A version of this article by Craig Shepherd, First Samuel’s CIO, appeared in a recent edition of Investment Matters (our Weekly blog). In view of the positive response to it from clients we thought there is merit in diving deeper into the topic and circulating it to a broader audience.
Q. Why invest in companies? A. Evolution
As an investment manager, and after pursuing a lifelong interest in companies, microeconomics, technology and innovation, I suspect that I am a little biased towards investing in companies rather than other financial assets.
However, it is during years such as FY-23 that some of the lesser appreciated aspects of equity investment can come to the fore. One of those aspects that I appreciate is adaption and evolution.
Consider purchasing a term deposit or a financial product such as a pension, or worse still a single house in a single street. These are surely all financial products similar to shares, and they may well prove profitable. But what you buy is what you get.
Companies, however, are organic creations.
Not in the Year 12 biology sense, but with complex systems armed with the ability, and frequently the necessity, to adapt. Often, the best place from which to drive change is from a position of incumbency and/or market power.
In periods of transition companies should outperform simple financial products.
Just some of the examples that come to mind from First Samuel’s core Australian shares sub-portfolio.
As little as a decade ago Worley was among the world’s leading oil & gas construction firms. Its future was aligned with the future of oil. But what Worley worked out is that the core skills of its nearly 50,000 strong worldwide team (of consultants, engineers, construction workers and data scientists) were solving complexity.
The sustainability projects of the future were fertile ground for Worley, so much so that, as at May 2023, 39% of Worley’s revenue is sourced from the delivery of sustainability-related projects globally. This percentage continues to grow, and the supply of such projects continues to expand; see chart, below.
Woolworths has had a central role in food retailing for many decades. Pessimists were concerned in the early 2000’s that the store-based business model, replete with magazine sales, stale fruit and vegetables, large carparks and limited home delivery, would be swallowed whole by new competitors.
Today, Woolworths has survived threats from Costco and ALDI and thrived, at the same time also building the leading online, ‘click and collect’, and wholesale solution in the industry. Its in-store offering has moved with ease with changes in customer preferences, and its store format has evolved, too.
From the provider and operator of processing equipment throughout the early 2000’s Mineral Resources used its considerable operational expertise to vault to its current position as a best-in-class mining service company.
Unlike the plethora of other mining services companies, Mineral Resources saw how the leverage that its operational ingenuity provided could be expanded to mine ownership and partnership models. This in turn provided the team with the incentive to invest in new resources and materials.
Its cooperative DNA, where for decades it established mutually beneficial relationships with mine owners, created a natural extension in energy and lithium. To date, it has proven to be the most canny at establishing key profitable relationships with global players that have sought a foothold in WA.
On some occasions a firm is well suited for change, insofar as its people and processes can easily adapt to new opportunities. In the case of Seven group and its owners, the Stokes family, the adaptive streak lay in the board, owners and senior management. Seven Group has over and above others in our opinion been able to redirect capital and resources into new profitable arenas for more than 30 years.
The wealth creating moves haven’t simply been a result of good fortune or good timing. But instead, the Seven Group’s ability to concentrate ownership of high-quality cash generative assets through the cycle. Many other firms either lack the discipline, or fail to resource their vision adequately.
This hasn’t been the case with Seven. Its value has been rewarded over the past year. Much of the increase in value it created was directly due to opportunities that mere financial investors had consistently failed to appreciate.
MMA Offshore was the proud owner of a vast fleet of boats at a time when global demand had dramatically weakened, and both the utilisation and value of the vessels had cratered. Instead of being a pure owner of these boats, investors in MMA Offshore were the owner of the team that managed these boats as well. This has been key – not just about the asset but the owner in charge of managing with adversity.
The team ultimately grasped the scenario, raised funds, wrote-off value, diversified revenues and literally battened down the hatches on its fleet of highly specialised marine vessels. The management team ensured that following a decade of weakened demand, it was well-placed for the opportunities ahead.
Today those opportunities have re-emerged, including an upsurge in demand and higher prices for ship rental. It is now competing for new projects globally, not only in traditional roles but increasingly in the development of sustainable options such as offshore wind.
Not so successful transitions
On the flip side, consider some of the companies that First Samuel clients have less exposure to, and are much more constrained by their culture, product range or external forces such as global demand or domestic interest rates.
Already protected by government in a near cartel, the banking industry is heavily regulated, slow to adapt and excessively profitable. From this position it is very difficult to adapt and seek out new opportunities.
BHP and RIO…
The downside of global dominance, in both iron ore (scale and cost) and copper (scale and cost) is the ability to nimbly adapt to changes in demand (both in quantity and types of demand) can be compromised.
On occasion this works in your favour, BHP and RIO had little idea that iron ore demand would explode with the growth of China in 2004, and they were handsomely rewarded by high iron ore prices. But this easy money has ultimately meant that neither BHP or RIO is well placed in the now emerging metals or materials. Neither has used its profits to diversify its earnings. In fact it has done the opposite. Actually, BHP has been less resilient in the face of success.
The problem with companies that breed stagnation is most evident in the extraordinary dedication its closest competitor Fortescue Metals is taking to innovation and investment through Fortescue Future Industries. Fortescue simply refuses to be the company that doesn’t change. BHP doesn’t even own a lithium mine.
Adaption and evolution are, of course, not without their pitfalls, as is apparent in some of the least successful positions in clients’ portfolios this year, including EarlyPay and TZ Limited. However, complex organic enterprises have the ability (not the certainty) to adapt and respond to pitfalls and mishaps.
We look forward to such adaption in FY-24. Otherwise, companies that are more adaptive will acquire the assets or the markets of those that are not.