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Sebastian Evans
Expert
+ About Sebastian Evans

Sebastian Evans is the Managing Director and Chief Investment Officer of NAOS Asset Management Limited, and has been with NAOS for 10 years, predominantly investing in Australian Emerging Companies through two Listed Investment Company (LIC) vehicles; NAOS Emerging Opportunities Company Limited (ASX: NCC) and NAOS Absolute Opportunities Company Limited (ASX: NAC).

The power of valuations

Thursday, July 06, 2017

By Sebastian Evans

Investors often talk about the potential for companies to grow earnings and the effect this has on a company’s value over the long term. We would argue that factors which may contribute to a price earnings (P/E) multiple re-rating can be even more powerful as a valuation tool. The following scenario explains why the P/E applied is such a key variable when valuing a company. 

Valuation Scenario 

  • Company A has earnings per share (EPS) of $0.10 and is valued today at $1.20, the P/E is thus 12 times earnings.
  • If we assume that this company can grow its earnings at a compounded rate of 5% p.a. for the next three years then the earnings per share would be $0.116.
  • Assuming the P/E held constant at 12 times earnings, the subsequent share price would be $1.39 at the end of year three.
  • If we apply a larger multiple of 16 times earnings compared to the original 12 times earnings at the end of year three, you can see in the chart below that this causes a significant share price re-rating from $1.39 to $1.86.

  • The three year per annum return profile for Company A with no change in P/E would be 5.07% compared to 15.65% with an increase in P/E to 16 times earnings.

The key variable from the equation above is what P/E Company A should be valued at rather than what the EPS will be at the end of year three.

Based on the above, it is clear that most of the leverage in a company’s valuation is within the multiple that an investor is willing to pay for a company’s earnings stream at a point of time in the future. A company’s P/E can be dependent upon a range of subjective factors such as industry backdrop, reputation of management, consistency of earnings and industry consolidation along with many others.

 

A good example of this occurring within the market is a company called Service Stream (ASX: SSM). In FY2015 SSM had an EPS of $0.03 and a share price of circa $0.40. This implies a P/E of slightly over 13 times earnings. For FY2017 SSM has guided for EPS of $0.07 per share and the share price today is $1.31 which implies a P/E of almost 19 times earnings. 

At a broad level, the SSM business has not changed considerably over the past three years, it has three business divisions and is mainly a contracting business with a focus on the telecommunications and utility industries. Interestingly even the revenue profile of the business has not changed dramatically, which in FY2015 was $411 million and in FY2017 is expected to be $497 million. 

So what has led to the re-rating in the P/E of SSM? In our view three main factors: Firstly, the debt profile of the business has decreased significantly due to management’s focus on cash flow generation. Secondly, a new management team which has met and exceeded market expectations consistently. Finally, the industry tailwinds for demand in SSM’s services driven by the rollout of the National Broad Band Network (NBN). 

Clearly investing in such a business three years ago would have presented any investor with a number of potential risks but as the results show, the risk adjusted return profile has more than compensated any investor, and as such investors are now comfortable applying a higher P/E ratio when valuing this company.

NAOS try to invest in companies with characteristics similar to those of SSM, namely an existing revenue profile, a strong balance sheet, lack of broker or wider market coverage and potentially a new management team that has been in the role for 12-24 months, as these factors often lead to a potential P/E re-rating by the wider market and resultant share price appreciation.

This is a sponsored article from Naos Asset Management.

This article is general information, it is not intended as financial advice and does not consider the circumstances or investment needs of any individual.

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The characteristics of a true active fund manager

Wednesday, May 31, 2017

By Sebastian Evans

There has been much debate of late about the benefits and shortfalls of active vs. passive portfolio management. This article will not highlight the benefits of either argument, but instead highlight what investors should look for in a truly active managed fund. One key point is that many fund managers who market themselves as active, and thus have a higher fee structure, do not do themselves and their peers any favours as their underlying portfolios are much more inclined to that of their passive counterparts. Investors should consider the following when looking for genuine exposure to an actively managed product.

1. How many individual stock positions does the portfolio hold?

Many investors believe that that the more stocks that a portfolio holds, the lower the level of risk within the portfolio due to increased diversification. While this may be true, the effect on return is that, over time, you will achieve a return that is very close to that of the equity index in which the portfolio is invested in. More investors need to focus on risk as well as return.

Studies have shown that to achieve a balance of risk and return, the ideal number of holdings is between 10-20 individual positions. The challenge for fund managers is that it increases the pressure on the investment process and philosophy, as any significant price movements are magnified both up and down.

2. Can the portfolio hold a significant amount of cash?

The terms defensive stocks and cyclical stocks are often in fashion when the macro environment dictates what a portfolio manager holds. However, if a market is overvalued, often the best hedge for any investor is cash, and not a defensive set of stocks. There is little advantage is owning a stock that goes down less than its peers if it still produces a negative absolute return.

3. Is the portfolio benchmarked to an equity index?

Many investors would want and have exposure to active funds benchmarked to the ASX 200. Approximately 38% of the ASX 200 is within the Big Four banks, Telstra, BHP and RIO. This quite often means that any active manager that is benchmarked to the ASX 200 will likely have 30-45% of their portfolio within these seven stocks, regardless of whether or not their research suggests that these stocks would provide a positive absolute return over the next one to three years.

For any manager that is benchmarked to an equity index, is it a respectable result for them to be down -5% if the benchmark is down -8%. Could this return have been better for investors if the portfolio manager was not as focused on index returns? To highlight this point further, Telstra was circa 4% of the ASX 200 index in July 2015, and has returned negative -24% before dividends since then. It cannot be said that an ‘active’ manager who was underweight Telstra, but still owned the stock, has truly outperformed.

4. Are the Funds under Management (FUM) ideal for the portfolio’s investment universe?

Finally, fund managers are often victims of their own success. If their respective funds generate superior risk-adjusted returns, this often leads to increased investor awareness and capital inflows from new investors. This increased FUM profile can place a significant amount of strain on the investment management team and the investment process that proved so successful previously.

A fund that was invested $100 million in small companies can often be running $500 million to even $1 billion within the same investment universe. What this often leads to is the necessity to hold more liquid positions (larger companies) which are often more efficiently priced, and also hold a greater number of positions which can lead to lower quality investments. The outcome of this is often overall lower performance to that of when the fund size was small and more appropriately sized for the desired investment universe.

It is true that an actively managed portfolio will not be for every investor, but a product with the right structure and attributes, together with a long-term investment horizon, can lead to significant outperformance over time.

This is a sponsored article from Naos Asset Management.

Disclosure: The two listed investment companies (‘LIC’s’) that Naos Asset Management manage, being the Naos Emerging Opportunities Company (ASX: NCC) and the Naos Absolute Opportunities Company Limited (ASX: NAC), both hold less than 20 stocks each and can have cash weightings of up to 100%.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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