Getting down to bottom-up thematics

Thematic investing is simply investing in companies which stand to financially benefit from a long-term trend or theme. These trends or themes are usually well identified and expected to continue for years to come, and include ageing populations, growing middle-class Asian populations and the growth of the internet (plus others).

The positioning of share portfolios to benefit from a thematic is a classic top-down investment approach. This “birds-eye-view” approach needs to be complemented with bottom-up investing skills to be truly effective. There are a range of companies with quite different business models vying to benefit from each of these thematics. These bottom-up stock picking skills include targeting the stronger business models and paying the right price for a security at the right point in time. They also involve identifying management and boards with the right vision, experience and skills to execute a sound business strategy.

The best exposure to a thematic is a company whose products and services have clear advantages over competitors. The more desirable companies have know-how and intellectual property embedded into their products and services. They typically have developed this expertise or domain knowledge over many years of continual investment.

This research and development spend creates legal and financial barriers for new competitors trying to enter the market. Ultimately it enables the company to extract high margins and a high return on equity. Other characteristics of stronger business models include a high percentage of recurring revenues, high gross profit margins and big sales engines.

The selection of early-stage desirable companies is primarily a qualitative process with less reliance placed on the current investment metrics. There are always pros and cons, and there are times when a leap of faith is required by investors. As a professional investor I have had the benefit of meeting with a lot of company management over the years and have taken the time to try to understand and compare the relative strengths of companies.

Aging populations

The aging of our population is one of the biggest trends occurring today. The over-65-years segment is expected to grow more than 150% between now and 2050, compared with less than 30% growth in the overall population.

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In theory investors should be able to tap into this thematic by investing into real-estate investment trusts that specialise in retirement villages. Retirement village investments in Australia have, however, been poor investments over recent years. The poor returns have been explained due to the industry being largely deferred management fee (DMF) based. The combination of a relatively immature retirement sector, the DMF structure and too much debt has resulted in poor investment returns. The point being that the existence of a thematic does not guarantee returns. Investors may be better rewarded by investing in more subtle and less capital intensive plays on the thematic such as medical service providers.

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The benefactors in the medical space could include medical service providers like Ramsay Health Care, Sonic Healthcare and Primary Health Care. Private hospital operator Ramsay Health Care has been immune to profit squeezes from governments to-date, while the pathology companies have been more vulnerable.  The blood products company CSL as well as medical device companies like sleep company ResMed and hearing company Cochlear should continue to benefit from this theme.

The ability of western economies to fund the sheer number of elderly will require new and innovative medical products and services that bring real financial savings to society. Investors with more risk appetite can explore some of the Australian biotech companies that are in the process of clinically validating and commercialising their respective technologies. Companies like Pharmaxis in the respiratory space and Sirtex in liver cancer treatment have good technologies and are selling product today. 

Feeding the growing Asian middle class

There are also some seemingly attractive investment themes that in reality are very difficult to access through stock exchange listed companies. This includes feeding the growing Asian middle class with animal proteins like milk, beef and lamb. This demand is growing, however the majority of corporate farmers, despite having large tangible assets, are often not big cash flow generators.

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The cash returns from farming are volatile year-to-year and relatively low compared with their land value. These high land values combined with weak cash flow don't lend themselves to stock exchange investors who like predictable earnings and growing dividends. Land has consistently appreciated over long periods of time and patient sharemarket investors can be rewarded as some Australian land still looks cheap on the international stage. However, investors may find better returns by investing in service providers to the agricultural sector.

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The growth of the internet and digital economy

The growth of the internet, the universal thirst for data and the outsourcing trends in information technology are changing our business landscape. The amount of data moving on various networks globally is expected to grow by nearly 30% per annum over the next five years. The big Australian listed internet companies in the key internet verticals of employment, real-estate, car sales and travel offer a far better service than traditional media ever did. The internet has quickly gained a massive audience, turning the media industry and increasingly the retail sector on its head with more structural change to come.

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The online service companies Seek, REA Group, Carsales.com, Wotif.com and Webjet have been great investments. The telecommunication companies, the internet service providers, hosting and data centre companies should also benefit from the growth of the internet. The less direct beneficiaries include logistic companies, but their services are further down the value chain and are more open to competition.

In summary, there are stronger and weaker ways to gain exposure to an investment thematic. The existence of a supportive top-down investment thematic is appealing but it doesn’t guarantee investment success. Investors should primarily be selecting companies according to the strength of their business models. Successful investments should stand on their own two feet today, and the existence of a supportive thematic trend or government policy should be seen as upside potential to the company valuation.

The investment successes of the likes of CSL, Cochlear, Computershare and ResMed supports investing into companies that have intellectual property and know-how embedded into their products and services.

Andy Gracey is portfolio manager at Australian Ethical Investment.