3 stocking fillers for the grandkids

Financial journalist and commentator on 3AW and Sky Business
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Let’s say you’d like to start your grandchildren off with an investment in the stock market, with a stock or two in the Christmas stocking. Part of this strategy should be one of the index-tracking exchange-traded funds (ETFs) that aim to give an investor the long-term return of the market index (minus fees), such as the Vanguard Australian Shares Index ETF (VAS), or the iShares Core MSCI (Morgan Stanley Capital International) World All Cap ETF (IWLD), but part of it should also try to tap into some individual stocks that are capable of building wealth in a portfolio. Here are three prime candidates for a spot under the tree this year.

 1. CSL (CSL, $280.08)
Market capitalisation: $127.5 billion
Five-year total return: 28.6% a year
FY21 estimated yield: 1.3%, unfranked
FY21 estimated P/E: 34.7 times earnings
Analysts’ consensus valuation: $297.65 (Thomson Reuters), $274.84 (FN Arena)

Unfortunately, buying CSL now is not going to earn the return of someone buying it in its float (out of government ownership) in June 1994, at the equivalent of 77 cents. Nobody – least of all the Australian government – knew what CSL really was, and what it could be. But an exceptional management group did grasp what the company could be, and CSL has become a true global leader, the world’s largest maker of plasma-based therapies, a global leader in treatments for immunodeficiency and bleeding diseases such as haemophilia, and one of the world’s biggest suppliers of flu vaccines.

CSL buttresses its position by investing hugely in research and development to create new products, creating a pipeline of products that opens up new revenue streams and keeps the company ahead of competitors. It has also invested heavily in growing its network of plasma collection facilities, which keeps it at market-leader status in its immunoglobulin product speciality. Plasma supply can barely keep up with demand at the moment, and the emerging China market is a whole new factor – and CSL is a leading player in that market. CSL is superbly positioned to keep growing and creating shareholder value over the long term.

Along the journey from 77 cents to $280 in share price, CSL has consistently rewarded investors who buy it and watch it go higher. But its share-price trajectory has not been without the odd speed-bump – most recently, it lost nearly one-quarter of its value in late 2018. And it has often been the subject of argument over high price/earnings (P/E) ratio investment – where high P/Es can often indicate “expensive.” Over time CSL has traded at an average historical P/E of about 27 times earnings, meaning that it is hardly ever considered “cheap” – and it certainly doesn’t look cheap at the moment, trading on an historical (FY19) P/E of 35.6 times earnings and a prospective FY20 P/E, on analysts’ consensus estimates, of 41.4 times earnings.

There are two ways of looking at this. CSL almost routinely under-promises and over-delivers in terms of earnings. The quality of its franchise, balance sheet strength, outstanding track record of management and confidence in future earnings growth have justified a high P/E multiple through its listed life. With long experience of the stock, the market doesn’t really value CSL on its current earnings alone – it looks at the company’s suite of competitive advantages and its prospects for growth.

Having said that, like any stock, CSL is vulnerable to an occasional experience of P/E contraction, if the broader market turns down – and buying it now could easily see a capital loss, over a period of time.

But buying CSL for the grandchildren is a different matter. There you have working for you one of the best companies in its industry, with outstanding intellectual power driving significant growth prospects. Your grandchildren probably won’t get an investment that multiplies in value by 365 times – as CSL’s fortunate IPO subscribers have received – but they will have a stock that has grown in value by compounding its earnings, and its business growth.

2. Cochlear (COH, $229.85)
Market capitalisation: $13.3 billion
Five-year total return: 28.5% a year
FY21 estimated yield: 1.7%, fully franked
FY21 estimated P/E: 40.9 times earnings
Analysts’ consensus valuation: $200.00 (Thomson Reuters), $198.24 (FN Arena)

Global hearing-implant specialist Cochlear is another stock where its owner had no idea of its potential: it was floated at $2.50 in December 1995 by the Pacific Dunlop group. Seven years later, Pacific Dunlop was no more, but 24 years later, Cochlear is almost a “100-bagger,” trading at $230.30.

