DNR Capital Australian Equities Income Portfolio manager Scott Kelly recently spoke to Financial Standard about how he determines what qualifies as quality.
Kelly begins by explaining the five factors DNR use to determine quality, adding that an additional sixth factor is reserved for its income portfolio. Industry structure and pricing competitiveness form the first of the six tests Kelly applies to his best ideas.
"The most important one is industry structure. Does the company have the ability to pass on pricing? How competitive is the market?" Kelly asks.
In addition the firm looks at a company's management and its history with the board, in particular how they are incentivised. It's a factor sure to come under further scrutiny after incentive structures in Australia's large financial institutions were placed under the microscope during the Royal Commission - an element of pressure that eventually forced ANZ to cull sales incentives for its financial planners.
Kelly then examines earnings momentum, balance sheets and ESG risks. He outlines ESG risk is central to decision making around stocks, but adds that not ticking one of the five boxes does not necessarily preclude an idea from making it into his portfolio.
"There is plenty of research out there to demonstrate that those companies that have (ESG) policies, that do it well, outperform those that don't," Kelly said.
"If one (idea) doesn't tick the box it doesn't mean it's 'uninvestable', it just means we'll do a lot more work around it."
The sixth factor allows Kelly to assess dividend sustainability. Investigations typically delve into the consistency of dividend policies at a company, as well as cash flow and capex metrics.
"It means we're really only looking at 60 or 70 companies in any detail at any point in time. That allows us with a team of seven to have about 10 to 12 stocks each that we are looking at in detail - whether it be modelling or talking to competitors," Kelly explains.
He adds that this typically means DNR's portfolios carry fewer companies, which is a direct result of the high conviction philosophy at work.
"The concentrated or high conviction nature of our philosophy means that out best idea will go into the portfolio. So rather than having a portfolio of 50 or 60 companies - which some fund managers have - we think that to give investors the best chance of outperforming is to have your best ideas in a concentrated way. Our internal target is around 15 to 30 companies," he said.
Kelly says that weighting allocations depend on the risk-return profile across the stocks.
"A couple of our biggest positions at the moment would be Brambles and Woolworths, which have been increasing. We feel as though the risks have been reducing but the valuation has remained compelling so we're happy to own more of them," Kelly said.