Unconstrained growth found in fresh places

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Many investors appreciate the extreme concentration in the Australian stock market. Only 20 stocks account for about 60% of the total value of the market, and within those largest 20 stocks, there is a heavy weight to just a few sectors, especially banks and resources.

More subtly, there is also a heavy weighting in a relatively homogenous group of stocks with similar investment attributes.

Big caps dominate

Consider the following 12 stocks in the ASX 20 Index:

  • The four big banks (CBA, Westpac, NAB and ANZ)
  • Telstra
  • Wesfarmers
  • Woolworths
  • Transurban
  • Scentre
  • Suncorp
  • IAG
  • AMP

All are commonly considered ‘blue chips’ and are well owned by Australian super funds and other investors. They account for approximately 27% of the total value of the All Ordinaries Index.

They all have solid core businesses with large market shares in relatively consolidated, mature and domestically-constrained industries. They generate strong and consistent cash flows but have limited opportunities to reinvest those cash flows back and so are left simply to distribute them to shareholders.

Strong dividend yields but little else

Reflecting as much, their investment proposition is generally dependable and attractive dividend yields but little earnings growth.

Despite this, these stocks should not be dismissed. At the right price, their typically fully franked yields are appealing. And, at times, they can offer some interesting growth prospects. For example, the big four banks should grow to the extent that the credit cycle allows. Alas, that is currently very little. Indeed, almost all of them rely on economic or industry conditions for their growth and struggle to achieve any if conditions are not supportive.

But it is not just economic conditions that can constrain earnings growth for these blue chips. Many are also facing a rise in competition. For example, the banks’ more profitable niches are facing competition from financial technology, or ‘fintech’; Telstra faces new entrants and new telecommunications networks (TPG Telecom in mobile and NBN resellers in broadband); and Scentre faces online competition pulling retail spend from its shopping centres.

There is perhaps some circularity. When the pie is not growing, growth can only come from taking it from a competitor. Taking market share entails competitive attack and response, most commonly through lower prices that reduce revenues or margins, both of which act to reduce the industry’s profit pool.

For example, last decade the supermarket industry enjoyed benign competition, dominated by Woolworths, and this supported decent earnings growth. Since then, competition has intensified, with a rejuvenated Coles and the expansion of Aldi and Costco. All players have come to ‘invest’ in lower prices and a better service offering, and their investment has pressured the top and bottom-line growth for the industry. With lower barriers to entry, and the possibility of new entrants such as Amazon, the constraint on growth arising from the competition is unlikely to abate.

Diversification has become one investment type

The upshot is that some investors who thought they were diversifying by buying a selection of blue chips have actually concentrated their portfolios into a particular investment style, one characterised as low-growth yield plays.

For genuine diversification, investors should look to companies offering the opposite, such as:

  • offshore markets in which to expand
  • fragmented industry structures
  • differentiated customer offerings enabling market share gains
  • structurally growing markets and
  • opportunities to reinvest cash flows back into the business for growth.

We typically look for companies with ‘exportable competitive advantages’, being those with innovation, brands or products that travel well offshore.

Examples include:

Innovation

  • Proving that big isn’t always boring the high-growth CSL is a blue chip that is actually the sixth largest stock on the ASX. The company is a low-cost manufacturer of plasma-derived medicines, for which global patient demand is in strong growth. CSL is investing over US$600 million annually in R&D to develop new and improved biomedicines, which allows it to gain a revenue advantage over competitors in respect of each litre of plasma collected. The company continues to leverage this competitive advantage to profitably take market share and expand internationally, including most recently into the large Chinese market.
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  • Aristocrat, best known as a slot manufacturer, is spending over $250 million annually on the design and development of new and improved games. Successes like ‘Lightening Link’ allow the company to take market share in the 90 countries it sells into, with the most important being the large US market. The company also leverages its gaming innovation into its nascent online ‘social’ casino-style games business, for which it now has over 1.4 million daily users around the world and counting.

Brands

  • BWX owns the Sukin brand, an Australian brand of natural skincare creams that has essentially found its own spot in the ‘masstige’ market. BWX has a strong presence in Australia, but more importantly for its long-term growth prospects, the company is expanding into various offshore markets. It is exporting Sukin products into the UK, where it has just recently started selling through Boots, the UK’s largest pharmacy chain, as well as into Canada, China and elsewhere.
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  • Treasury Wine Estates owns luxury and ‘masstige’ wine labels such as Penfolds and Wynns that are increasingly in demand in offshore markets, including most importantly in the high growth and highly profitable Chinese market.

Products

  • Reliance Worldwide manufactures plumbing products, including the innovative Sharkbite branded push-to-connect plumbing fittings. These fittings are growing in popularity among plumbers worldwide, allowing Reliance to steadily take market share, most importantly in its largest market the US, and to enter and expand into other international markets, with the most promising being in Europe.
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  • ARB is a manufacturer of four-wheel drive accessories such as bull bars and canopies. It has a strong brand; it tailors its products to specific vehicle makes and develops innovative new products that it exports to 100 countries worldwide. The exporting of these products enable ARB to steadily grow its businesses in offshore markets.

 

Julian Beaumont is investment director at BAEP, a boutique partner with Bennelong Funds Management. This article is general information that does not consider the circumstances of any individual.

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