Identifying stock opportunities
Our portfolio construction process is done on a bottom-up stock basis, with each company researched and modelled by a sector analyst. Once an analyst has identified the potential for a thematic, like healthcare cost containment, they ask: “Is this thematic giving me a rising tide that lifts all boats in that thematic or is it something that will uniquely benefit only company X or company Y?”.
That is when skill as a sector analyst comes in. Analysts need to work out which stocks impacted by that theme best fulfil the four pillars of future quality criteria: quality of franchise, management, valuation and balance sheet.
Also important is casting a wide net in terms of research, analysis and taking advantage of the team’s collective experience. Ideas can come from anywhere and this was the case for the healthcare cost containment theme we identified, which built up organically from doing work around stocks like ICON, LabCorp and Phillips. As the analysis progressed with these stocks, the scale of the cost challenge facing global healthcare payers became increasingly obvious – as did a list of exciting companies that would help meet these issues head-on.
The US healthcare market is often a “proving ground” for new healthcare technologies; partly because they have the largest budgets to pay for them. The US already spends about 20 per cent of its GDP on healthcare, which is forecast to rise to 25 per cent over the next five years. While cost control is urgently needed, it can’t be at the expense of innovation.
One key area where new technologies are opening up even more meaningful savings is healthcare information technology. This takes many forms, from better managing patient health data, to enabling patients to be treated as well in their own homes as they are in hospital. Patients are becoming ever more engaged in their own care and payers are increasingly aware of the better health outcomes and lower costs delivered by this engagement. As a result, there is confidence in the long-term growth in truly connected healthcare.
The quest for future quality and an attractive valuation
Every stock that goes into the portfolio must have a path to attaining and sustaining a high cash return on investment. Our hurdle for this is 10 to 12 per cent. There are a lot of companies that can deliver a 10 to 12 per cent return for a couple of years if the economic wind is in their sails or pursue a very aggressive restructuring program. But if ultimately their industry structure or the franchise quality of that business isn’t strong enough to support that improvement or return in the medium to longer term, then they tend to disappear very quickly.
Empirical evidence shows that companies that get to 10 to 12 per cent and stay there, generate even stronger returns than businesses that started above that level and stayed there. Setting the bar here also gives the chance for those improving fundamentals businesses to come through. This represents roughly 25 per cent of our portfolio. Traditional quality growth managers probably wouldn’t own these businesses, but they give our portfolio a certain richness of opportunity.
We don’t spend too much time trying to gauge where companies are from a top-down perspective. Instead, we focus on stocks that have that franchise quality and management quality. That said, an attractive valuation is just as important – we won’t buy quality at any price. Cash flow-based metrics are essential, as companies that tend to look like the “next big thing” may be unable to fund themselves if the credit cycle turns against them.
China, particularly, is committing a lot of capital to healthcare, deploying newer technologies like artificial intelligence and machine learning to bridge the gap and become the global leader in research and development.
Key for us is trying to find the right investment opportunities to participate in because often those stocks in China are very aggressively valued, and there are challenges to be overcome in the due diligence process. We tend to wait until the technology is verified by real commercial application, and a tipping point has been reached in terms of profitability and cash generation.
It is at this point that returns typically move higher, and share prices follow returns.
Greig Bryson, portfolio manager, Global Equity, Nikko Asset Management
