Ignore EBITDA and P/E ratios? This fund manager does

Ask A Fundie: Pengana’s Chris Tan reveals how he picks shares for his fund and how it ignores benchmarks.

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Image source: Pengana Capital

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, Pengana Capital portfolio manager Chris Tan tells us how he picks the shares for his fund and why it ignores EBITDA and PE ratio numbers.


The Motley Fool: What’s your fund’s philosophy?

Chris Tan: I’m part of the Australian equities team and there’s two funds. There’s a core Australian equities fund and then there’s a smaller income fund. We share the same philosophy, generally. 

(They’re) absolute return, benchmark-unaware funds. What we aim to do is preserve capital and give a fair rate of return, which we loosely define as the risk-free rate plus say 6% equity risk premium. 

As a benchmark unaware and absolute return fund, we can hold a higher proportion of cash. Generally we don’t have to be fully invested and from time to time that has helped the funds quite a lot maintain a capital.

MF: What’s the cash percentage at the moment?

CT: It’s about 15% at the moment. It has been as low as a late, late single digits or even down to almost 5 recently. In times gone by, it’s been as high as 30, I believe.

Buying and selling

MF: What do you look at closely when considering buying a stock?

CT: We like to keep it simple. The first question we ask is, “Is this a good business?” 

We’re fractional owners of businesses… You need to understand it. You need to understand the industry, the competitive position, the revenue model and are management competent? Do you trust them? 

That’s the first hurdle. If you don’t really understand a business, you can’t truthfully invest in it in good conscience.

And if we like that, then the next hurdle is can we acquire it at the right price?

To us, the right price is a function of cash earnings and predictability of those earnings. We don’t invest on earnings before interest, taxes, depreciation and amortisation (EBITDA) or price to earnings (P/E) ratios. What we do is we try to reconfigure the financial statements to reflect the underlying cash profitability of the business. 

From a big picture point of view, we’re looking for businesses that are resilient, where they generate cash and as a shareholder, you can scrape off some of that cash every year without damaging the business and the business can go on and generate even more cash the next year. That’s the ideal scenario.

Our (measure) is something called the ‘after tax cash earnings yield’. 

That’s how much cash the business generates that’s theoretically available for shareholders after maintenance capex… Then after any interest in tax and what’s then left for shareholders. We work that out as a yield on the purchase price of the stock.

Generally we like to buy things that are showing an after tax cash earnings yield of 6% or better. And with a path we think to growing towards a double digit on that initial purchase price.

MF: That’s a similar philosophy for both the core and the income products?

CT: That’s exactly right. For the income funds, we like to see a material amount paid out as a distribution that we think is resilient, repeatable and will grow over time. That’s really the only difference. 

So something that is an exciting story that generates a lot of cash but reinvest a lot of it – like CSL Limited (ASX: CSL) – would be in the core fund but would not make the income fund.

MF: What triggers you to sell a share?

CT: I’m sure that I’m not the first fund manager to tell you that’s actually often a more difficult decision than the buying – because there is a tendency to fall in love with companies. It’s a common mistake. 

The most obvious reason (for selling) is: has there been a fundamental change to the investment thesis? For instance, you had an investment thesis and you had milestones and you expected the business to turn out in a certain way. And when it becomes clear that that thesis is not, it doesn’t hold up, that’s your main trigger to sell. 

Sometimes the thesis can actually improve, but generally that’s when you look at it and try to be honest with yourself. And this is where a team approach is very useful as well, so everyone can weigh in.

And has it just got too expensive? We do use after tax cash earnings yield threshold for entry, as I’ve explained, and these are never hard and fast rules in investment. But there comes times when things just get too expensive in terms of that hurdle rate. Then you exercise some degree of judgment. 

But as I’ve said, it’s easier to say than it is to put into practice.

Outlook for the share market

MF: Where do you think the world is heading at the moment?

CT: A difficult one. Because we are bottom-up investors, we do think about macro (economics) but we don’t try to expound on them too much and use them as a main driver for our investments. 

The key influences we see are low rates for a long time. Stimulus, lots of fiscal stimulus, which are obviously on the plus side. A COVID-19 vaccine’s built into market prices at this stage. All these influences really to look through the next, say, 12 months earnings to what you believe the normalised earnings will be. 

One year PEs don’t really help you a lot at the moment. It’s difficult to say ‘The market’s expensive on that basis’, because what you’re really doing is looking past that. 

One thing that I think is clear is that a lot of listed companies will actually come out of this stronger from a competitive point of view because they have had access to capital. Their competition, who haven’t and are smaller organisations with less ability to ride out the storm, are going to fall by the wayside. 

I’m thinking retail is an obvious example of this. They will come out of this with lower rents. They’ve had some help with payroll. For some of the bigger listed retailers, their smaller unlisted competition are basically going under.

MF: Some cynics have said that a lot of companies have used COVID-19 as a bit of an excuse to do some efficiency improvements? 

CT: Absolutely. There is the old ‘don’t waste a crisis’ mentality going on there. 

We’ve spoken to quite a few companies that were mulling restructurings and cost cuttings and they’re always very difficult to push through given the sensitivities with your workforce, and politically for some companies. 

But they’ve used (COVID-19) to really accelerate that and say, “Right, okay. We’re going to be a lot leaner coming out of this.” 

Overrated and underrated shares

MF: What’s your most underrated stock at the moment?

CT: I’ll go for Ampol Ltd (ASX: ALD).

