A look at the poster child for Owner-Managed

Airlie Funds Management

July 2022

My love affair with owner-managed businesses began back in the mid-1990s when I was in my 20s, and naturally as one imagines at that age, an investing genius. Surely sensing my potential, my bosses allocated me a 'small-cap' company to cut my teeth on as an analyst (read: limit any potential damage to portfolios). The trading liquidity of the company was low, and it did not get a lot of airtime among the bigger, sexier companies. I took a good look at the company, reading all the (hard copy!) annual reports, and got a sense for the underlying quality of the business. The company - Reece Limited - was outwardly pretty boring - a plumbing wholesaler that was majority-owned by the Wilson family, a family that had no interest in spruiking the stock to pump up the share price. This put them at odds with 90% of other companies on the bourse, and pretty much all my experience of management teams thus far.

Over a few years, we slowly but surely accumulated enough stock in Reece to make it a meaningful holding in the portfolio. The results had been impressive, with the company growing profits at a meaningful clip and the share price following. So, expectations were high leading into another half-year result when I excitedly printed the results out - sales were up meaningfully! Double digit! ... but net profit was down ... meaningfully!

To better understand my consternation, perhaps a slight detour on how the market operates and concentrates on short-term performance. There ... that is the detour. In my experience, the market was (still is!) ONLY interested in the right here and now, and it wants profit growth NOW and the promise today of more of the same into the future with no detours taken along the way. The reward? A nice upward path for the share price. In my experience as an analyst to that point, this is what companies strove for each half year and they would move hell and high water to achieve it, egged on by market participants (buy and sell sides). The poster child at the time was US-listed General Electric with the lauded Jack Welch as CEO. It turns out the remarkable quarter-over-quarter profit growth that GE produced was an illusion, but that is another story.

"My love affair with owner-managed businesses began back in the mid-1990s when I was in my 20s."

So, I frantically looked at this profit result from Reece with a growing sense of sickness in my stomach - costs were way higher than the previous period, in my mind destroying a beautiful sales result. The 'market' in its short-term wisdom declared this a poor result and reacted accordingly. The stock fell. Now as I have mentioned, Reece was majority-owned by the Wilson family, with ownership of over 70% of the shares on issue. The family did not communicate much with the market, nor frankly did it seem to care what a bunch of financial analysts thought about how the company was run, rightly so as we'll see below. However, in my infinite wisdom I was determined to tell CEO Alan Wilson what was what, and didn't he understand the purpose of producing half-yearly profit growth numbers? Hadn't he heard of operating leverage?

So, with more patience and politeness than I deserved, Wilson heard me out and further explained the strategy that was already laid out briefly in the result commentary (had I bothered to read it). Where I saw a cost blow-out, he saw great opportunities for investment to grow - simply, rolling out the Reece store network in more locations around Australia, taking market share, and becoming ubiquitous within plumbing and bathroom. I hung up the call having learnt a valuable lesson. Now I had dutifully read the Warren Buffett letters and paid lip service to buying 'pieces of companies' not 'lottery tickets,' but in the cut and thrust of everyday markets, I too had absorbed the focus on the short term. The penny dropped that Wilson was investing now for future growth, and that the opportunity could be massive.

Now around that time in the late 1990s, Reece was actually half the size of the big player in the market - Tradelink (owned by the mini-conglomerate Crane Group). The chart below shows that Reece was half Tradelink's size in terms of sales and profits.

Reece versus Tradelink

Quality of Management: Benefits of an owner-managed business

Source: Company reports

Fast forward more than 20 years and Wilson's strategy has played out perfectly. From a relatively unknown company based in Victoria, the Reece name has become synonymous with plumbing and bathrooms nationwide. The chart below shows the result - sales in Australia/New Zealand up 8x and profits up 22x. Amazing results and all without raising any equity (until its expansion into the US in 2018) or meaningful debt. In fact, the company acquired property sites for a lot of its best-located stores along the way. Meanwhile, you can see what happened to Tradelink - 23 lost years where sales went nowhere, and profits backwards - overseen by numerous management teams and a new corporate owner (Fletcher Building).

Source: Company reports

Which now brings us to the lesson in all this. Standing in 1998, armed only with sales and profits of Reece versus Tradelink, traditional business theory would usually predict Tradelink would go on to dominate, given it had a larger store base and hence larger sales base to generate economies-of-scale benefits, etc. Yet we see that an owner-managed business can meaningfully outperform a competitor. Why might this be the case?

