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, Nucleus Wealth head of investments Damien Klassen tells us how he picks the shares for his fund and why he's holding onto a pile of cash.
The Motley Fool: For Nucleus Wealth's growth fund, what's the philosophy?
Damien Klassen: We have a big focus on quality and value. The way we think of stocks is that every stock's got an inherent quality to it, and then a particular value. And it's about finding the right cross section of those two.
For example, if we're looking at a very high quality stock within our portfolio, then we're actually happy to pay a little bit more for it. Whereas if we're looking at, say, the average quality stock, then we want to be buying it really cheap.
The discipline for us is all about finding that right match between the quality and the value of the stock that we're buying.
One more overlay is, on the growth funds we then use… both quantitative modelling and macro outlook views to work out the right mix of whether we're buying equities or whether we're putting the money into bonds or cash.
MF: So at the moment what's the split between equities, bonds and cash?
DK: Very much towards bonds and cash. We're basically looking at valuations and we figure that we'll have a better opportunity to buy it at cheaper prices.
So the last couple of months we've been winding back and just given the risks around, now's more time to be cautious and we've managed to pick up some decent returns from bonds.
We saw earlier on this week, the RBA cutting rates down to levels they said they'd never do. And we've had that view for a while that they would need to keep doing more – and we still have the view they need to keep doing more. So we don't think all the returns have gone from that end of the market yet.
MF: Did you manage to buy a bit during the February-March dip?
DK: We bought a little bit. The key thing we did was we got out of everything very early. So it was actually the end of January, early February that we cleared out completely.
We'd been watching the coronavirus stats growing quite quickly. And we just figured that we're reaching a point in the cycle that it was time to pull out.
MF: There's a viral video of you saying in January that the coronavirus would be a headwind.
DK: Yeah. There's an interview we did on the ABC where the stockbroker was saying, "No, it wasn't going to be the next financial crisis", and I was saying, "Look, I think it is going to be the next financial crisis."
What it meant was we saved a lot of money for our clients from that decision and that, so we've been quite measured in terms of what we've been buying.
And we think that the market bounce back reached heights that we don't think is justified. There's certainly stocks out there that are fine, but in aggregate, we think the aggregate stocks that you can get, the risk return just doesn't add up.
Buying and selling
MF: What do you look at closely when considering buying a stock?
DK: The first thing we do is any stock must fit into that quality value rank. We spent a lot of time trying to work out whether what we've got is true. What I mean by that is that it's quite easy to create quantitative models that back-test very well in the past. The problem is getting models that are actually going to work going forward.
For every stock, you do need to go through and do a fundamental screen. So stocks that come up as being both very high quality and very cheap might seem like they're going to be the greatest things ever, but almost always they're value traps or they've got some fundamental problems.
It might be a healthcare stock that looks really great, but its patent is just about to expire in three years time or something like that, and there's going to be a wave of competitors coming through. Or it might be a mine that's finishing in five years. They're making great profits now, everything looks great, but the profit's going to run out.
And so a lot of it is going through the fundamentals and not taking just a quantitative [view], but the qualitative as well.
MF: What triggers you to sell a share?
DK: Because we run this quite disciplined process in terms of quantitative measures, it actually puts the focus back on the analyst to justify things, because I think people have this natural tendency where you find a stock that's quite cheap and the quality is just average.
It's nothing special, nothing terrible, but it's an average stock and it's very cheap and people go and buy it. And next thing you know, the stock's gone up a lot, say it's doubled. And people start trying to convince themselves that actually, maybe this is a really high quality stock.
It's easy to fall in love with stocks from that perspective, and that's where we use a quantitative process. Because the quantitative process doesn't care about when you bought it or when you sold it. It's basically just saying, no, this stock is expensive now, and the quality hasn't changed and it's up to the analysts to come back and justify the change or make changes to our outlook to keep it within the model.
We do have a lot more scope for the very high quality companies. We have scope for that to run a little bit further. So we can buy them when they're average quality, average price. And they might run up to being a little bit expensive before we finally pull the trigger and say, "Okay, enough's enough. It's just too expensive at this point."
What's coming up?
MF: Where do you think the world is heading at the moment?
DK: Back into more lockdowns is probably the obvious answer.
We're in this weird tension where I think the coronavirus was treated as being a very short term problem by governments all around the world, and lots of stimulus was thrown at it: "We just need to get through this short two, three months shut down, and then everything will be back to normal".
If we can just keep everything going the way it is then it'll be fine, which if you don't know how long it's going to go for, that's a fine assumption to make. But now we know it's not, and we know the vaccines aren't coming quickly. And when they do come, it'll be question marks about how fast they get rolled out… So some of the measures to put in place at the start and not the right measures for this type of outcome.
For example, we put a lot of the stimulus was all front-loaded, and that is starting to fall off. Now we actually need stimulus to get people into new jobs because the old jobs – whether it be the number of waiters needed, people in the tourism sector or the number of airline hostesses we need – is a lot lower than what it used to be. We need to be finding those people new jobs. So the stimulus needs to be focused more about that, rather than trying to say, "Can we just maintain what we used to have?"
