Stocks to watch in an uncertain market: CSL

ST Wong, 9 February 2017

A defining investment theme for 2016 was unpredictable events and share markets. Everything seemed topsy-turvy. Forecasts were smashed, and investor behaviour seemed to change. Keynes’s famous ‘animal spirits’ apparently enlivened the market: this seemed especially true towards the end of last year when Donald Trump was elected the 45th US president, suddenly turning on a party for shares.

Well, not entirely true: investors raced to buy up ‘riskier’ or ‘value’ shares but they also raced to sell off ‘quality’ companies.

These events have created a particularly uncertain environment for investors. When quality is punished, risks unclear, and macro forecasts no better than a flip of the coin, what is the way forward?

Firstly, let’s avoid being too hung up on the macro picture – no-one can accurately forecast the macro future, a fact surely put beyond doubt by 2016’s Brexit and Trump surprises.

Instead, let’s focus on quality. In Australia, CSL is an example of a quality stock that sold off. We have followed and owned CSL for years. More recently, the health care sector has been in the headlines for reasons ranging from political controversy over drug pricing to Obamacare and so on.

Late last year, our fund performance was negatively impacted by CSL. It hurt. But we are pleased to see the company announce its FY17 profits are exceeding management’s expectations – possibly 7% to 10% better. CSL’s share price reacted positively to the news.

Each fund manager has their own investment process. At Prime Value, a key to our approach is to avoid making a ‘call’ on the macro environment, and then filling our boots to express that call. Instead, we look for companies that are well capitalised on the balance sheet and off; have the potential to compound earnings over three to five years; and are managed by teams aligned with outside minority shareholders like us.

CSL meets every tenet of our investment philosophy. (1) The balance sheet is strong and robust. Net debt to total capital has risen to 55% as of FY16, and will decline to 45% by FY19. Much of this improvement is the result of a highly cash-generative business that will produce cash from operations of approximately $1.5bn in FY17.

(2) From a compounding point of view, CSL continues to build value through investments in a long duration R&D pipeline. The benefit of having a strong cash flow position is allowing CSL to seek long-term opportunities from its platform. The company spent 10% revenue on R&D in FY16 and will increase to 10-11% over the next few years.

(3) CSL’s outlook is compelling. The company is currently benefitting from a gain in market share in plasma collection. This comes on the back of a decision to invest in infrastructure over the past few years. The company has a strong record of creating value from high margin products. We expect CSL to allocate appropriate investment capital if high value opportunities are identified. We talked about CSL’s cash flows earlier: this advantage gives CSL the ability to sustain new sources of revenue over the long term.