SG Hiscock: Has earnings growth disappeared on the ASX?

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The recent reporting season highlighted that earnings growth in the local sharemarket has been anything but certain, with many companies disappointing and the future remaining unclear. But it is possible to find companies with solid earnings growth, you just have to know where to look, says Callum Burns, SGH ICE Portfolio Manager, with SG Hiscock.

In the past financial year the earnings growth of the broad market (ASX 300 Accumulation Index) was negative 3 per cent, Mr Burns said.

“The weakness in earnings was primarily due to the challenges facing the Resources sector which experienced a 32 per cent fall in earnings. This was somewhat contained by Industrials which – excluding Banks and Property – delivered 9 per cent earnings growth, however only one third of this was driven by sustainable revenue growth. 

“The earnings outlook over the next 12 months for the market as a whole remains uncertain with our transitioning economy still trying to find its way.”

With uncertain times looming it is necessary to look further afield. However, the proposition of investing in the generally perceived ‘risky’ small cap stocks, those outside the top 100, may leave some investors hesitant to allocate to this space.

Although traditional wisdom has it that small caps are a riskier proposition than large caps, Mr Burns said this is not necessarily the case for all companies.

 “Being a large company does not automatically mean it is high quality. Equally, being a small company does not automatically mean it is high risk. There are many companies with good and sustainable long-term earnings growth that are outside the ASX 100. In fact many of Australia’s best companies reside outside the top 100.”

Mr Burns said the solid earnings growth of the companies within the SGH ICE portfolio over many years proves this is the case.

“While the market has struggled to grow earnings since the Global Financial Crisis the median growth in earnings of the portfolio holdings has been greater than 10 per cent a year. 

“The key to achieving this long term sustainable earnings growth, at an appropriate risk level, is to invest in companies that have a sustainable business franchise. That is, good quality companies, with a sustainable competitive advantage where it is difficult or inconvenient for clients to discontinue using the product or service.

 “These types of companies often have pricing power, and can increase their prices with minimum negative impact on the customer base.

“This investment approach is very different to that of most other Australian small cap fund managers but our experience is this approach offers investors an opportunity to generate strong returns over the medium to long term, while reducing some of the risk associated with the small cap sector.

“The majority of the companies displaying these characteristics are outside the top 100 and tend to deliver more certain earnings growth than those that don’t have the sustainable business franchise characteristics,” Mr Burns said.

As these opportunities are largely outside of the ASX 100, it can make it difficult for individual investors and advisers to monitor and evaluate them.

Eliza Weaving, General Manager, Funds Management Distribution Partners, with Equity Trustees, said the answer to the key question on how to access sustainable growth from the ASX is to use a managed fund with a proven record over the long term. She pointed to the example of the SGH ICE Fund.

“The Fund has returned 20.5 per cent a year in the three years to August 2015 and it has done so with a level of risk – as measured by standard deviation – of 8.9 per cent, which is low relative to its peers* .

“In fact it has been a top quartile performer across one, three, five and seven years to August 2015.

“The main tool of this funds management team comes from the quality of the companies it invests in – those with sustainable business franchises. The success of this approach is evidenced by robust and sustainable earnings growth delivered over many years by the SGH ICE portfolio companies and by the comparatively lower level of risk, as measured by standard deviation, taken to achieve its returns.”

Mr Burns said in addition to focussing solely on business franchises, the fund uses diversification as a key measure to help ensure the funds long-term returns are sustainable.

“One technique the SGH ICE Fund uses to help manage risk is to spread investment across companies and never hold too much of one company.  The fund invests in between 40-50 predominately small cap companies, and has never held more than 5 per cent of the portfolio in any one position for a meaningful period.”

Another way it manages risk is to invest in a range of companies that are in different phases on the lifecycle spectrum. “The fund typically invests around 60 per cent in growth companies, 25 per cent in peak cash flow companies and no more than 10 per cent in companies that are in the establishment phase.”

Another essential element however is to buy at the right price. “Paying too much for a company, no matter what its prospects, is never going to be a good investment,” Mr Burns concluded.

* Morningstar Direct

 

SG Hiscock & Company is a boutique investment manager established in 2001 and 100% owned by its staff. It has a broad range of funds and a mix of some of the largest wholesale clients in Australia. The customer base also includes a large number of high net worth and retail clients who predominantly invest through financial planners and platforms, and Equity Trustees as distribution partner.

Trusted since 1888, Equity Trustees Limited helps with the financial and emotional challenges of preserving, growing and transitioning wealth between generations. It provides a range of financial services to corporate and private clients including Wealth and Asset Management, Estate Planning and Administration, Philanthropy, Superannuation, Aged Care Advice and Placement.

Equity Trustees is a publicly listed company on the Australian Securities Exchange (ASX: EQT) with offices in Melbourne, Kew, Sydney, Brisbane and Perth.

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For more information please contact:

Callum Burns                                                                                   Eliza Weaving

SG Hiscock                                                                                       Equity Trustees

Phone: 03 9612 4650                                                                  Phone: 03 8623 5312

 

Equity Trustees Limited (‘EQT’) (ABN 46 004 031 298) AFSL 240975 is the Responsible Entity for the fund.  This publication provides general information only. 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. EQT do not express any view about the accuracy or completeness of information prepared by third parties.  Past performance should not be taken as an indicator of future performance.  In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. You should obtain a copy of the product disclosure statement before making a decision about whether to invest in this product.