Clearly they’ve been hurt with lockdowns and particularly with aviation and shipping with a loss of demand there… And these are big fixed-costs businesses. They have a tremendous network of assets, which is actually their main strengths in my view, but at the moment though there’s a huge fixed cost base there and you’re actually not selling a lot of your product compared to previously. There’s an issue with refining. That’s been running at a loss. There’s issues about whether to close that down or not. 

But when we look at some of the parts valuation, it’s really, even if you put the refining operations at zero, you’re still getting a lot of upside to the current price. 

Your two remaining businesses are fuel & infrastructure, and convenience retail. The fuel and infrastructure is widely regarded as a very strong business. That’s very well run. It has a lot of breadth, vertical integration and a lot of synergies and profit available to them.

The convenience retail has undergone a series of investments. Now we think that they’ve got capital discipline right. This was actually part of the reason why it was subject to a takeover bid from Alimentation Couche-Tard Inc (TSE: ATD) from Canada. I’m sure you’re aware there was a bid for the company that was abandoned due to COVID-19 and that was at $33 or something. The stock’s $24, $25 now. The bidder is on record of saying that they haven’t walked away forever. They still maintain a strong interest in Caltex, or Ampol as it is now. 

So that’s one we see with temporarily depressed earnings, you will get demand pick-up back when we see aviation and lockdowns unwound… There is a school of thought thinking that there’s going to be more people commuting (by car) rather than being on public transport.

The other side of it for the convenience retailer was there was a price war for the last couple of years… We believe that there is now equilibrium in the downstream retail market and that was bought out recently where the volumes were a lot lower but they actually maintain the same amount of P&L by raising prices.

So even if you put (refining) at zero, the two remaining businesses, when you value each of them, you get a share price most analysts can get it into the 30s. And then we have the wildcard of the bidder coming back and Ampol has a treasure trove of franking credits that could be unlocked in a takeover scenario.

MF: What do you think is the most overrated stock at the moment?

CT: I’m not sure if overrated is the word, maybe it’s expensive? Right now I’d probably say it’s Woolworths Group Ltd (ASX: WOW). If you look at it from a historical price-to-earnings point of view, it does look expensive. 

But the thing is, it has really an unrivalled position in Australia in terms of its network, its ability – it’s the leader. For a long time there were price wars with Aldi coming in, Coles, Woolworths, and now we believe there’s equilibrium in that market. Everyone’s in their lane. Woolworths is the leading franchise.

We believe they’re ahead of all the competition in terms of their investment. The capex, so their competitors need to invest a lot more heavily than Woolworths do and this whole COVID-19 episode has really played into their strengths. We can see some food inflation coming back and just stronger demand for longer for groceries. 

The other aspect as well is that the share price was hurt in the second quarter of this year by the failure to spin off or sell their hotels business, which was obviously hit by lockdowns around Australia. 

Now that will be back on track in sometime next year, probably in calendar year 21. (This) will leave Woolworths much better, more focused. And there could be a capital return to shareholders there. 

So it’s optically expensive, but it’s a very, very high quality franchise.

Looking back

MF: Which stock are you most proud of from a past purchase?

CT: Certainly from the recent past, I would say Bapcor Ltd (ASX: BAP). It’s a business we’d liked for a long time and it was always just a bit too expensive and COVID-19 allowed us the opportunity to buy it.

We bought a little bit early, to be honest with you. We probably started buying in late February or early March, but we had done a lot of work on it and were able to just keep adding as it went down into the crazy times. 

Now it’s rebounded – its [price] level’s much higher than or higher than it was pre-COVID. And there’s a lot of momentum there. 

We see that as a business that is really, really resilient. Recession-proof almost.

When economic downturns happen, these businesses have always done well. People tend to tinker with their cars – they don’t buy new cars, they run their older cars for longer. Clearly for the last two years of new car sales shrinking for two years in a row, the fleet of second hand or older vehicles on the road is just getting larger. 

Bapcor will make their money servicing or supplying mechanics who service the after-warranty or second hand car market.

[Bapcor] did a capital raise and they’re now poised to consolidate more smaller competitors. So there’s good industry structure as well. There’s really two main players, Bapcor and Repco… And there’s an Asian growth story further down the line as well.

MF: What was your take on the reporting season that just finished?

CT: For us, the reporting season was free of major surprises… I mean, there were a few little surprises here and there but nothing too serious. 

Our broad takeaway was that earnings were generally better than expected. And they were supported by a resilience in revenues, which clearly was aided by the various stimulus measures in the market. Cash flows were generally strong.

A big trend there, which will probably reverse to an extent next year, was that working capital balances were unwound. Retailers ran down inventory, collected on receivables and delayed payments as much as they could to conserve and generate cash. 

They’re all positives and showed the strength of some of these businesses. They will unwind, it will go back the other way a bit next year, but things should be better anyway then. There was quite a lot of balance sheet restoration from capital raises.

Another striking feature was that the high PE stocks continued to drive the market rally and IT in particular, which is even though it’s only less than 4% of the index, it contributed about 20% of the market’s rally in August. With Afterpay Ltd (ASX: APT) being second only to CSL, which is the biggest company in Australia in terms of its contribution to index performance.

MF: I gather with your Australian equities funds, because it’s benchmark unaware and there is a ‘after tax cash earnings yield’ criteria, you guys don’t hold that many tech stocks? 

CT: That is absolutely right. We can’t justify buying companies. Some of these are great businesses, but we can’t really value those… They burn cash they don’t actually generate.

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Tony Yoo owns shares of AFTERPAY T FPO and CSL Ltd. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of and has recommended Bapcor. The Motley Fool Australia owns shares of AFTERPAY T FPO and Woolworths Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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