03 September 2019

    Ghosts and Ghoulies and spilt milk

    Things that went bump in the night in August

    There were plenty of things that went bump in the night in August. When that happens deciding whether it is a temporary ill wind or a more serious “Ghostie”, to borrow from the well-known poem, is one of the keys to long-term investment success. I share some thoughts on how we go about separating the two.

    “From Ghoulies and Ghosties, and long-leggity Beasties, And all Things that go bump in the Night, Good Lord, deliver us.”

    There was too much interrupted sleep in August with frequent bumps in the night. The “bumps” ranged from big picture global concerns to a couple of poor results from key investments in our portfolios.

    Difficult markets and difficult investments pose questions that demand answers. The most important question is whether things have fundamentally changed for the worse, or is the bad news just a short term blip?

    Getting that answer right is critical. If things have fundamentally changed then exiting an investment or changing our exposure to an asset class might be the right call. If the bad news is a short-term blip then being brave, looking through the bad news, and adding to a position is often the right decision.  

    Over a savings lifetime difficult markets tend to be blips rather than permanent features

    Much of the news dominating headlines in August was about the broader economy or socio-political concerns. Trade wars, protests in Hong Kong, massive spikes in Argentinian bond yields and the ongoing Brexit negotiations, all fit into this category.  

    In my commentary last month I discussed our thoughts about the macro economy and how we think the investing environment will change over time.  Much of the news over August was consistent with the paradigm shift I outlined. It’s worth reading that piece if you didn’t get the chance.

    While it is always fun discussing the global economy, often the concerns of the day, the things we are all worrying about, tend to fade over time. The economic machine has powerful restorative forces that tend to push it back to equilibrium. Good times rarely last forever. Nor do bad times.

    I have seen plenty of both throughout my career. The exuberance of the tech boom of 2000 didn’t last. Similarly, the mid 90s emerging market mania cooled. The worst of times didn’t last either. In the depths of the GFC few would have thought the following decade would be as strong as it has been.

    There will always be things to worry about but often the most obvious concerns are the ones we should expend the least of our energy on. Time will heal them.

    Companies are different. Blips may point to fundamental weaknesses

    While the broader economy tends to be, as an economist would say, “mean reverting,” individual investments may not be.   An apparent short term blip is sometimes a symptom of a much deeper malaise.

    Companies being disrupted are a classic example of this. Just think about Sky TV in New Zealand. The company’s revenues peaked in 2016 as it began to get disrupted by internet TV.  Those first profit warnings in 2015 weren’t blips. They were hints at an existential crisis. The company’s share price went on to fall by 80%.  Paying attention and responding appropriately was important!

    In August, a2 Milk, New Zealand’s largest listed company and an important investment in our portfolios, had a poorly received profit announcement, highlighting that profit margins for next year would be a lower than the market had expected. The company’s share price fell by 18.9%.

    Asking the right questions

    Anytime a company disappoints we do a lot of research to determine if it is a short term blip or the start of a longer-term trend. Asking the right questions helps zero in on this. For a2 Milk, as would be the case in most situations, we focussed on three key things.

    • Do customers love the company’s product? a2’s most important customers are Chinese mums buying formula for their infants. So, for us, the most important gauge of whether customers still love the product is a2’s market share in China.  The good news is that for the six months ended June; market share accelerated at the fastest pace in almost two years.

      a2 also has an early stage business selling liquid milk into the US market. Revenue growth in liquid milk in the US accelerated from 140% growth in the 6 months ended December 2018 to around 175% for the six months ended June 2019.  Customers still love a2 Milk’s product! 

    • Is the moat intact?  We often talk about the idea of a moat. A moat is those attributes of a business that protect it from competition. In the case of a branded consumer goods product it is the strength of the firm’s brand and its distribution network that is the primary moat. We are, oddly enough, encouraged by a2’s profit announcement. The company’s margins of next year are depressed because it is investing more into brand and distribution. These are the very things that will widen its moat. This improves the business and makes us more confident about the future.

    • Has the growth runway changed? The ability of a company to grow its earnings, and hence its share price, is a function of the size of the market that it sells its products to.  Declining markets are rarely good for company growth. In the case of a2 we have no concerns that its market opportunity is at threat. If anything it is expanding. The liquid milk opportunity in the United States is getting traction and they are expanding the Chinese infant formula market away just babies towards older children. These initiatives speak to a rosy future.

    For us the short-term blip in a2 looks like an opportunity.  We have added to our investment in the company. I like to think of this bump in the night as more like a friendly ghost! Fingers crossed, but at least on a2 Milk, we think you can rest easy.