years, and Shire is currently on a 7.5% FCF yield.
Ryanair is Europe’s largest and lowest cost airline, and it has the best metrics for on-time service and low cancellations. Ryanair’s growth will be fuelled by more planes (5% passenger seat growth through 2024), direct relationships with customers through their myryanair portal that cuts out middlemen OTAs, and potential to moderate their price reductions and grow margins as they’re already 20% cheaper than next best-priced carrier Wizz, and 50% cheaper than Easyjet. These opportunities should drive 10%+ EBIT growth, with potential for higher shareholder returns from dividends and buybacks.
Alibaba operates the Taobao and TMall B2C ecommerce platforms in China, with GMV 2x that of amazon. These platforms operate as digital marketplaces, with clients bidding to improve the positioning of their products (70% of revenues) and paying commissions (30% of revenues). GMV is still growing at 20-25% p.a., and the China retail revenue is growing 30-35% p.a. as advertising (positioning) revenues increase. Alibaba also owns a large and fast growing cloud computing business (similar to AWS), 33% of ANT Financial (lending & payments) and stakes in many other businesses. Sell-side consensus estimates are for 28% EBIT growth for the next 3 years, and Alibaba is currently priced at 3.8% FCF Yield.
Tencent operates China’s dominant social media portals WeChat (Weixin), QQ and QZone. WeChat has over 800mn MAU and operates primarily as a mobile-centric messaging service (more like WhatsApp than Facebook). The basic service is free, but Tencent monetizes them through add on services such as gaming, personal homepages, classifieds, and content. This ecosystem benefits from extremely strong network effects. Tencent is in the early stages of monetization (ad rate is less than half Facebook’s), driving the potential for 25% annual growth in sales, EBIT & EPS for the next 3 years.
Baidu is China’s Google equivalent. EBIT growth took a pause in 2016 as Baidu was required to scrub their advertising client base after scandals of Healthcare companies misrepresenting the benefits of using their health products. These initiatives are now largely complete, and EBIT growth should resume at 30-35% p.a. from 2017. In addition to their core search business Baidu owns 21% of CTrip, 80% of the IQiyi video service and some O2O services. Baidu is also investing heavily into AI and autonomous cars. FCF yield is 4.8% at current levels.
Netease is primarily a video game develop for the Chinese market, and is the clear #2 provider behind Tencent. Gaming provides 80% of gross profit and has been growing at 40% YoY. Netease also has an advertising business due to their email products (126 & 163), and news portals. Netease also has a cross-border eCommerce business that is likely to be a long-term follower behind Tmall (Alibaba) and JD.com. Consensus forecasts are for Netease to grow EBIT at c. 18% p.a. for the next three years, and it is currently offers almost 5% FCF yield. Netease has typically had the most shareholder-friendly cash distribution policy of the Chinese internet firms, with regular dividends and buybacks.
TAL Education is at the early stages of consolidating China’s after-school tutoring market. TAL has close to 500 learning centres across 27 cities, and the number of centres is growing at 30-40% p.a. Enrolments grew c. 70% yoy in 2016 across China, and 30% yoy in the more consolidated Beijing market. TAL’s advantages stem from a better learning system that integrates “star” teachers whose lectures are live broadcast to multiple classrooms, teaching assistants in each room, and online tool like their Intelligent Practice System that is the nexus between student, parent, instructors and online teaching assistants. These tools are raising the barriers to competition, and have fuelled TAL’s market share gains from within the 140k tutoring institutes across China. Consensus estimates are for 35% EBIT p.a. growth over the next 3 years.
TSMC is the world’s largest outsourced semiconductor manufacturing firm, with over 50% market share. TSMC does not compete with its customers such as Apple, unlike competitors Intel (PCs) and Samsung (phones). TSMC generally has the world’s leading technology and a long track record of delivery to customers’ needs. Although the business is capital intensive TSMC should grow EBIT 12% p.a. over the next three years and is currently priced on a FCF yield of almost 6%.
Amorepacific is the leading Korean cosmetics company (cosmetics c. 90% of revenue) and at the early stages of global expansion. Revenue mix is c. 50% domestic, 20% Duty Free (often to Chinese customers), 15% China direct, and 15% other. Amore’s share price has dropped 30% since mid-2016 as travel restrictions and concerns on South Korea/US relations have reduced China-related growth. I believe these effects are temporary, however, and that this dip represents a buying opportunity for long-term investors. Consensus estimates are for 20% EBIT growth for the next 3 years
Shenzhou International is a vertically integrated garment manufacturer with a focus on athletic apparel. 75% of their business is with Uniqlo, Nike & Adidas, and these firms have moved more of their production to Shenzhou in recent years to mitigate supply chain execution & ESG risks. With this increased interest from customers Shenzhou has been capacity constrained, limiting their prior growth. To alleviate this pressure Shenzhou has recently completed a factory in Vietnam, and is ramping up production there over the next 2 years. This increased production capacity will fuel 16% p.a. EBIT growth over the next 3 years (consensus estimates), providing for excellent shareholder returns. In addition, most production remains in China, making Shenzhou a beneficiary of any further RMB depreciation.
Nexteer is the global #3 of car steering systems, with strength in both the US (it was GM’s in-house steering division) and China (Chinese parent AVIC part owns Changan auto). High tech parts supplier is an attractive part of the auto industry as the OEM’s preference for modular manufacturing increases the complexity and R&D requirements of the integrated systems the tier-1 suppliers provide. Nexteer’s revenue is growing from increased use of Electronic Power Steering, especially in SUVs and in the Chinese market, and will benefit from the shift to “steering by wire” as part of the transition to autonomous vehicles
Fuyao Glass is one of the world’s largest auto glass companies. Fuyao dominates the market in China with c. 75% market share, and they are growing their overseas market shares with new plants in the US & Russia. These new plants will help Fuyao repond to their customers’ needs more rapidly, and they already have a backlog of orders that will help them grow their non-China market share from c. 10%. Although autoglass is a largely commoditized business, Fuyao has a more efficient manufacturing process that helps them generate the highest margins of all autoglass makers, and acts as a barrier to competitors that cannot operate as efficiently. Fuyao’s Chairman has a history of shareholder-friendly capital allocation, as he has gifted many of his shares to a trust that relies on dividends to fund their charity work.
Financial Disclosure: At the time of publication the author owned all 20 stocks listed in this article.
Note: This post was originally published on Seeking Alpha on March 30th, 2017.