Money Management: International equities, luxury goods and sticking to fundamentals

The bias of Australian financial advisers and their investors towards domestic equities is well documented.

At the same time, it doesn’t follow that this bias has been to their detriment, having enjoyed stable stock prices and relatively low market volatility in the past few years.

Quality Australian businesses have offered (and continue to offer) growing and sustainable earnings and returns to investors.

However, as the pool of superannuation money grows ever larger in Australia, financial advisers are increasingly aware that limiting the equity exposure of their clients to the relatively small Australian market is problematic.

On the other hand, overseas markets have a great deal to offer.

They have an exponentially larger universe of stocks, as well as a greater diversity in industries.

The economies in which overseas businesses operate are bigger and more diverse than ours, often with higher growth potential.

Internationally-based companies frequently offer superior economics and scale, and therefore better long-term growth pathways – all of which translates into better and more predictable long-term earnings growth and better overall long-term returns to investors.

So why has accessing these markets historically been problematic?

The rise of technology and its effect on investment

One of the recurring problems faced by advisers and their clients considering overseas investment has always been the challenges of accessing these markets.

In addition to the technical issues associated with buying and selling stocks in a foreign country and currency, a lack of in-depth, reliable information has meant that judging the quality of businesses has been very difficult.

Our geographical location at the end of the world and the time difference alone have meant that investors on the spot have had the advantage.

Which in turn have meant that Australian financial advisers and investors who do want exposure to international equities have been forced to choose foreign investment managers.

The good news is that technology has revolutionalised the approach to investing. And in many ways, as the world becomes larger, it is also becoming smaller and more accessible.

Australia’s physical location is not the barrier to investment it once was, and Australian investors now have the ability to trade and access information 24 hours a day.

This doesn’t mean it’s no longer important to travel to overseas markets, and to talk to company management face-to-face, but it does mean that an investment manager’s ability to access the information needed to identify quality, growth businesses here and overseas is better than ever before.

The result has been a new world of opportunity for Australian equity investment managers, who can now access numerous opportunities globally, and research them thoroughly.

This is one of the reasons that Hyperion made the decision to create a global equities fund to identify and invest in global stocks, applying the same proven bottom-up quality-focused investment process which has paid dividends for investors in Australia.

The reality for us is that (with a few exceptions) we believe global companies are of a higher quality than their Australian counterparts and, in many cases, better from a relative value perspective.

At the moment, five-year forecasts are higher, and predictability of future earnings stronger – which translates into good returns for investors, with relatively lower levels of risk.

Luxury goods, benefiting from significant social tailwinds

When we are looking to identify the stocks likely to offer the highest share price appreciation potential over a five to ten-year time horizon, we act like business owners with a long-term view.

At the moment, one of the sectors we particularly like is luxury goods. This is because we see significant tailwinds for the sector in the growth of the Chinese and Indian economies and the rise of the middle class – and its demand for luxury goods.

However, our investment process is successful only if we are able to identify which luxury good businesses are high quality, and which are not.

For us, quality depends on a business’ ability to grow; the size (and growth potential) of its addressable markets; low debt levels; and the predictability of its medium to long-term earnings streams.

Two such companies are French high-fashion house Hermes, and Italian car manufacturer Ferrari.

Both have been around for the long haul – Hermes since 1837, and Ferrari since 1947.

And unlike some of their competitors, both have eschewed offshore manufacturing for home factories, where they have end-to-end control of the high quality their brands rely on.

Both Hermes and Ferrari have strong brand equity which translates into better pricing power than many of their competitors.

Both produce items which are considered significant status symbols, and their strategy of strictly limiting supply has seen demand for their products fair well, even during the Global Financial Crisis (GFC).

After the GFC, Ferrari sales fell a tiny four per cent, compared with other ultra-luxury cars (except Lamborghini), which fell 40 per cent over the same period.

The typical wait for a Ferrari is between 18-24 months, and they hold their re-sale value better than their competitors. After three years, a Ferrari typically retains 93 per cent of its value, and will actually increase in value after 20 years.

The power of the Ferrari brand means that its competitive position in its market is secure, its pricing power will not diminish, and its capacity to profit from growth in demand is second-to-none.

And, in our view, Ferrari’s target markets (in particular Asia) remain underpenetrated, meaning there is still good capacity for growth.

Hermes has a similar story, and a similar business model.

When President Xi Jinping began implementing anti-corruption reform in China in 2012, the crackdown on gift-giving to public officials saw a significant drop in retail sales generally, and in sales of luxury goods in particular.

As a result, 2013 was a difficult year for many luxury retailers in China – growth in sales fell from seven per cent in 2012 to two per cent in 2013, according to a report by Bain & Co. And the average spend of China’s high-net-worth individuals also decreased significantly.

Yet against this backdrop of difficult retail conditions and falling sales of luxury goods, Hermes was one of the few companies not affected, and was in fact able to grow sales by 16 per cent.

Ultimately, the business fundamentals which drive earnings and shareholder returns over time are the same for all businesses, whether they are global or domestic.

However, given the larger, more diverse economies, bigger addressable markets and strong five-year earnings forecasts, quality international equities make a sensible addition to a balanced portfolio.

This article was written for and originally published in Money Management

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