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, SG Hiscock High Conviction Fund portfolio manager Hamish Tadgell tells why 2021 will be the year the market shifts from ‘hope’ to ‘growth’.
The Motley Fool: What’s your fund’s philosophy?
Hamish Tadgell: The strategy really is to invest in quality companies with sustainable, free cash flow growth in a margin of safety. The intent is really to construct a high-conviction portfolio of less than 25 stocks, with good sector and lifecycle diversification.
We’re largely unconstrained where we can invest, but we do tend to have a mid-cap skew and underweight the top 50. 100% Australia only.
We’re strong believers that markets are inefficient in the short term, and we seek to exploit that through fundamental research and taking a longer term perspective. We think that quality ideas are scarce, and you can build good portfolios with a few quality ideas.
The other defining hallmark of what we do is really got a pretty strong capital preservation focus. The portfolio’s outperformed about 90% of the time in down markets, on a rolling 12 month basis, over about 16 years. That means we’re prepared to accept some volatility at the cost of longer term returns, but it comes back to our view around the margin of safety and what we pay for stocks.
MF: What’s the investment horizon for each of the companies?
HT: It’s probably about in the 2- to 3-year view. We sort of don’t get too specific around it. I mean, we take a view around companies and the value, and we’re happy to hold companies whilst we think the investment thesis stands, and there’s value there.
How quickly the market chooses to price that in, we can’t really govern. We might hold it for longer, it might be shorter than that, but on average it’s about that sort of 2-3 years.
Buying and selling
MF: What do you look at closely when considering buying a stock?
HT: The process, as I said, is really built around the ‘sustainable growth in a margin of safety’. The way that we think about that is looking at quality, growth and valuation.
When we think about the quality of the business, we’re trying to find businesses with a competitive advantage that are well positioned in large growing end markets and that are well managed.
What we mean by that is finding management teams that have got the wisdom, passion, humility and engagement with shareholders.
The growth aspect is around that earnings quality and the sustainability of the free cash flow generation, returns, and discipline that the companies have got.
And the valuation is really trying to value that. Value the business and make sure that we’re paying an appropriate price, or a sensible price for the risks that we’re taking on.
If we’ve got very, very strong confidence in the earnings of a business, we may be prepared to pay a higher price. But it’s about shaving those risks off against the valuation and making sure that we think we’ve got an adequate margin of safety.
MF: What triggers you to sell a share?
HT: Selling is an active decision in a high conviction fund. We look at it [with] the same scrutiny as we do a buy decision, but there’s really 3 things we focus on.
One is ‘Can the risk return be improved or not’? That often comes down to a valuation argument, or it might be that there’s a better competing idea to put in the portfolio.
The second is ‘Has there been some impairment to the earnings power of the business’? Has there been a loss of competitive position or a decline in the earnings predictability for some reason? Or a regulatory change or something like that, which is impairing the potential earnings power?
The third is ‘Have we lost confidence in management’s ability to build value’? Management change or if management does something which is out of character with their strategy or that they’ve suggested to us they’ll do — then that will change us to consider selling.
What’s coming up?
MF: Where do you think the world is heading at the moment?
HT: It’s a good question. In short, we think that we’re transitioning from what I would say is the hope to the growth phase in the equity market cycle.
To put a little bit more context around that, we need to back up a little bit and understand where we’ve come from.
I think COVID-19, in our mind, is an event-driven crisis. It’s different from typical recession, in that it’s not structural or cyclically driven.
What we’ve seen is really the sharpest correction, and the quickest recovery in history on the back of this. Now, the market fell in that despair phase 35% in March, and from then back to October, it’s rallied back to recover most of its gains.
What’s driven that is this massive coordinated policy response – fiscal and monetary.
An important thing is to recognise that it’s built a bridge to address COVID, but it’s also suppressed unemployment, business values, and it’s seen household savings rates rise to decade highs. That’s all very unusual for a recession.
The other thing which has happened is that as markets have brought back, we’ve seen a pretty big disconnection between valuations and earnings. And also signs of what you might argue some irrational exuberance starting to creep into the market in terms of higher retail participation, but also some of the things that you would normally associate with later cycle – like the proliferation of IPOs, secondary market capital raisings, growing insider selling, the emergence of new valuation paradigms to justify some of the valuation stocks are trading on, et cetera.
That’s not unusual, in the hope phase, to see valuations move ahead of earnings. In that hope where people are buying the market on the basis of expectations of recoveries, earnings lag valuations.
But the question now is, is there sufficient confidence and ability for the economy to transition to the growth phase and continue to recover?
Historically the shift from hope to growth can be a bit bumpy. Particularly after a really strong rally like we’re seeing, where expectations are high – but there’s a still a fair bit of uncertainty around the path of the virus, how much scarring there’s been in the economy, [which was] protected to this point a lot by JobKeeper and the temporary measures that have been put in place.
But what happens when some of those roll off in the next couple of quarters? Will it reveal greater scarring than [first] thought?
The consensus view at the moment is very much the vaccination will allow us to get to herd immunity later this year, and policy support will continue to be supportive. I think Australia is in a really fortunate position. Our economy is one of the most open. We’re an island state, but it’s relatively open compared to what we’re seeing in the US and what the UK looks like at the moment.
