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“We are in a different world” where industry dynamics will drive returns

How sector analysis can deliver an enduring source of alpha

“We spend the majority of our research time on understanding industries,” explained Catherine Allfrey, portfolio manager of Wavestone Capital, when presenting to leading financial advisers at The Inside Network’s Equities Symposium in Perth last month. Investors have been faced with extremely challenging conditions amid a reversal of the 30-year interest rate tailwind, she said, and seeking any competitive edge is becoming more important by the day.

Wavestone’s approach to Australian equities is quite straightforward: it seeks to understand sectors better than anyone else, which ultimately assists with finding the best companies within those industries. “We take a five-year view and seek to understand where the best industries are to invest,” Allfrey said, with the singular aim of finding the “best compounders” within a diverse market of opportunities.

She highlighted the relative ease of investing for the last decade, supported by liquidity, strong economic growth, falling interest rates and relatively little geo-political risk, but suggested “we are in a different world” today, one in which the backdrop is a rising interest rate environment that has already had an impact on valuations.

  • Australia has clearly been among the biggest beneficiaries of the war in Ukraine, being a commodity producer, which has shielded the market thus far, but this unfortunately won’t last forever. One opportunity, though, lies in the abundance of duopolistic sectors and companies within the Australian economy and listed on the ASX.

    According to research undertaken by a Danish professor, the sweet spot for companies operating in duopolies is when one controls around 65 per cent of the market share. While it may have identical cost structures to smaller competitors, the sheer scale advantage means that returns on equity and to shareholders will be significantly higher.

    The first stage of the firm’s approach is to find “really strong industry structures and industry tailwinds supported by long-term trends”. For instance, this may be changing consumer behaviours, demographic shifts and the like. Once you know the market, Allfrey says, you then look for the dominant or growing players and assess their quality individually.

    Two current and classic examples are Cochlear and Qantas, both of which sit around the sweet spot of 65 per cent market share. One the one hand, you have a company that looks at its customer base 100 years into the future, and the other with significant barriers to entry. Both markets are expected to grow strongly, and both companies, Cochlear via a 12 per cent annual investment in R&D and Qantas through sheer scale, are set to reap the lion’s share of rewards.

    Other domestic examples including Bunnings, with a 70 per cent home improvement market share and Dan Murphy’s, part of the Endeavour Group which continues to expand following the spinoff from Woolworths. It isn’t all at the top end of town, however, with Allfrey and her team able to move into the mid- and smaller-cap sector, albeit with risk management controls capping smaller holdings at 2 per cent of the portfolio.

    While a rising tide is clearly a positive for companies operating in any given sector, it will only lift all boats to an extent, there will always be outsized winners and losers meaning stock selection is key. One such area that cannot be stressed enough is the key role that management plays in operating each of these businesses. Allfrey concluded by highlighting that “capital allocation is extremely important” and that in its discussions with management teams, its focus is on ensuring it understands that “money is precious” and are making the right decisions with shareholder capital. 

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