The other part is that there were a lot of things put on in terms of stopping corporate bankruptcies and letting people go without paying their rent. Personal bankruptcies, we need to start letting these occur in a measured way, because what's happening is the bad actors are going to start pulling down the good actors.
If you've got companies out there that should have gone broke six months ago, but didn't, and they're allowed to stay out there accruing more deaths… One supplier stops supplying to them because they won't pay their bill. They switch to the next supplier and the next supplier and the next supplier, and these guys can't take them to court because they're not allowed to, and so these guys just keep racking up these bills.
When they do go broke, now they can't afford to pay their employees entitlements, and maybe they pulled down some of these suppliers who were overextended giving free stuff. So you're starting to run into other problems.
And we're waiting to see if the next round of stimulus is going to be as big as the last one. It doesn't look like it's going to be, and a divided house in the US isn't going to help that. So we're quite concerned about the economic outlook. For us it's about trying to balance that with the extreme optimism we're seeing in the stock market.
Overrated and underrated shares
MF: What's your most underrated stock at the moment?
DK: I'm going to put it into a category. It's the value stocks which are underrated at the moment… Stocks that tend to be quite cheap, but there's no obvious catalyst.
Quite often the story actually just isn't that interesting within those stocks. I'll use an example. There's Intel Corporation (NASDAQ: INTC) – a supplier of computer chips – and their main competitor Advanced Micro Devices, Inc (NASDAQ: AMD), which recently came out with a much better chip. AMD is a lot smaller and more nimbler, and the share price has been on a tear. Whereas the Intel price has been going in the opposite direction.
So two companies in the same sector with wildly different outlooks and I would certainly agree that AMD from a fundamental perspective looks way better. But if you look at last year's earnings, Intel's a little bit under 9 times last year's earnings, whereas AMD's on 90 times last year's earnings.
So you've got to go, well, AMD is absolutely better. Is it 10 times better?
We look through that in a number of other different sectors. The names we come up with, quite frankly are quite boring. It might be things like HP or others that are just trading on price-to-earnings (P/E) ratios below 10, growth is looking actually quite anemic. And you're not looking like you are going to get much performance, much earnings growth out of them. But at those rates, you're actually getting a good yield.
They're doing buybacks. As long as the capital is being managed, you just don't know when it's going to come good though, because it isn't a sexy story.
It's another thing when the market takes a bit of a tumble. A stock that's on a 100 times PE has got a lot further to fall than a stock that's on 7 or 8 times PE.
MF: What do you think is the most overrated stock at the moment?
DK: Certainly there's some stocks in the tech sector that don't deserve their premium. So we look through it and behind every bubble, there's usually a grain of truth and there are stocks out there that we can look at within the tech sector we see why.
Tesla Inc (NASDAQ: TSLA)'s… probably one of the poster childs of very expensive, effectively not earning anything. It's a story stock. So they make really nice cars, but is a stock 4 or 5 times better than what it was at the start of the year?
It's pretty tough to come up with a reason why. But there's a good story behind it, and everyone loves Elon Musk. Maybe not everyone, but there's a large number of people who love him.
MF: He has a personality cult going on, hasn't he?
DK: Exactly. We tend not to meet management for that reason. We'll listen in to calls and we'll run through the transcripts and all that sort of stuff, but we try not to get too close because you can fall in love with stories and magnetic founders.
MF: Which stock are you most proud of from a past purchase?
DK: Vestas Wind Systems A/S (CPH: VWS) is a stock which we bought a few years ago… It is the world's biggest supplier of wind turbines. It's a Danish company. We're starting to tip it out now, because it is getting very expensive.
A lot of the green stocks have all been pushed up with the whole idea of, okay, Trump's not going to be president anymore and we'll have a Democrat president. Therefore possibly a Green New Deal can bid up the prices of these.
At the time (of purchase), Trump was in and pushing hard against these renewable energies. Our view was that the costs for renewable energy would reach a stage where they were compelling even without subsidies.
So that was one we bought and rode that up. Now we're starting to move out of that. We still like the company, still think it's high quality, but it's just the sector that's flavour of the minute at the moment.
And we'd like to buy back in at lower prices.
MF: Has COVID-19 changed or altered your investment methods at all?
DK: In terms of the overall philosophy we have for trying to buy high quality stocks at the right price, no, it hasn't. What it has changed dramatically in terms of what we've done in our quantitative models is it means we've completely down-weighted both last year's earnings and the current year's earnings.
Because what we're looking at very much as a company is, where did we think this company can actually get back to? It's not about what they're going to deliver in 2020 or in 2021, because we know those are distorted periods.
It's about trying to work out how much insight we really have into those later years… and also looking at historical (performance) and where do we think there's a reasonable level for companies to get back to?