Today, the company holds more than two-thirds of the worldwide hearing implant market, with more than 550,000 devices sold since 1982, in more than 100 countries. Cochlear implants have been established as the global “standard of care” for children born with a severe-to-profound hearing loss, with high adoption rates across most developed countries. Cochlear is not the only company working in this field – it has intense competition – but like CSL, a big commitment to R&D at 12% of revenue (running at more than $180 million a year) and research keeps it at the front of the pack.

While cochlear implants (88% of revenue) are the bulk of the business, Cochlear is also a leader in bone conduction implants for people with conductive hearing loss, mixed hearing loss and single-sided deafness.

Despite selling all around the world, and established cochlear implants as the standard treatment in children, Cochlear has only scratched the surface of the potential market, with a clear growth path in adult populations. The company believes it has only penetrated 5% of its potential market. Cochlear implantation in older adults is increasing, as clinicians better understand how severe-to-profound hearing loss reduces a person’s ability to communicate and be socially engaged. Hearing loss is associated with an increase in anxiety and depression, reduced quality of life, and can result in poor lifetime economic outcomes – this makes Cochlear a clear candidate for the ESG (environmental, social and governance) investment revolution, as it grows its adult-market business.

At $230.30, COH is also trading at what looks like very high P/Es – on Thomson Reuters’ evaluation, 44.9 times FY19 historical earnings and 44.7 times forecast FY20 earnings; with that comes the risk of P/E contraction, and in fact, analysts see it as over-priced in the short term, with a consensus valuation of $200 (Thomson Reuters) and $198.24 (FN Arena). But we’re looking longer-term – Cochlear is a great Australian stock that will still be doing wonderful things when the grandchildren inherit the shareholding.

3. Altium (ALU, $35.92)
Market capitalisation: $4.7 billion
Five-year total return: 65% a year
FY21 estimated yield: 1.7%, unfranked
FY21 estimated P/E: 41.8 times earnings
Analysts’ consensus valuation: $37.93 (Thomson Reuters), $33.53 (FN Arena) 

Electronic printed circuit board (PCB) design software company Altium is one of the ASX’s genuine global technology stars – and it has the P/E to go with that status, at 59.1 times historical FY19 earnings and 54.2 times expected FY20 earnings.

Altium also has the growth prospects that go some way toward justifying such towering P/Es. Just this month Altium told the stock market that it expects revenue of between US$205 million– US$210 million in FY20, on an EBITDA margin between 37%–38%, up from 36.5% in FY19, and 35% in FY18. That implies a revenue rise of about 25% – Altium does not give net profit guidance, but from that, analysts are extrapolating for earnings per share (EPS) growth of about 20% in FY20, and 24% in FY21. FY19 was the eighth straight year in which Altium delivered double-digit revenue growth and grew its EBITDA profit margin, but the company was a victim of its own success, slightly missing analysts’ consensus estimates in terms of revenue and net profit growth.

However, Altium is sticking to its long-term target of delivering US$500 million in revenue from 100,000 subscribers by 2025 – at the end of FY19, it had 43,600 subscribers – and it also aims over the longer term to deliver a combined revenue and profit margin growth rate of more than 50%.

The market is starting to come around to that belief. Altium’s products are deeply embedded in the profound technological shifts we are experiencing, in the rise of forces such as cloud computing, big data, artificial intelligence (AI) and 5G. The PCB is at the heart of the burgeoning use of “smart” connected devices in everyday life – Altium says it is “committed to achieve market leadership to the point of being the dominant provider of PCB design software by 2025.”

Altium is moving up-market in its software suite and analysts think its growth opportunities – particularly in China – are huge. The China business reported 37% growth in revenue in FY19. Also impressive is that Altium is debt-free and ended FY19 with US$81 million ($116 million) of net cash on the balance sheet.

Given the pace of advances in technology that we have experienced in recent years, no-one is going to predict what sorts of things our grandchildren will take for granted – but Altium is very likely to be involved somewhere, for at least the foreseeable future, either independently or as part of a larger organisation that takes it over. Either way, the grandchildren’s portfolio should benefit.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.

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