Wallara is a bottom-up, active manager of Australian equities. Through our application of shareholder value analysis techniques we aim to identify stocks expected to deliver above average growth in shareholder value that we can purchase at a reasonable price.

The fundamental value of any company is the present value of its future cashflow stream, discounted at its cost of capital. Management can increase the future value of a company in two ways: by increasing the return generated from its existing assets or by investing capital in new assets that will generate a return above the cost of that capital.

Not surprisingly, investors are prepared to pay more for a dollar of high returning assets than for a dollar of low return assets. Therefore, every year a company can increase its return on assets, those underlying assets will rise in value, and this will be reflected by an increase in the shareprice. Practical ways management can increase returns is by lifting profit margins or by tighter management of capital.

The chart below shows a company that has steadily increased returns from 1993 to 2001. Over this period the shareprice has increased at a compound annual rate of 19%, compared with 6% for the S&P/ASX200 index.

The second way companies can create value for shareholders is through "profitable growth". By this we mean investing capital in new assets that will generate a return above the cost of that capital. The cost of capital can be thought of as the minimum level of return an investor demands from a company. That return will be influenced by alternative investment opportunities such as term deposits. If management can identify opportunities to invest in new projects that will generate a return greater than this "cost of capital", then this will create value for the investor. The charts below show the flat return profile of a company that has grown very strongly over the past several years (right hand chart). Because the return has consistently remained above the cost of capital, this company has achieved "profitable growth" which is value creating. In fact the shareprice has increased 22% p.a. over the last eight years, compared with 6% p.a. for the S&P/ASX200 index.

The principles of shareholder value analysis are soundly based on well established theories of economics and finance and, indeed, are widely used by senior corporate managers in Australia and overseas. The quotation from the 1995 Annual Report of Pioneer International illustrates this point.

"A prime focus will be the need to create value for shareholders. For that proposition to be effective, the corporation has to be positioned so that it earns the cost of capital, even at the low point of the business cycle."

At Wallara we use these same tools to identify share investments that will deliver superior returns for our clients.

PROCESS

The practical way we apply these techniques is explained in the three steps of our investment process.

STEP 1. - FUNDAMENTAL RESEARCH

The activity we spend most time on is detailed analysis of the performance and prospects of individual companies. In addition to financial analysis, this process also involves the study of the competitive position of the company within its industry, the outlook for that industry, and the appropriateness of the company’s stated strategy from a future value creation perspective. During this process we gain information from company publications and statutory reports, trade and business journals, stockbroker research, and, most importantly, direct contact with company management.

Once we have built up a solid understanding of a company, and have conviction in our forecasts of future financial performance, we then apply our shareholder value analysis techniques to calculate the returns generated by the business, its cost of capital, and its valuation each year.

The measure of return we use is called the Cashflow Return on Investment (CFROI). It involves many adjustments to remove distortions inherent in conventional financial accounting measures of return such as Return on Equity or Return on Capital Employed. For example, under current accounting standards, assets held under operating leases (ie. rented) do not appear on the balance sheet. For companies such as airlines, where the use of operating leases is common, this can make it difficult to assess underlying economic performance over time when there are changes in the proportion of total assets that are rented.

The objective of the CFROI calculation is to "level the performance measurement playing field", so that the true economic returns of each company can be judged consistently over time and across different industries.

The second element of our shareholder value analysis is to calculate the value of the company using a discounted cashflow methodology. This calculation uses historical actual financial results for past years and, of course, our forecasts for future years. An important test we apply is how well these historical valuation measures explain past shareprices. If, as shown in the chart below, the shareprice tracks our calculated valuations fairly closely, then we gain confidence that the valuation model is effective. This is an important issue – after all, if your valuation model cannot explain past shareprices with the benefit of hindsight, what hope is there to derive a future shareprice using an imperfect forecast?

This methodology explicitly takes into account the following factors: the return on investment being achieved by the company, the rate at which it is growing, its financial structure, its sustainable competitive advantage, the age of its assets, its size and its cost of capital.

The purpose of this research is to identify stocks that have strong future shareholder value creation potential and are reasonably priced by the sharemarket compared to our assessment of their current fair value. The characteristics of companies that rank strongly in this analysis include high sustainable competitive advantage, high return on investment, presence of low risk growth opportunities, strong balance sheet, and an understandable business model.

STEP 2. - BUY/SELL DISCIPLINE

Stocks are added to the portfolio if they rank relatively strongly against four key purchase criteria:

1. Management quality;
2. Trend in returns on investment;
3. Change in consensus earnings revisions; and
4. Degree of undervaluation, taking into account future value creation potential.

Stocks are sold when there is an adverse change in their outlook, the price has risen too far beyond our assessed valuation, or to make way for a better idea.

STEP 3. - PORTFOLIO CONSTRUCTION

Wallara portfolios are fairly concentrated to ensure only our best ideas are put to work, but without losing the risk reduction benefits of portfolio diversification. The number of holdings is between 25 and 30 and guidelines are applied to control risk by limiting the maximum and minimum exposure of the portfolio to individual stocks and selected sectors.