The strategy behind Australian Eagle’s high-altitude returns
Vesna Poljak Markets Editor
May 19, 2019 — 11.59pm
As scholars of business would know, the former booze giant Foster’s spent more than $6 billion building the wine business known today as Treasury Wine Estates.
And as legend would have it, Treasury was worth only half as much when it was floated in 2011.
“Earnings weren’t going anywhere, they were having problems in the US, they were having problems in Europe. The company itself – the margins had halved from when we first looked at it,” fund manager Sean Sequeira recalls.
Australian Eagle Asset Management, which used to be Alleron, went long Treasury shares at $4. The way Sequeira saw it, the downside was limited: it had only $300 million of debt and a small but dazzling source of growth.
“What we did see is they had 30-plus per cent volume growth in Asia, which they said was China, basically … they had 5 per cent of their volume going into there, so it’s only tiny, but 5 per cent of the volume was producing 25 per cent of earnings,” he said.
There was a new chief executive, Michael Clarke, who articulated a strategy for improving margin. Although Sequeira’s entry price looked shrewd with the benefit of hindsight, Australian Eagle took only a small position in Treasury to start with.
Sequeira built upon this as further results confirmed the thesis that focusing on Asia would lead to margin growth across the company.
“If you’ve got a widget and you’ve got more demand, you just produce more widgets. A wine company, at the time they had 32 million cases. You’ve only got 32 million cases. Every year. Unless you start planting a hell of a lot, or buy at that time, you’ve only got 32 million cases,” he said.
“If you’ve got demand in one area you can create scarcity in the others by just pulling volume from there and that’s what they ended up doing.” Treasury stock closed at $15.64 on Friday.
Sequeira cites Treasury to explain Australian Eagle’s obsession with change. While it is regarded as a growth manager, and that is largely true, Sequeira is looking for something more specific and measurable than growth at any price.
“What we look for is when a company is turning from what would be considered by the market to be low quality, to a much higher quality company with growing earnings,” he explains. But quality alone is not enough.
“What we need, is what we call a trigger. People say, ‘you need a catalyst then’. No, a trigger specifically loads upon our thesis, so it actually says, ‘what am I looking at? What do we expect this company to change into?’ And if that is truly going to script, certain outcomes should be observable.”
Australian Eagle has a 14-year track record for its long-only strategy that has returned 3.8 per cent above market for 14 years, or 11.6 per cent after fees compared with the market’s 7.8 per cent.
It also developed a long-short strategy: after fees it has returned 19.7 per cent a year, on average, from July 1, 2016.
“We would say it was like fighting with one hand behind your back,” Sequeira says of long-only investing. “We’re still outperforming, we’re still doing well with one hand behind our back, but imagine with two?”
The thinking behind long-short rests again on the quality scoring, being long high-quality and short low-quality earners.
There is something about every business that we like.
— Sean Sequeira
“For anyone who says ‘I buy stocks that are undervalued’, that’s fine, do that, you’ve got minimal downside risk. And that’s what we would look for too. But it’s going to stay undervalued unless something changes and that’s the biggest thing that we look for.”
Caltex is a stock where Australian Eagle is short, but used to be long. “We got a massive uplift, bought it at $11, sold it at just under $40,” he says.
But two things stuck out: in 2015, Chevron sold down, and the company started distributing its franking credits.
“[Caltex CEO] Julian Segal’s fantastic, we followed him from Orica to [Incitec Pivot] and made a fortune in IPL because of him,” the fund manager says. “Despite him being very, very good, we do believe there’s not that much upside in here.”
Sequeira argues there’s more reliance upon refinery earnings under the updated Woolworths relationship. “More importantly, they are actually expanding into the convenience sector, buying back all of their franchises, the debt on the book is, we believe, way too high given the potential volatility of earnings.”
A short-seller, Sequeira is not trying to emulate the likes of VGI Partners by pursuing activist short targets. By running a 150-50 long-short strategy, he believes the portfolio will perform better in market downturns without being overly exposed to drawdown risk.
