The distortion has sharpened the sting of inequality and, aided by changes in the communications and media landscape, is driving political and social change. We believe we are in a new phase called the “war on inequality”, which is characterised by rising populism, regulation and redistribution.
The full implications of this are far from clear. Even so, we expect growing debate about where listed and private companies serve the public good and where they are over-reaching or don’t belong.
Another seismic change has been the rise of China and change in world order. The global financial crisis has aided China’s emergence as an economic superpower, and it is entering the next phase of its industrial modernisation to upgrade its economy through its Made in China 2025 policy.
We see it as akin to the US-Japanese relations in the 1970-80s when Japan emerged as an economic super power. In our view, the trade tensions and tariff wars reflect a broader structural and more permanent change, to which investors will have to become acclimatised.
Against these changes, central banks are on an exit path from quantitative easing, adding to the risk of higher rates and market volatility as liquidity is withdrawn.
If we are late cycle and the macro risks are rising, how do you navigate these from a portfolio perspective?
In talking about where we are in the market cycle, I think it’s important to recognise that the current cycle has been atypical for a couple of reasons. It has been a very long cycle, which in itself is unusual. What is particularly striking, however, is that equity market returns have been so strong despite weaker than average economic growth.
The aggressive policy settings by governments and central banks around the world have delivered low interest rates. Coupled with the more recent US Trump-inspired fiscal boost, this has had a dramatic effect in driving markets up through increased valuations, most pronounced in growth companies. Even where company earnings growth have been lower, the impact of zero interest rates and aggressive policy has driven up valuations.
The problem for investors is that higher valuations by their nature ultimately imply either greater risk of a correction or lower future returns.
The pull-back in markets in recent months has been on the back of escalating geo-political tensions as politics has taken over from central banks as the main driver of financial performance. More broadly, however, it likely also reflects a growing realisation that we have passed peak policy stimulus and profitability this cycle, resulting in a reassessment of valuation risks.
This stage in the cycle warrants exercising greater caution and trading off some growth for valuations that are less stretched, and at the same time building in a higher margin of safety than perhaps over the last few years.
Which sectors and stocks are likely to thrive in this environment?
While the present cycle is certainly mature, we continue to believe that if global growth remains positive but more moderate through 2019, stronger growth companies will remain appealing. The challenge facing investors is balancing the growth prospects of individual companies against low and rising interest rates, greater volatility and valuation risks.
It is important to recognise that the volatility in share prices we are seeing in many cases isn’t rooted in the fundamentals of the company. Rather, much of it is “noise” generated by trend-following algos and quant strategies that are distorting market moves.
Our approach is to focus on the fundamentals and look for companies that are still growing, are reinvesting in their businesses and are leveraged to attractive thematic end markets, but which are at a more reasonable price. The east coast infrastructure boom, China’s war on pollution and shift from to coal to gas and the fintech disruption of traditional banking are a few themes we are playing through the portfolio.
In a positive but lower growth environment, we also expect corporate simplification to become more of a trend. In the last 12 months the level of divestment and spin-off activity (as seen in BHP Billiton, Rio Tinto, AMP, Brambles, Wesfarmers and the major banks) has increased markedly.
While one needs to look at each case on its merits, history shows corporate simplification often provides opportunity for company-specific drivers to become more important and value to be unlocked for shareholders.
How big a risk for investors is misjudging valuations?
Understanding valuation and the quality of the franchise you are buying is absolutely critical. As they say, price is what you pay and value is what you get.
In the words of Benjamin Graham, of Intelligent Investor fame: “The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to ‘earning power’ and assume that prosperity is synonymous with safety.”
It is particularly at times like this – following a market correction in an already mature cycle – that it is important to heed these words. I have them taped to my computer screen as a constant reminder!
While the stock prices of many companies now look more attractive, more than ever there is a need to exercise caution and focus on the underlying quality of the businesses.
Past cycles and history are littered with examples of companies that have performed strongly, corrected, look attractive, recover some performance, but go on to flame out as the true quality (or, more to the point, low quality) of their businesses materialises and momentum turns. Some, like Babcock & Brown, flame out totally and are scorched in corporate memory, while others are never heard of again. Remember Davnet which boasted a market cap of $7 billion?
What’s been your best (personal) investment decision?
Probably taking a job at Arthur Anderson in corporate recovery. At the time I had just graduated from university and wasn’t entirely sure what I wanted to do. A friend was going to work on a mine in South Australia which I thought sounded like a good idea. My father shrewdly suggested I explore what other opportunities might be going before leaping in.
It was the early 1990s, Australia was in recession and insolvency practitioners were recruiting. I joined Arthur Andersen’s insolvency practice. It was a remarkable introduction to understanding business. It scorched in my psyche from an early stage the perils of debt, importance of cash and working capital and how to deal with a wide variety of people, often in quite difficult and distressed situations. It also provided a great opportunity to work abroad.
More than anything else it cultivated my interest for analysing businesses. This spawned my interest in becoming an equities analyst and joining JB Were and then eventually moving to funds management. If I trace it back, it all started with my decision to work in insolvency and not take the job on the mine.
What’s been your worst (personal) investment?
Selling shares I bought in the IPO of CSL to pay for shares in the Telstra 2 privatisation in 2000. At the time CSL had just decided to go offshore and acquire the ZLB operations of the Swiss blood bank and the shares were trading at $12 or $13. Having made around five to six times my money on the IPO and being sceptical about its initial offshore expansion plans, I thought I would bank my profits to help pay for the second instalment on my T2 shares.
The Telstra shares are still worth about what I paid for them and CSL is up more than 14 times – 1400 per cent! While it wasn’t sheep stations, it proved a valuable lesson from many perspectives.
What key lessons have you learned about markets and investing?
Managing your emotions and behavioural biases and having a disciplined approach to which you remain true are probably two of the most important lessons I’ve learned. It is not easy to do, particularly if you are being contrarian or underperforming for a period, but I would say they are the most important things in creating wealth over time.
The flow of information and noise these days is incessant. If you try and drink from the fire hydrant and digest everything, you are going to get knocked over and fail to focus on what’s important. To manage the deluge, it’s important to have a rigorous and repeatable process that helps filter out the noise and provides a framework for decision making.
This extends to not being distracted by the “fear of missing out”. Avoiding the latest and greatest idea may see you pass on some things that may turn out to be winners, but experience also suggests it helps avoid the madness of crowds and a fair share of howlers.
How do you relax?
I’m always reading or listening to podcasts or talking books – mostly non-fiction but a wide range of material including history, psychology, biographies, current affairs and business news. I think it’s important as an investor to have an innate curiosity to learn and read a broad subject matter, but if it’s what you enjoy doing, it certainly helps.
I also enjoy staying physically fit. Outside running, playing squash, the occasional game of golf and when not watching my children in their sporting endeavours, I look to get out in the country. I married a farmer and have reasonably strong ties to the land. We have a small farm which is a constant source of activity and a great escape. I can often be found on the ride-on mower listening to the footy (as a long suffering Carlton tragic) or a podcast.
My other great interest is fly fishing. I expect it may be the discipline of constantly assessing the landscape and thinking about the changing natural state, similar skills to what’s required in financial life, that got me hooked! Both require planning, patience and consistency to be successful, although I have to say the trips to the South Island of New Zealand to fish are more spectacular than company site visits.