Firstly, it's worth defining how we think of owner-managed businesses. We break our definition into two groups:

1. High ownership, high control: By this we mean an owner/founder who retains a shareholding of more than 20% of the shares on issue and manages the business. Companies such as Reece, Fortescue (Andrew Forrest), Seven Group (Stokes family) and Harvey Norman (Gerry Harvey) fit this definition.
2. Low ownership, high control: This group is a bit more nuanced. For example, despite owning only about 14% of News Corp, the Murdoch family is unanimously considered 'owner-managers' of the company (helped by the family's higher ownership of the voting shares). Other examples include the Lowy family formerly at Westfield (less than 15% ownership) before its merger with Unibail-Rodamco, ARB Corp (4WD accessories) run by Roger Brown and his brother (less than 10% ownership), and even ResMed (sleep apnoea devices), co-founded by Chairman Peter Farrell and now managed by his son - Mick - despite the Farrells owning less than 5% of the company.

So why can companies that fit these definitions do so well? We believe it comes down to three fairly obvious factors:

• A strong focus on the core
• Long-term planning
• Resilience, leading to optionality (typically underpinned by conservative debt structures).

Using Reece as an example and running the company through the three factors:

Example: Reece

With a continuous management team implementing the above, the results can be powerful. Reece has had two CEOs in 50 years - Wilson and now his son Peter - while, as mentioned, Tradelink has had at least five different senior management teams over the past 20 years. The result of this continuity for owner-managed companies is that the 'culture' that is developed over time can be an amazingly powerful weapon in a company's success.

Owner-managed - The numbers re-crunched

We have been keen on this owner-managed theme for some time and indeed in the Airlie Australian Share Fund a third of our holdings are owner-managed companies. We first put together an owner-managed index in 2018 that backed up our view that owner-managed companies overall outperformed over the long term, because of the reasons listed above. At the time, we noted the limitations of our exercise:

• Had we captured all the owner-managed companies out there?
• Was survivorship bias distorting our data? (ABC Learning anyone?)
• What about when the owner-manager sold down or stepped back? (Computershare, Primary Healthcare)

"Owner-managed companies have outperformed the S&P/ASX 200 Accumulation Index over each period."

We have pored over the data set and re-crunched the numbers (with the help of Macquarie Equities) to test the limitations listed above. We have included all owner-managed businesses up until the point at which the owners stepped back. Some simple conclusions have been drawn (and the numbers are shown in the table below):

• As a collective group, large and small cap, owner-managed companies have outperformed the S&P/ASX 200 Accumulation Index over each period: 10 years, 15 years, and the full history of our test over 22 years (since 2000).
• This outperformance includes notable blow-ups ABC Learning, Babcock & Brown et al associated with the GFC meltdown.
• Small-cap owner-managed companies are the place to be - over the years think ARB Corporation, Mineral Resources, and Premier Investments. Companies that have compounded at more than 20% p.a. for years. More recently (past five years) companies such as AfterPay have made the owner-managed universe.

Performance of owner-managed companies versus the market

Source: Macquarie Equities, Airlie

Further refinement

We have further refined the notional index by applying Airlie's investment filters that favour financial strength, business quality and management capability. We believe that not all owner-managers are created equal. We feel some look after minority shareholders better than others and/or their businesses fail our quality test. As mentioned, ABC Learning and Babcock & Brown were two high-profile situations where shareholders lost all their money. Both companies failed Airlie's test on financial strength. Further, we have excluded some business models (notably the buy-now-pay-later space) where we feel there is a question mark around sustainable profits. Note that the exclusion of AfterPay penalises our notional index performance.

So, taking our investment process filters and looking 10 years over the performance of owner�'managed businesses versus the broad market:

Source: Macquarie Equities, Airlie

So, 10 years ago $10,000 invested in Airlie's notional owner-managed index (purple line) is worth $60,000 while $10,000 invested in the market is worth about $30,000. Of the 70 owner-managed companies that make up this notional index, the strong performers include: Fortescue, ResMed, Goodman Group, Mineral Resources, and Northern Star. To be clear, we have not owned all of these companies in our funds over the years. Although it is pretty evident to us now that our performance would have been enhanced if we had! The poorer performers include: Monadelphous, Nufarm, Freedom Foods, and Oroton. We have not held any of those companies in the fund.