“In general if you have a stable growth rate, the market will price it well. When the growth rate is changing, we believe that’s where our niche is,” he says.
The Berkshire rule
Until 2007, QBE was one of the most highly rated insurers in the world. Frank O’Halloran had built a business based on niche insurance companies with an ability to price risk better than anyone else. But growth led it to areas where it had no competitive advantage.
“When anything happened globally, any catastrophe, anything at all, QBE would pay. So if you’re not earning above-average returns but you get the volatility, the value of each dollar of earnings has to go down and that’s what happened,” says Sequeira.
Again, a new CEO, Pat Regan, was an agent of change. He sold the problematic Latin American book for 1.4 times book value, got out of workers’ compensation in Asia and removed exposure to American personal lines.
Rising interest rates meant every 1 per cent increase was worth $US260 million ($378.7 million) to the bottom line off QBE’s $US26 billions of cash.
But the market was unconvinced, and QBE was languishing on 1.1 times book value.
“They just sold the problem child for 1.4 times book, and can I tell you, when we were looking at this a year prior, someone had asked Warren Buffett, ‘when would you buy your stock back?’ And he did say 1.2 times book, the [net tangible asset value]. Well this was 1.1 and it had cash as its investments.
“If he really wanted to – he didn’t need the cash but if he really wanted to – he could have had $US26 billion and paid 1.2 times. Everyone would have sold it to him.”
Sequeira still owns QBE.
See everyone, or see no one
Australian Eagle doesn’t go out and see management. “You are going to be influenced. That’s their job, that’s the reason they’re CEO; they got to the CEO position because they can sell themselves. Who am I to tell them about their business?” says Sequeira.
Growing up in the Western Sydney suburb of Pendle Hill in a working-class family, Sequeira wanted to be a petroleum engineer until he got a taste for financial markets working at Citibank after his year 12 exams.
Crossing over into investment management, he was mentored by Albert Hung, who is one of the founders of Australian Eagle and still a sounding board. Hung is also part of the portfolio construction team.
“You always have to believe you could well be wrong, you have to have the humility,” Sequeira says of his guiding instinct. And when he is wrong, he will exit a position rather than ruminate on it.
His memory for detail served him well when the portfolio added a long in Elders, a company he covered in 2001. Like everything he has ever covered, he maintains a model on it.
Fund manager Sean Sequeira maintains a model on every company he has ever covered.
Elders used to be a top 100 stock, but destruction of capital and a deviation from its core network of rural services nearly sent it to the wall.
“We saw the stock go from 30-odd cents up to $3, when we first bought it. What was suggesting that the company would go from $3 up to $8, $9 at one stage? What changed was they bought back the preference shares six months early. That indicated to us that cash flow was stronger than what was expected and that they were preparing to start to pay dividends.”
The fund manager still thinks there is “significant upside” from here because Elders is “doing pretty well” in an east coast drought.
“There is something about every business that we like,” he says. “We go back into the ’90s on certain companies.”
In plain sight
Design software company Altium is often spoken of as a member of the WAAAX club – WiseTech, Appen, Afterpay and Xero – but in fact the stock has been listed since 1999.
The company was close to maturity, but then the stock rocketed because Altium made a number of purchases that expanded its addressable market from $US500 million to an to an estimated $US9 billion.
“They found that 100,000 people were using [the product] in China and only 1000 were paying, and that’s normal for China, but [Altium] have to have a strategy for monetising that and they did,” the fund manager says.
Should it successfully build out its single ecosystem for designers, suppliers and manufacturers, “the stock is maybe worth a lot more”.
Similarly at Fortescue Metals Group, Sequeira is happy to maintain his long position because of the quality of cash flow and earnings. “If the current [iron ore] prices hold for Fortescue, the stock’s on 2.5, three times earnings. Obviously these are anomalous prices, but you don’t have much downside from here.”
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