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20 lessons in 20 years – Part 9

Monday, October 15th, 2018
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Companies with recurring earnings provide more consistent returns over the longer term

By Daniel Moore and Anton Tagliaferro |  12 October 2018

One of the key attributes that IML has sought in companies when investing in the Australian sharemarket since our inception in 1998 is to look for companies that will generate reliable, predictable earnings over the long term – what we have always referred to as a recurring earnings stream. Focusing on this key aspect has not only helped IML avoid virtually all the spectacular corporate failures of the last 20 years such as Onetel, Babcock and Brown and Onesteel but it has also helped IML’s deliver returns which are far less volatile than the return of the overall sharemarket.

Companies that generate recurring earnings are generally found in sectors that have demonstrated stable to growing volumes over long periods of time – sectors such as the Healthcare, Gaming, Packaging and Supermarket sectors.  Having said this, one has to regularly assess the regulatory and competitive landscape and risks in each of these sectors to select companies that can continue to generate predictable earnings into the future.

On the other hand, companies operating in more cyclical sectors of the economy such as the Resources, Steel, Housing Construction and Airlines tend to generate far less predictable earnings.  The demand and pricing for products of companies operating in these more cyclical areas can vary greatly and fairly unpredictably from one year to another. These sorts of companies tend to be far more volatile investments because their earnings tend to be very volatile over time.

Chart 1 below shows the ups and downs of the number of new dwelling commencements and residential build approvals in Australia over the past four decades. This cycle tends to directly impact the earnings of companies like CSR which are heavily reliant on this housing construction cycle.

Chart 1: Australian housing starts

On the other hand, Chart 2 shows the steady, stable growth of Brambles pallets over time – reflective of the company’s fairly predictable, recurring earnings over time.

Chart 2: Brambles’ pallets growth around the world over time

Source: Brambles and IML. Date: July-95 to June-17

So what are the advantages/benefits of investing in companies with recurring earnings:

We have also observed that in the last 20 years that companies involved in more cyclical sectors have often tended to be fairly poor at reinvesting their excess capital into new opportunities. In our view, this is generally because the management of most cyclical companies have tended to feel most comfortable making acquisitions when their cash flows are strong – which is usually a time when the cycle in their industry is at a high and when it is usually very hard to find good investment opportunities!  Conversely when the cycle is at a low point and acquisition opportunities are usually abundant and potentially most value accretive, cyclical companies typically have weak cash flows and are not in a strong position to make these opportunistic acquisitions.

In the last ten years we have seen some of our major Resource companies make several poor acquisitions when their cash flows were strong. BHP was a repeat offender in this regard with their acquisitions and investments in US shale oil tallied up to US $40 billion between 2011 & 2014 which they subsequently sold recently for US $10.8bn. RIO acquired Riversdale which owned coal assets in Mozambique in 2011 for US $3.7 billion with these same assets being incredibly sold only 3 years later for a mere US $50 million.

Companies with more predictable recurring earnings don’t have the same cash flow timing issues as cyclical companies. This doesn’t preclude them from making poor acquisition decisions, but it does mean they have consistent cash flow to take advantage of good investment opportunities as they arise. CSL and Amcor are great examples, where their management teams have been disciplined and made several successful counter cyclical acquisitions over the last 20 years. CSL’s acquisitions of Aventis Behring in 2004 for $1 billion USD made them a global leader in plasma therapies and Amcor’s $2 billion USD acquisition of Alcan during the GFC made them the global leader in flexible packaging. Importantly these company-transforming acquisitions were purchased at very opportunistic prices. These well-timed acquisitions led to shareholders in both companies enjoying very consistent growth in earnings and dividends over the last decade.

The lesson for investors is that investing in a portfolio of companies that is heavily skewed towards companies with predictable, recurring earnings that are well managed will tend to deliver more consistent returns than investing in a more cyclical companies over the long term. 

 

 

While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.