Policymakers importantly are willing and able to support the economy returning to employment. It provides good potential for an ongoing recovery transition from that hope to growth phase.
Through the course of this year, you could see some bumps, but things rarely move in straight lines. We should continue to see this transition from hope to growth, and with it probably means that you’re going to continue to see some rotation in the leadership of the market.
Overrated and underrated shares
MF: What’s your most underrated stock at the moment?
HT: I’d probably say Uniti Group Ltd (ASX: UWL), as it’s now called.
It’s a fibre network provider. Over the last 18 months it transitioned from providing fibre network services to residential, greenfield residential developments to become much more a fibre infrastructure company. It’s recently just bought OptiComm Ltd, and also bought Telstra Corporation Ltd (ASX: TLS)’s Velocity business.
I think COVID has highlighted the importance of digital technology and also fibre connectivity.
What we found interesting and one of the observations we’ve made is that these assets are increasingly being appreciated as social infrastructure assets. The utility type assets – much like toll roads and airports – but I don’t think they’ve been historically thought of in that way.
COVID has helped really shift that focus and show that these businesses have strong annuity earnings and, in some ways, aren’t as volatile or… impacted by things like economic activity such as passenger movements and car traffic and so forth.
The one thing that struck us is that during the bid they made for OptiComm, Aware Super, which is the old First State Super, made a rival bid. In our mind, this reinforces the point that these assets are starting to be viewed in a different light, [as] the social infrastructure type assets.
Our view is that Unity is now the number 2 player in what is essentially a duopoly market with NBN. And they’re the only player that’s got the ability to sell in the wholesale and retail channels, through having recently won structural separation approval from the ACCC.
It’s a business that… has probably emerged stronger from COVID to become really what we think will be a social or a fibre infrastructure business going forward.
MF: What do you think is the most overrated stock at the moment?
HT: The way I’d probably answer that is not to call out any particular stock, but in our mind there are a number of pockets of what we think is overvalued.
It’s not to say that these are bad businesses or anything, but I think it’s just a function of the environment. It’s a function of the fact that long duration stocks have benefited massively from lower interest rates and lower discount rates, and equity risk premium.
But I would also say that things do change, and I just finished reading over the summer break Howard Marks’ Mastering The Cycle book, which is a great read. He talks a lot about the cycles and talks about the ‘nifty 50’ and the 1990s, and how there were similar periods of overvaluation…
There’s a tendency to over-amplify the short term but things, as I say, do tend to change. We need to change the position when the cycle changes. If interest rates were to back up even a little bit, then we get some rise in inflation expectations, I think that will start to put some pressure on that more long duration parts of the market. Particularly with the extreme cases.
MF: Which stock are you most proud of from a past purchase?
HT: Saracen Mineral Holdings Limited (ASX: SAR) has been a very strong contributor for us over a long period of time.
We bought it as a small cap gold producer, and it’s grown to become a top 100 stock, and with the recent merger-of-equals with Northern Star Resources Ltd (ASX: NST), is now going into the top 20 if that goes through.
Probably in recent times, the stock that perhaps I’m most proud of would be something more like Carsales.com Ltd (ASX: CAR). It’s more just because it really shows our process at work, in that it’s a really strong business that we think has got a strong competitive advantage. Number 1 position in the market, with some good overseas growth options.
We bought it when it was out of favour, I think it was about October 2018. On the back of declining new car sales volumes and concerns around that. In that time, we’ve probably doubled our money since. It’s more to the point that we’ve got a process and we liked the stock for a long period of time. We thought that the margin of safety wasn’t there, the stock corrected, and it provided an opportunity for us to buy what we think is a really good franchise at an attractive price.
That’s rewarding when you’re staying true to the process and it’s delivering good outcomes.
MF: Did you guys manage to pick up any bargains last March during the COVID-19 crash?
HT: One of the things that we’ve really been focusing on through the whole COVID is the difference between uncertainty and risk. Risk is something you can price based upon assumptions that you make. Uncertainty is events that you can’t really price, because by its nature it’s uncertain and it happens.
The question is how you deal with uncertainty – so our plan through COVID has been very much to look to buy strong, quality companies which have corrected, or which we think are looking more attractive. But also look to buy quality, cyclical stocks that are leveraged through a recovery, which we think will benefit. And then thirdly, look to sell out of things that we think are going to struggle to recover, or are going to be impacted from COVID permanently.
MF: Is there a move that you regret from the past? For example, a missed opportunity or buying a stock at the wrong timing or price.
HT: We’ve seen Lynas Rare Earths Ltd (ASX: LYC) for a little while, which is a rare earths play.
Coming out of COVID, one of the things that’s got a lot of focus is supply chain resilience and that’s extended to sourcing your critical metals. I guess this has been amplified by China taking a more I guess aggressive diplomacy view recently, and concerns that given China holds 90% of the world’s rare earths, or supplies 90% of the world’s rare earths, and 80% of the rare earths into places like the US – how do you find alternative supply?
Lynas is clearly a company that’s well positioned to participate in that.
MF: Lynas has the biggest rare earths deposit outside of China, is that right?
HT: Yep. And it’s just recently won a contract with the US Department of Defense to help build a heavy rare earths plant in the US.
I guess the question is whether you’ve missed it or whether it’s going to continue to go [up]. That’s I guess something we’re evaluating. It would have been nice to have get in at the ground level.