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, Totus Capital portfolio managers Ben McGarry and Tim Warner pick a pair of stocks that have tailwinds galore.
Best share #1: The world is rebuilding
MF: What is the best stock buy right now?
Ben McGarry: Fortescue Metals Group Limited (ASX: FMG), in the short term, still looks very good to us.
We've owned Fortescue since the Vale dam collapse a couple of years ago, on a supply shortage in iron ore that would be supportive for pricing.
The supply continues to disappoint. We had the Rio Tinto Limited (ASX: RIO) quarterly out this morning and iron ore volume supplies to the downside. It's very difficult to see where major new projects are coming online which is quite a different setup to the last time we had an iron ore price slide.
[Fortescue] is about to pay about 9% of the market cap in an interim dividend… a half-year dividend after the next result. That should be paid in early September.
At spot pricing this morning, the iron ore price is at US$220 a ton. You know, these guys get it out of the ground for less than US$20 a ton. So the spot pricing versus where the market has their long-term iron ore forecast, and even near-term iron ore forecast, is way out of whack.
Spot pricing [is] less than 3 times earnings, comes [with] a huge dividend yield, a net cash balance sheet, it has long-life assets, owns its own rail, port and shipping infrastructure, and has a founder that is highly aligned with returning capital to shareholders.
We actually liked the market structure of iron ore as well. It's a nice consolidated market globally and, as I said, it's difficult to see where the supply is coming from over the next few years with most of the world trying to stimulate their economies to grow.
Tim Warner: It fits our process around cash-generative, owner-operator. Whilst it might not be a year-long growth story, it still fits within our process and adds some diversity to the book.
BM: You've certainly got super-clean accounting in the major iron ore companies, same as you've got in the major tech companies.
Because they're so cash-generative, they don't need to dress up their earnings with tricks like amortisation of intangibles, et cetera. It's a very clean part of the market in terms of reporting and accounting.
Best share #2: The world is having their groceries delivered
MF: If the market closed tomorrow for 5 years, which stock would you want to hold?
TW: HelloFresh SE (ETR: HFG), which is the leader in the meal kit delivery space.
Our view is that the product is fantastic. It offers convenience, value, and quality — all in one solution. Both Ben and I are users of meal kits and believe that there's a sticky habit-forming process from using them.
The category's got a long runway for growth. The grocery retail market is an extremely large market, it's one of the biggest markets in the world. And the online share of that lags a lot of other categories in retail.
Then, of that, meal kits, it's only such a small portion. So it's a very nascent opportunity in a huge market, which we like for the long-term growth prospects.
The business model is counter-positioned against the incumbent supermarket retailers. So it structurally has higher margins due to their vertical integration throughout the whole supply chain, from the producer through the brand through the wholesaler that they take all the margin — whereas a typical retailer only takes the retail margins at the end.
[This] makes it extremely hard for the incumbent, legacy retailers to compete in this niche category as it's a different business model and they're focusing on trying to just do online retail, not delivering meal kits.
You've also got the food wastage, as it's a B2C business… The customer is ordering in advance, they minimise food wastage, which is like 10% to 12% for retailers, which is a huge cost to their cost of goods.
One's a retailer, one's a manufacturer and we think they're in this nice sweet market spot where it's hard for these incumbent guys to compete. They are in a huge market where they can just take little bits of share, which is not very meaningful to the large supermarkets — but to them, it's extremely meaningful.
In the short term, from a market perspective, it looks to be a temporary COVID beneficiary. Everyone thinks that everyone's just jumped on the meal kit bandwagon because it's easy and we're in lockdown. And I'm sure there's some truth to that but trends that they have been reporting, and what we're seeing from data, is that we think it's more of a structural change that's being accelerated forward.
Pre-COVID, these businesses were profitable, free cash-flow generative, and growing at 30% to 40% top line… So, there was a business model here with structural change happening and we think it's only being pulled forward. And then finally it's a self-funding business model, it receives cash upfront from their customers and pays their suppliers later, doesn't need to raise any capital and it can deploy that capital at really high rates of return for a long period of time.
So we like that one on a 5-year buy and hold.
Looking back
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.
BM: Look, we did well in the first quarter of 2020 and we got more bullish, but not quickly enough in the second quarter of 2020.
[We] were sort of surprised by the level of stimulus and with interest rates near zero, a lot of companies with very high valuations took off. The sort of environment in the second half of last year with a lot of monetary and fiscal stimulus and zero interest rates meant that unprofitable companies and companies with less proven and more faddish business models were some of the best performers in the second half of 2020.
We were slow to recognise that and gave up a chunk of the good performance in the start of the year.
MF: Was there a specific company you wished you bought into during that period?
BM: The two that, you know, surprised us the most were Tesla Inc (NASDAQ: TSLA) and Afterpay Ltd (ASX: APT). And the issue that we should have been quicker to recognise then was that the 'customer love' for the product. I think that's the common denominator.
MF: Do you have a position on Afterpay at the moment? Either short or long?
BM: No, we've sort of steered clear. We think the buy now, pay later space is tricky, in that it's highly competitive.
The main protagonists are burning a lot of cash. And they've been clear beneficiaries of a strong retail environment during the COVID period and the stimulus.
We've got a lot of respect for Afterpay management but it's just unclear how the industry is going to evolve over the medium term.
