16 Oct 2018
Quality or Value?
There has recently been discussion amongst the team at Castle Point about the category of an investment into the portfolio, Gale Pacific. We invest in both quality and value companies and the characteristics of these companies are generally quite different. See our previous article “Why long-term investing works…” for an explanation of the two different types of companies and why we think putting them together works so well in a portfolio.
Categorising the investment is important to us because it helps us keep a strong investment discipline, and equally important, it helps us understand when to sell it. In both quality and value investments we expect profit growth. However, in value opportunities the growth in profit is generally due to improving profitability from existing revenue. With quality companies, and especially mid-cap growing companies, we expect the extra profitability to come from revenue growth.
As a result, our sell discipline is very different for each of these categories. Value stocks should be bought cheap and sold when they are reasonably priced. Mid-cap growers can be bought reasonably-priced and are only sold if the price becomes excessive. We don’t like to re-categorise a company at a later date as that reeks of poor investment discipline.
Gale Pacific is an industrial fabrics business specialising in shade cloth. It started out as a highly innovative company, transforming from a small Australian knitting mill into a global enterprise with the introduction of the world’s first shade cloth knitting technology. However, as companies often do, Gale Pacific lost its way and tried to diversify through acquisition into products in which it had no competitive advantage.
A new CEO, Nick Pritchard, took over in 2013. He had previously worked for Gale Pacific, building the Cooleroo brand. He then moved to Newell and built the Irwin business for them in Australia, ultimately becoming Country Manager. Over his time at Newell he benefited from learning from a well-run, international company with plenty of management resources. He then returned to Gale Pacific, completely changed the executive team and refocused the business to its core competency of technically driven industrial fabrics. The business was in a bad way, customer relationships were stretched, and manufacturing and supply chains were inefficient.
It has taken longer than he expected to tidy the business up. This culminated in the company having to issue a profit warning just as he had hoped to show some positive results. The profit warning was largely due to matters outside of their control, being a cool US spring, currency, and raw material price fluctuations. Gale Pacific is currently out-of-favour and on undemanding valuation multiples, classic value attributes.
Gale Pacific also shows many of the characteristics that we would expect to see in a mid-cap-grower. The new management team appears to be high quality and is revitalizing the business with an emphasis on company culture and focused new product development. The industry in which it operates means that there is the potential for this business to materially grow revenues and become a much larger business than it is today.
Gale Pacific is unlikely to be a runaway price performer like some of the racier mid-cap-growth stocks, but it has the potential to be a steady long-term grower. Growth investor, Phillip Fisher, notes in his book, "Common stocks, uncommon profits", that the best growth company investment is one that is out-of-favour. Obviously, the best investment opportunity is a cheap quality company, but these opportunities are very rare. Our crystal ball is never limpid, but if our investment thesis proves correct Gale might cease to be cheap but quality will remain.