The two most important data points to watch would be U.S. unemployment and earnings revisions for 2020 & 2021 for the MSCI World Index.
Perhaps more than anything, the COVID-19 crisis has been a ‘consumer recession’. Not only have consumers been in varying degrees of lockdown – and therefore not been in a position to spend – but the economic hit has been massive and resulted in ~38 million people in the U.S. losing their jobs in a very short period of time.
One of the biggest unknowns at this point is around the re-opening of the economy. If the states re-open too quickly, there is obviously a risk that we see a second wave of COVID-19 and head back into lockdown. This scenario clearly isn’t priced into markets at the moment and if anything, they are pricing in a seamless reopening.
As far as earnings estimates are concerned, we have seen the current year EPS estimates for the MSCI World Index downgraded by 33% YTD – most of which has come since early March. Against the backdrop of the COVID-19 crisis, such a sharp earnings contraction is hardly a surprise. However, as we look a little further ahead, the 2021 EPS estimates for the market look heroic – implying that 2021 EPS will be 21% higher than 2019 EPS. This disconnect arguably poses the biggest risk to a sustained recovery in equity markets from current levels.
One of the more interesting newer positions in the portfolio is Booz Allen Hamilton – which is a U.S. based specialty IT services business. It almost exclusively services the U.S. government (i.e. Defence department, Intelligence agencies etc.) which effectively means they have far less earnings risk than the market as a whole.
The company’s recent results were very strong and it actually upgraded guidance when many companies are withdrawing guidance all together. Management expects to grow revenue by 6-10% and EPS by 10% this year. Historically it has grown sales and EPS by 7.2% and 17.5% p.a. respectively which is a very impressive effort.
From a research perspective, we have followed the name since 2012 and progressively built our thesis since then. Several members of the investment team have met with the company in recent years and we feel like we have a good understanding of the business and how it will perform.
As we look ahead, we feel the ability to deliver positive earnings growth in the current grim earnings environment really sets the company apart. Furthermore, the earnings environment seems to be actually improving as evidenced by a recent $800m / 5 year contract win.
In terms of valuation, we don’t feel that the company is overly expensive on a 2021 P/E of 21x and Free Cash Flow yield of 5.0%. If we look out two years, we can see 35% upside from current levels.
At a very high level, we look to screen for possible investment candidates based on a variety of profitability, growth and financial strength metrics. It’s only once we have formed our judgemental views on companies that pass our ‘Quality’ test do we look at them from a valuation perspective.
As far as the global small and mid cap equities space is concerned, we start by filtering for developed market companies with a market cap in excess of $1 billion (size) three consecutive years of 15% (profitability) and an Average Daily Traded Value in excess of $5m. As at the end of May, 460 companies pass this screen – which we feel represents a fairly deep and diverse starting point from which to invest.
Using this universe as a starting point, if we were to apply the following filters we would arrive at a group of 10 companies that arguably exhibit an excellent combination of profitability, growth, financial strength, liquidity and valuation support:
1. Return on Capital > 20%
2. Net Debt / EBITDA < 2.5x
3. Long Term EPS Growth > 5% p.a.
4. Sales Growth (5yr historical) > 5% p.a.
5. Operating Income Growth (5yr historical) > 5% p.a.
6. Free Cash Flow Yield > 4%
Of the ten names that pass our filters, we currently own Arista Networks, ICON Plc, Moncler and Partners Group.
We intentionally don’t look for ASX equivalents overseas as we feel the whole point of looking overseas is to find investment options that can’t easily be found domestically. Having said that, we do feel that it’s instructive to look at the relative value proposition that can be found within the specialty health care field – more specifically, we would argue that there is a material scarcity value placed on the relatively limited universe in Australia when compared to the much more attractively valued global peers.
As a comparable subset, we would argue that the global peers are materially more attractively valued than the Australian peers. While they aren’t exact like for likes, collectively they represent specialty health care names with comparable long term EPS growth outlooks – yet the global peers trade on a material discount to the Australian peers.
Get our latest updates and investment manager performance reports