Two key themes emerged in the 2014 reporting season that many companies attributed to adverse performance: an unseasonably warm winter and weaker consumer confidence after the Federal Budget. Some even cited a combination of the two.
It was easy to relate to this commentary, as autumn and much of winter felt quite warm and there was plenty of negative media interest surrounding the tough budget. But as investors, it’s important to understand if those companies were using temporary issues as an excuse for structural pressures. This concept may seem obvious, but how often is it applied in practice?
Companies always face challenges
Every reporting season is defined by challenges, such as weather, tough budgets, poor consumer sentiment, the threat of higher interest rates, rising unemployment, lower commodity prices, a strong Australian dollar, increased regulation – the list goes on.
But if you held or bought shares in a company after considering that a challenging environment was temporary, did you follow up in subsequent periods to ensure that the company’s operating performance returned to expectations? Or did the company point to another set of factors to explain itself, with no reference to previous commentary?
To illustrate, let’s delve into the commentary of previous periods to understand what challenging (but temporary) conditions were cited for underperformance. The commentary surrounding these market conditions was just as prolific as the unseasonable weather and tough budgetary concerns in FY14.
In 2013 it was claimed that consumers were cautious during the national election. In 2012, some companies pointed to the minority government, a slowing Chinese economy and European instability to justify their disappointing performance. In 2011, weaker conditions were caused by the carbon tax debate, uncertainty in international financial markets and domestic natural disasters. In 2010, the challenges took the form of abnormal weather and interest rate increases by the RBA.
While many of these events may seem like distant memories, they may have influenced your investment decisions. When viewed with an historical perspective, it can become apparent that temporary events may not be the underlying cause of multiple periods of disappointing results.
External factors versus sustainable competitive advantage
When a company continually attributes operational performance to external factors, it is an admission that it does not have a sustainable competitive advantage. This is much like a boat on the ocean, whose movement is dependent on the coming and going of the tide.
Whenever you buy shares in a company, you should believe the company will sustainably outperform the wider market. But how can you generate excess returns in the long run if a company continually references difficult external conditions?
Top fund managers strive to invest in companies with sustainable competitive advantages that can provide meaningful returns during most stages of the market cycle. While these companies are not immune to challenging market conditions, management will typically reference internal forces, rather than external forces, to justify returns.
The unseasonable weather and budgetary concerns from FY2014 will soon fade from company commentary and the market’s consciousness, and you can be sure that other challenging market conditions will present in the next reporting period for underperforming companies. We hope the moral of this article is more enduring.
Ben MacNevin is an Analyst at The Montgomery Fund.