The small-cap effect is evident when we split our notional index into two market cap groupings. So, the bigger companies (purple) versus the smaller ones (green):

Source: Macquarie Equities, Airlie

The conclusion we draw is that the owner-managed model is immensely powerful in a small company, where the success factors of owner-managers can be leveraged into truly remarkable results. Examples in our fund include ARB Corporation, Premier Investments, Nick Scali, PWR Holdings and of, course, Reece. So going back to years ago when I was allocated Reece to analyse, the market capitalisation was less than $250 million. With a market cap of nearly $9 billion today, Reece remains the poster child for the power of backing the right owner.

Author: Matt Williams, Portfolio Manager

Funds operated by this manager:

Airlie Australian Share Fund

Important Information: Units in the fund(s) referred to herein are issued by Magellan Asset Management Limited (ABN 31 120 593 946, AFS Licence No. 304 301) trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation. This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Airlie makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Airlie. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any third party trademarks contained herein are the property of their respective owners and Airlie claims no ownership in, nor any affiliation with, such trademarks. Any third party trademarks that appear in this material are used for information purposes and only to identify the company names or brands of their respective owners. No affiliation, sponsorship or endorsement should be inferred from the use of these trademarks.. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Airlie.

4D podcast: interest rates, inflation and infrastructure

4D Infrastructure

August 2022

Funds operated by this manager:

The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader.

Is the sky really falling in?

Insync Fund Managers

July 2022

A different message for the year's mid-point...

Each month we show how we invest practically by focusing on a Megatrend, then one or two stock examples in support. Given we are halfway through the year and with so much negativity about after the last 5 months of stock price volatility, we thought a closer look at these negatives is warranted.
 
We will assume you are already well versed with 'the sky is falling in' commentary and opinion from elsewhere. All good decisions however come from looking at both sides.

Negativity Bias: We notice the bad far more than the good. It's why commentators lead with bad news. It gets our attention.

Cognitive Bias: We're more aware of, and seek out, information supporting our view or assessment, even if we can't point to why we have that view. As an extension, we often then block or discount information to the contrary.

Time bias: The immediate and near term has a greater weighting in how we respond than further out; even if it is counterproductive to achieving what we are seeking.

Straight Line Bias: We assume most lines and trends will continue as they are now, unabated. For example, today's inflation rate combined with negative headlines is interpreted as inflation will keep increasing.
Fear Bias: We tend to emphasise and process negative information ahead of positive information. So much so that positive news is often received with cynicism or suspicion. Fear beats positivity every time.

Inflation, recession, high interest rates.......

Commentators have espoused many things in the last 5 months, the general message swinging between ongoing crippling inflation, high interest rates, and recession. We have noticed 5 common assertions they often use, and for our investors benefit we felt it worthwhile examining each one carefully. What we discovered may surprise you, and so, remember those 5 genetic biases.

The inference is that investing in growth assets will be a risky decision and thus growth managers will face hard times. As a Quality Style manager, we are not convinced of these inferences, as what we found suggests otherwise. The details behind our reasoning can be found in our recent White Paper on this subject (on our website).

Common Assertion 1: Carbon prices will continue to rise.

• Supplies globally can easily meet demand (the potential temporary exception of gas to Europe accepted). OPEC sees oil and gas price pressures as 'transient', and not worth the expense or risk of lifting output creating oversupply.
• Net Carbon Demand continues to drop as Oil Intensity in our economies also falls (has been for the last 15 years).
• The Russian war will end, with bad news outcomes mostly factored into its price already.
• Longer term, carbon demand growth overall will be offset by green energy, emerging energy storage solutions and shrinking populations in developed nations.
• Scant evidence supports a sustained price rise above the present US $100-$120/ barrel trading range, especially as the US reopens shale extraction.

 
Given this, prices are not likely to either significantly increase or decrease. As carbon energy is the PRIMARY driver of key inflationary factors, should it trade around where it is now, it will fail to drive inflation further.

The red line in the graph shows the general basket of major commodities. They too are falling and earlier than carbon energy has. Indeed, this might not only point to a fall in inflation but to the prospects of a recession. We will address that further on.

