When is quality ever cheap?

When is quality ever cheap?

Perhaps one of the more challenging forms of value investing is deep value. Deep value is about buying troubled companies that are in need of restructuring or turnarounds, but the difficulty of course is that some turnarounds don’t turn.

We all want to buy high-­quality businesses, those with ­attractive economics, with a demonstrated track record and with bright prospects. The only challenge with this form of value investing is that quality is rarely available cheap.

Fortunately, however, even very high-quality businesses occasionally stumble and when they do, the markets can overreact by treating that which is temporary as permanent, sending the share price plunging. It is not unusual, however, for investors to take their cue from prices. For many investors, a plunging share price is not a signal to buy but a signal to panic, fear and worry.

Across the mid-cap and small- cap universe of Australian stocks, the last three months of 2016 produced a veritable smorgasbord of opportunity to value invest in quality businesses. A litany of companies saw share prices crash by 25-50 per cent in the quarter ending December 2016. And even high-quality businesses with bright prospects have been caught in this selected sell-off.

Healthscope

Take Healthscope, the operator of 45 private hospitals, whose shares were sold off by as much as 31 per cent from their recent highs amid concerns expectations of 10 per cent earnings before interest and tax growth were unachievable. Admittedly the company provided an update suggesting the hospital admissions for the September 2016 quarter were unusually volatile and weaker than expected, particularly in the month of September.

Looking back at the last 20 years of Australian surgical procedures, quarterly volatility is nothing unusual, but the trend is strongly positive. And this trend is unlikely to change given the largest contributing group to private hospital admissions is the 65-74 year-old cohort and the 85-plus cohort, which are also the fastest growing demographic cohort in the country.

Vita Group

Another company whose temporary setbacks are being treated as permanent is Vita Group, led by Maxine Horne. The largest licensee of Telstra stores announced a renegotiation with Telstra of their licensee revenue arrangements.

Although long-term benefits of the changes may accrue — and we believe they will — the market saw fit to sell first and ask questions later. The share price has declined 57 per cent from its highs. A value investor is rarely presented with the opportunity to back one of the country’s best retail merchants at such a price discount.

The recent experience of Vita Group and Healthscope is not unique and as sure as night follows day, the pendulum will swing back. How did the sell-off come about when the broader market in the three months to December 31 was improving for most stocks?

For some years the large funds management institutions have been underweight the banks and the mining resource companies — having expected little growth from those two sectors.

In order to boost returns, they drifted down the market capitalisation spectrum looking for high- quality mid-cap companies to invest in. More recently, however, their sentiment towards the banks and resource companies became more optimistic. In any event, being underweight meant additional buying and to fund those purchases, cash was extracted through the sale of mid-cap high quality growth companies.

Stock market investors like smooth lines. They believe earnings should grow every year, and by a steady amount. Any disturbance of this fairytale could trigger consternation. In the real world, business is not smooth. There are rival businesses and economic ­cycles, competitors to defend against, there’s changing consumer tastes, controllable and uncontrollable internal ructions, and a variety of inputs whose costs can change. But by definition, extraordinary businesses come good.

Quality and growth don’t stay cheap forever. Perhaps 2017 will be the year investors realise the growth prospects in mid-caps is better than for the banks and resource companies. Banks are about to hit a stone wall of rising ­financial stress among highly indebted apartment investors who cannot afford higher rates, much less rising vacancies, all while prices might begin to decline.

Montgomery owns shares in Vita Group and Healthscope.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.