Quality Australian stocks or not? 2 hits (and 3 misses) – Glen Freeman

Two Australian stocks – unloved goods and a global audio technology company – are number one for the three quality-focused fund managers interviewed below. We will reveal the companies soon.

In the first part of this series, the funds explained how they define quality (along with more clearly the different styles of growth and value). They also discussed how to find companies that meet their strict criteria.

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Where is it going now for equity investors as value stocks are also exploding?

And in this concluding text, I asked them to reveal some specific company choices.

But first, the contenders.

For Investors Mutual’s portfolio manager Michael O’Neill, his choice of Quality Applicant is Qube Holdings (ASX: OLD). Like his true choice of quality, he also works in logistics, ports and bulk transport.

“Qube has this halo to be perceived as high quality, but in fact it is a relatively lower quality infrastructure fund,” he said.

“The return on capital is relatively low, on average one-digit, and management is far from transparent in showing the return on the various divisions.”

O’Neill also cites high capital spending over the past decade, a series of stupid acquisitions and stock plans that have done little but diluted existing investors. He also considers Qube expensive, trading at 28 times the PE ratio, with 2.5% wild profitability and poor cash flow conversion.

One technology company that doesn’t look like the other

Vertium Asset Management CIO Jason Tech indicates the contrasts between REA Group (ASX: REA) and Altium (ASX: ALU) to highlight a common investor error.

“They are often grouped together because of their high growth prospects, but they are not the same in terms of quality,” he said.

“Both have high returns on equity and very strong market positions. But Altium’s profits are of lower quality as the company aggressively reduces its software products in an economic slowdown. REA’s profits are of higher quality, as they remain relatively stable when the housing market slows. “

Why paying extra has never been a quality

Finally, Elston Asset Management portfolio manager Justin W├Ârner demolishes Afterpay by one degree, claiming that it has never been a quality business – although its price is similar.

“The uptake by retailers was exciting, becoming the biggest advertisers and promoters of Afterpay services. But to be a quality company, you need strong and sustainable competitive advantages, “he said.

Woerner argues that the product of BNPL’s services and low barriers to entry, “any business that can get funding and build a simple technology platform can compete, and we’ve seen that.”

“Over time, the number of competitors has increased and the sector has become crowded with other suppliers,” says Woerner.

Now let’s turn to the companies that think they can rightfully claim the title of quality.

Both “true quality” choices

Unloved company with a discount

Michael O’Neill, Investors Mutual Limited

Aurizon stands out as an unloved and heavily discounted company, but it is actually a high-quality infrastructure. And we consider it that way because there are regulatory and contractual safeguards that position it well for an inflationary environment.

It also comes down to competitive advantage and sustainable cash flows. About 60% of AZJ’s revenue comes from its regulated monopoly – Queensland’s Central Coal Railway Network – which should maintain or even increase its revenue over time. This is because regulated yields adjust upwards with interest rates. The company also receives “truth” for each regulatory period, which is every four years, for the difference between the company’s projected inflation and actual inflation.

Another 40% of AZJ’s revenue comes from basic transport services for high-quality Australian coal and bulk goods. This is not regulated, but the profits are provided by high-quality producers under contracts of 5 to 10 years. The company is also gaining isolation against cost inflation with almost 100% passing the increase in fuel costs.

There are some problems, including the overhang of ESG, in which its share price fell. Transport volumes will be affected as we switch from coal. But management has some protection, so if their volume falls, the impact on profits is somewhat muted.

The company also recently announced a proposed acquisition of One Rail’s bulk cargo operations. This would accelerate the transition and diversification to bulk. This company also has a lot of hidden capacity, so it probably costs a lot more under the ownership of AZJ.

Combining all this together, we see AZJ as a high-quality option and one that is traded on a 14-fold PE multiplier with 5.5% fully franked yield.

Noticeable interruption in the share price

Jason Tech, Vertium Asset Management

We like to look for discrepancies between the company’s share price and its basis for growth and quality. And the only action that stands out in terms of this break is Aurizon. At first glance, AZJ is a low-growth company, so some may say that it is appropriate for a company to have a low rating. Although this takes into account the growth side of the investment coin, it ignores the quality side (the break). AZJ is a high-quality business, given that more than 60% of its revenue comes from a monopoly infrastructure business, and the rest is based on long-term contracts.

We have seen recent takeovers of private capital Ausnet services, Spark infrastructure, Sydney Airport and now potentially, Atlas Artery (ASX: ALX). These transactions emphasize that lower discount rates (or higher valuation factors) should be used to value high-quality infrastructure assets. If the public stock market is reluctant to value these assets properly, then private markets will eventually do so.

Market leader in audio technology

Justin Warner, Elston Capital

One of our most convincing positions right now is the digital audio networking technology company Audinate (ASX: AD8). Manufacturers such as Sony, Bose and Yamaha are integrating Audinate technology directly into their products during production, creating an ecosystem of digitally connected devices that are brand-independent.

The market leader, AD8 has about 19 times the penetration of its main competitor and operates in a very large global market. By comparison, the penetration of digital connectivity worldwide is less than 10%. AD8’s market leadership, combined with ongoing investments in the product development program, provides the company with a great opportunity to generate organic revenue growth.

High barriers to entry

The potential for a new competitor to enter the market is small, as they will have to invest large amounts of capital and time to:

  • recreate Audinate’s technical innovations,

  • correspond to the functionality of the product and

  • shift the position of AD8 with manufacturers.

The business is in a strong financial position. Gross margins are over 70% and the business has a net cash of $ 65 million at the end of the 2021 fiscal year. We also like the fact that the company’s co-founder Aidan Williams remains an important member of the management team.

Catch the first part of this series

Make sure you “FOLLOW” my account to receive notifications of future messages when they are published, and be sure to like this one (if you enjoyed reading it). If you missed the first part, click here to find out how our contributing fund managers determine quality and select companies consider that they meet the criteria.

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