Healthy milk and baby formula company a2 Milk Company Ltd (ASX: A2M) has been my biggest winner of the past two years, returning an astonishing 464%. I thought it might be useful to revisit my process to look for lessons.
Why I bought a2 Milk:
The company's premise is that it offers healthy milk which is easier to digest and provides a variety of health benefits. While a2 is working on research to support these benefits (with some success), my view was that as long as people came to believe that its product was healthier, it did not matter whether it actually was. Already plenty of people eat things like kale, chia seeds, and almond milk, based on purported health benefits with no scientific evidence.
So, I thought that with an attractive premise and recognisable brand, a2 could claim market share in the milk + baby formula industry, while simultaneously charging higher prices and achieving higher margins. The company also had a lot of growth opportunity via its (then-unprofitable) ventures in the UK, USA, and China. Baby formula to China was also shaping up as a hot product, following the repeal of the one-child policy in late 2015.
Valuation:
I originally bought shares at $1.96, at which point I thought a2 was fully valued based on its ANZ business. I also thought that success in any of its three markets – China being a distinct possibility as the baby formula boom was in full swing at the time – would generate a lot of value beyond this price over the next 10 years.
Shares subsequently dropped to $1.41, where I doubled my stake in May 2016. One of the reasons I was confident enough to double down was that I liked everything I saw about a2, its product, its opportunity, management's salary and alignment, their strategy (outsourced manufacturing) and so on.
Fast-forward two years…
Problems at Bellamy's Australia Ltd (ASX: BAL) with its distribution and take-or-pay arrangements created a huge opportunity for a2, which the company capitalised on. A2 posted I think 5 profit upgrades in 2016, as the company swung from loss-making to profitable, and delivered further huge growth in 2017.
Along the way its earnings multiple expanded from a ~25x P/E at the time I purchased, and I sold a chunk of my shares at $5.50 as the company had grown to more than 20% of my portfolio. Most recently, punters have bid the company up to astonishing heights and I think it could be a while before a2 can exceed today's prices.
So what's the secret?
If you'd asked me in February 2016 or, indeed, most of last year, I would have told you that a2 Milk was the company I least expected to be a big winner in the near term, for two reasons. First is that I paid a high price for it, and second was that – even though it outsources manufacturing – it is still effectively a manufacturing company because it still indirectly suffers all the risks of managing inventory, disease in the a2 cow herds, possible manufacturing/supply issues. Other risks, like regulatory risk in China, were not to be sneezed at.
I thought the share price would likely go nowhere in the near future but grind substantially higher over the next 10 years as the company claimed market share and expand overseas. Instead I got a baby formula boom and a huge influx of eager investors bidding the company up to new heights.
Not a bad problem to have, all things considering, but I think that while a2 was a good purchase decision (given the business performance since then), it also experienced a fair bit of luck with competitors' problems and so on. As to the share price itself, I think it is predominantly just luck that it has risen so far so soon.
