Update No. 200 – 30/01/15

I have a confession to make.

I actually think the work I do in allocating EGP’s assets is relatively simple (must be why I charge such low fees!). Our results over the last 12 months have been unspectacular, but since inception, we have comfortably averaged outperformance of the market that exceeds 5% (we target 3 – 5%) annually, so simple methods have worked thus far.

I should define simplicity I guess. If I find two companies that trade at similar valuations, without too taxing an effort, I can usually come to a view of which of these two have the superior prospects. EGP don’t use complex derivatives, trade puts, calls or options, we simply try to narrow the field down to about 20 or so businesses within our approved area (ASX listed) whose valuations look most compelling based on their prospects and favour those whose prospects look most compelling compared to that price with the largest investments.

I should also mention that despite my describing it as simple, managing other people’s money is definitely not easy. I make strong efforts to cultivate a group of shareholders for EGP that I believe think about their investment in similar terms to the way I do. But when there is a reversal in share price performance for EGP, or when we trail the market, as the person allocating the capital, you can’t help but wonder what your investors are thinking. When investing my own funds only, I would simply check whether I thought my original theses still held on the stocks responsible for the decline and move on. I try to behave the same way with your money as I would with mine, which is why my Wife and I have around 80% of our net worth wrapped up in EGP.

The good thing about investment markets, if you stay away from the speculative end is that even if you make a poor choice between two companies of similar valuations, you will usually do OK. If you can get a strike rate of 60% or more, you will likely beat the market, probably by a statistically significant margin.

To demonstrate the thinking, I will describe two companies with similar valuation multiples and determine which I think is cheaper based on my view of their prospects.

The first business I will look at is Telstra (TLS), Australia’s foremost telecommunications business – TLS is currently trading at about $6.50 per share, in FY14, TLS earned 34.4c, this leaves it on a trailing twelve months (TTM) multiple of about 18.9x. Ten years ago (FY05), TLS had earnings per share (EPS) of 34.8c. Over the last 10 years, has averaged EPS of 30.7c and paid nearly 100% of these earnings as dividends. At the end of FY05, a share of TLS carried $1.07 of debt; at the end of FY14 the same share carried $1.27. Given basically 100% of earnings were paid out; the extra 20c of debt has arisen out of Capex exceeding the depreciation charge. TLS has monstrous cashflows of around $8b per annum, but half of this is consumed annually with Capex. It is very hard to determine how much of the $4b Capex bill is ‘growth’ Capex because despite spending this amount annually for 10 years, there has never been any growth to show for it, but perhaps it is coming? On the plus side, TLS have not grown their shares on issue and (now that the share price has more than doubled in a couple of years) will even begin buying back stock.

The second business I will look at is Sonic Healthcare Limited (SHL) – SHL is a diagnostics and pathology company, deriving roughly 50% of its revenues from Australia and 50% internationally – SHL is currently trading at about $18.80 per share, in FY14, SHL earned 96.2c, this leaves it on a trailing twelve months (TTM) multiple of 19.5x, close enough to the 18.9x for TLS. Ten years ago (FY05), SHL had earnings per share (EPS) of 28.5c. Over the last 10 years they have averaged EPS of 72.2c and paid about 75% of these earnings as dividends. At the end of FY05, a share of SHL carried $2.39 of debt; at the end of FY14 the same share carried $4.92. Given only 75% of earnings were paid out; the debt and the additional shares (SHL has increased their shares on issue by 45.8% over the 10 year period) have arisen primarily out of adding Goodwill to the balance sheet through acquisitions, as the Capex has usually been similar in quantum to the depreciation charge. SHL have been better than most at acquiring businesses, and appear to have made few mistakes with their acquisitive efforts.

So TLS has basically averaged zero growth, and according to consensus estimates will average EPS of around 37c over the next 3 financial years. SHL has averaged nearly 13% annual EPS growth over the last ten years, though that has slowed to more like 5 or 6% over the last few years.

When you buy a share, the past means nothing though; you are purchasing a share of the businesses future earnings. Now I don’t rely too much on what analysts, brokers and the like say, but they can be a useful starting point for how things are expected to go. Consensus for TLS is for EPS a little under 37c per annum on average over the next 3 years, or around 7 or 8% above FY14 levels. For SHL, consensus is for EPS averaging $1.10 per annum over the next 3 years or around 14 to 15% above FY14 levels.

Both industries have pretty good dynamics, healthcare is expected by most to grow at above average levels as we become older globally and health spending increases are likely to grow faster than inflation, by a pretty good margin – it’s hard to imagine the diagnostic industry will change meaningfully over the next 10 or 15 years. Telecoms have similarly positive industry drivers, but the risk of a major technology breakthrough that shifts revenues away from the major carriers is more realistic in telecoms than healthcare. For example if Google come to play with a Mobile Virtual Network, offering VOIP type service, huge streams of revenue could be gouged out of Telstra (though they’ve managed to milk the fixed line business for longer than I’d have expected). Such an action would take longer to play out than you might think, but the key point being that in my view, the likelihood of something that ‘torpedoes’ the revenues is likelier in TLS than SHL.

This post has become lengthier than I had intended, suffice it to say that with a history of superior per share earnings growth, a near-term future that appears to have a greater level of per share earnings growth and an industry segment that is less at risk from major structural change, in a head to head battle with TLS and SHL at present when they trade on similar multiples, I would choose SHL. I should point out I have a pretty ordinary record when tipping against TLS. I told an analyst friend at the time perhaps 3 years ago when the share price was deeply depressed, it was trading for circa 10x earnings and with a yield that approached 10% that I couldn’t see very much earnings growth and if he was to do really well out of the purchase, it would require margin expansion – but that if he didn’t get that, he’d do OK as a 10% yield with little reason to expect a dividend cut was sound compensation. Luckily for him, he ignored me and with a little EPS growth and a near doubling in the earnings multiple he’s been an extremely happy holder. I wouldn’t count on very much further multiple expansion though, so from here on out, TLS management will need to do something they haven’t really done for 12 or 13 years and increase EPS.

Fortunately because there are smaller stocks with lower valuations and even better earning potential that means I don’t have to select either option. For example, just this week I added a (very small amount) to a business that yields a fully franked 10% dividend (14.3% grossed up), trades on a multiple of less than 4x TTM earnings, has a share priced 85% back by cash (if you back out the cash it trades on 0.6x TTM earnings), has grown its profits 5 of the last 7 years and roughly tripled its profit since 5 years ago. It is such a wonderful business, I would love to own the whole thing (were it permitted and doable at current prices, the deal would already be done!). Better still; directors have in the last few months purchased a little over 3% of the outstanding shares at prices 21% higher than what we’ve paid on average and what we purchased at this week. Unfortunately it is a tiny and very tightly held business and after adding to our holding this week it remains our smallest holding at around 0.5% of the stock portfolio. If I ever finish building the position, I will detail it in full because it’s a ‘never sell’ type, but it is very small and I really don’t need the buying competition – Tony Hansen 30/01/2015

EGP Fund No. 1 Pty Ltd. Up by 1.31%, trailing the benchmark by 4.55% since July 1^st 2014. Since inception, EGP Fund No. 1 Pty Ltd is Up by 72.59%, leading the benchmark by 35.96% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1.000 cent per share Franking Credit & 31 May 2014 Dividend of 7.000 cents per share plus 3.000 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}