Ask a Fund manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In this edition, Prime Value portfolio manager Richard Ivers tells us how he picks the shares for his fund and how he sees the post-COVID-19 world playing out.
The Motley Fool: What’s your fund’s philosophy?
We’re effectively looking for companies that can grow their earnings sustainably over long periods of time. And then we use a valuation overlay to ensure that we’re not paying excessively.
Often companies become a little bit overvalued. If they’re growing, I don’t mind that too much.
We were the number one small cap fund in Australia in the financial year just finished under in the Mercer survey. So we did 18% and the market was down 11%, I think… And that was our first year in the survey as well.
Buying and selling
MF: What do you look at closely when considering buying a stock?
RI: I’m trying to generate a 10 to 15% return for our investors and we’re trying to do that over long periods of time. So the turnover in the portfolio is relatively low. We’re trying to find businesses that can compound their capital, compound our capital over 3 to 5 years, ideally.
With that perspective, it really makes you focus on the quality of the business. We’re looking 3 to 5 years out, and trying to work out what businesses can grow, and sustain themselves, and compete in the industry against technological change and competitive forces.
And that really then pushes you towards the quality businesses. And so then we typically invest in the best of breed within any sector, in the belief that the strong get stronger.
MF: What triggers you to sell a share?
RI: It’s typically when the fundamentals have changed. It could be a change in the competitive environment, technology causing a lot of change, or the economic environment with COVID-19.
(COVID-19)’s basically turned everything on its head. We’ve completely reassessed every business in the portfolio.
It can also be internal. It can be things like changing the company strategy, or changing management, that makes us reassess our assumptions. Sometimes we just get it wrong and we just have to reassess.
Outlook for the share market
MF: Where do you think the world is heading at the moment?
RI: Generally, I think things are looking positive. Australia in the global economy, has rebounded quicker than we all initially expected. And it should continue to rebound, as we come out of what has been a pretty deep downturn experienced in March and April. And so, corporate profits should also be accelerating over the next couple of years.
Government support is going to have to roll off (eventually) and so there’s question marks around how people will react.
I think governments are going to… probably spend more and step in more than what people generally expect. And the reason for that is because this crisis is different to most other crises. The economic impacts were created by the government doing what they should have done, which was forcing us to take precautions.
It’s not like the GFC, which was irrationally exuberant and from speculative areas of the market, which is typically where the downturns come from. So (this time) the governments really have a certain obligation to step up and support the economy.
MF: What’s your most underrated stock at the moment?
RI: I reckon EQT Holdings Ltd (ASX: EQT) is a really high quality business that doesn’t get a lot of focus. Equity Trustees… There’s not a lot of coverage of it, not a lot of market and media focus on it.
There’s two elements to it.
You’ve got the corporate trustee side of the business, where they are a beneficiary of the Royal Commission that happened last year, which put increased focus on independence of trustees. And EQT is one of the two large independent trustees in Australia.
Colonial being sold by CBA caused Colonial to outsource the trustee role. And there’ll be more of these things happening. There’s a real tailwind in the industry for corporate trustees.
And then on the other side, you’ve got the personal trustee side. They have a number of charitable trusts which are perpetual in nature. They manage the money for [the trustees], and they also distribute the money to charities. And they grow over time.
So, it’s typically left when somebody dies and they leave it to EQT to manage it. And as long as I do a good job… as the name should suggest, perpetual, which is a fantastic, long duration earning stream.
MF: What do you think is the most overrated stock at the moment?
RI: I think there’s a couple of areas of the market that look pretty stretched on the valuation side at the moment.
There is the buy now, pay later sector – particularly the second and third tier players, where it’s becoming very competitive and there’s a lack of earnings. And some of these have pretty big market caps.
And the other area, medical devices, is an area where there’s also valuations pretty stretched. But some of these businesses remain stretched for long periods of time. In this space, you’re selling into hospitals and you need doctors to utilise the product. They’re pretty conservative customer bases to sell into, so it takes a long time to penetrate the market.
Some of these players have very little revenue and they have valuations well into the hundreds of millions and sometimes over a billion dollars, (with) a revenue of $20 or $30 million dollars. At some point, something’s going to have to change.
MF: Those investors are hanging in there for a massive windfall at some stage, aren’t they?
RI: Yeah. I think they get seduced by the margins and the fact that it’s healthcare. The big markets that they are, that they typically take much longer than you think, in the Australian market.
MF: Which stock are you most proud of from a past purchase?
RI: The one in the last couple of years would be City Chic Collective Ltd (ASX: CCX).
It was probably 10 years of looking at specialty fashion and analysing specialty fashion and not buying it. Then something happened whereby… they divested all of the lower quality assets.
All that work, over many, many years, put us in that position where we were able to act very quickly when the opportunity arose. We still went through the process – we modelled the company, we spoke with the CFO – and then we bought into the company within two days, for around 70 cents. (MF: CCX is now $3).
So we followed a process: We’ve done a lot of work over a number of years, when the opportunity arose, we moved really quickly, and we made a lot of money over it. So it’s been a five-bagger in about two years.
We made more money on other ones, but that one was just rewarding.
MF: What was your take on the reporting season that just finished?
RI: It was better than expected, I thought. And the markets were up over that period too.
Some of the key points that we took out of it was that there was a lot of uncertainty from management, or lack of guidance. But that wasn’t really because conditions were bad. In many cases, the conditions were okay, it’s just that I didn’t know what was coming… They didn’t know what they didn’t know, if you like.
The trading conditions have improved significantly since March and April. March and April were really tough months, but generally speaking, the conditions were generally okay, outside of the real structural impact of ones, like the travel, and bricks and mortar retailers.
I think cost reductions is another big factor. Almost every company cut costs. And many of them actually said that in the rebound scenario too, that they won’t have to put all those costs back in. So you could see that earnings are higher, if you look out a couple of years… Margins will be higher.
COVID-19 and risk management
MF: Has the arrival of COVID-19 changed your investment strategy at all?
RI: No, it hasn’t changed my investment strategy. It has caused us to completely reassess every business in the portfolio and continually reassess because things are changing. We went through that initial phase where the economy just collapsed through March and April, but then has recovered.
And some of the winners out of this experience have been unusual. Alliance Aviation Services Ltd (ASX: AQZ), which is an airline, has been a winner. You wouldn’t have thought an airline would be a winner, but it does regional flights. It does fly in, fly out workers… And social distancing on planes meant they had to fly many more flights. The capacity was low, you couldn’t have as many people on the plane. So, there were some strange winners.
MF: How do you practise risk management?
RI: It’s fundamentally from the type of businesses we invest in. That’s probably the most important thing. And it comes out in the numbers that we produce… In the months when the market falls, we outperform by around 85% of the time.
Every month, we have a number of factors which we assess to determine the risk of the portfolio. And this is done independently of me, this is done by a guy whose business is separate to the investment team. He looks across on a number of different factors.
Factors like what’s our largest exposure to a specific sector, so we’re not concentrating risk in specific areas. We look at the proportion of the portfolio under a hundred million (dollar) market cap, as a sort of a proxy for liquidity. We also do a quality score, so every stock that goes in the portfolio, I rank out of 1 to 10. And then we look at the average of the portfolio and how it’s changing through time, just to see if there’s any sort of style drift going on.