Common Assertion 2: Global shipping supply chains are crippled and expensive.

The problem with this is that shipping capacity and efficiency is rapidly improving and prices are falling. These facts and more below.

• Next 2 years the equivalent of an additional 25% of all TEUs (6 Mn+ 20ft containers) shipping capacity in the world today will enter the water.
• Those ships are bigger and more efficient. They consume less fuel per TEU, with a very large proportion of new ships over a whopping 14,000 TEUs in size. (the largest carries 21,000 containers)
• Bottle necks are evaporating as a vaccine driven Covid BAU takes hold.
• Container costs have averaged under $2k/TEU for over a decade - Covid increased this temporarily to $10k/TEU at its peak last October.
• It's now already falling DESPITE high fuel costs.

Covid is an event based disruption- not permanent. Life resumes, blockages unblock. This is already occurring.

Common assertion 3: Reshoring back to the West means higher prices

A UBS survey of American CEOs had 90%+ intending to move production away from China. Already 6 massive multibillion dollar chip manufacturing plants are already underway in Texas and Arizona. It comes down to what's being re-shored. Goods being re-shored are mainly higher value/complex goods (e.g. technology intensive). Let's look at some further current facts:
 

• Multiple US tariff wars, Covid, Taiwan, Hong Kong, and now Russia - CEOs are adjusting their risk/reward calculations en masse. (There's been exponential increases in both the number of corporations both acting and planning moves).
• Re-shored goods by in large face lower transportation costs and delays, and less logistical complexity.
• Higher technology inputs utilising higher skilled labour means wage price differentials are less than previously assumed in financial models.
•  White goods are already being made in the US at prices as if they were made in China (Ironically in one example Haier from China is the plant owner)
• Automation of new plants is reducing manufacturing- based wage pressures.
• No one is yet certain how much will return to major consumption centres (beyond strategic goods such as chip manufacturing and rare-earth mining) but indications are clear that it's a significant amount.

 
There are emerging spin-off benefits, not previously factored in, that offset nearshoring or reshoring costs; for example massive construction activity for rehousing all this manufacturing, along with the support industries providing the new equipment for them. US facility construction soared 116% in the last year, dwarfing the 10% gain on all other construction combined.
 
This move may will assist western economies increased resilience to geo-political events of the future (meaning more stable prices and supply).
 
Common assertion 4: The US economy is faltering, and now from the Russian war, the EU is too.

There are several arguments entwined in this, and so we shall try to be brief, knowing we have a fuller answer contained in our White Paper.

That red circle in the graph shows a critical historical disparity. The market has overshot the negative and is out of kilter with the 300 odd critical US businesses purchasing managers that this reliable benchmark survey covers. Investors are already expecting the US economy to contract, yet importantly not to the extent that it did during the pandemic, the GFC or the 2000 recession.

Despite all the news headlines, US hourly wage growth is exceeding the inflation of goods and services (ex food and energy). Real wages are growing at (a moderate) 1.7% pace, maintaining a healthy demand for labour and not too much of a concern for the Federal Reserve. Given the low labour participation rate, there is little chance that we see wages driving inflation. This is what would concern the Federal Reserve, as unit labour cost growth is the real source of endemic inflation.
 

Until the Russian war ends the EU is in for a bumpy ride- short term no doubt, but there will be positive surprises as is already evident.

Common assertion 5: Ever increasing interest rates.

Bond markets basically set the future of interest rates and particularly in the US. So, let's take a closer look at what they are telling us. Their expectations after allowing for inflation, energy and commodities prices, geopolitics etc. says the next 5 years will top at 2.55% and the 5yr-10yr expectation at 2.14%.

Let's say that again... 2.55% and 2.14%.

From this we can gauge the expectations for 10 years which currently stands at 2.35%.

Clearly interest rate rise expectations, are actually rapidly declining. This has implications for how much more the Federal Reserve is likely to tighten. Whilst there is sound basis to argue that the Fed Fund Rate is too low, it is unlikely to be lifted more than 3.5% due to the combined effect of slowing GDP growth and peaking shorter term inflationary expectations. Long term inflation averages a little over 3%, yet in the last 10 or so years, we got used to a once in a lifetime decade of ultra- low rates. Life, markets, consumers and companies adjust. This level of inflation is not bad for growth assets.

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

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