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, Andrew Martin – principal portfolio manager of the Alphinity Australian Share Fund and Alphinity Concentrated Australian Share Fund – explains why earnings leadership is a key factor for any company making it into the funds.
MF: How would you describe your fund to a potential client?
AM: We invest in what we call earnings leadership. Those are companies that are performing better than the market expects from an earnings perspective. Companies that are getting consistent earnings upgrades.
We don't want to overpay for those upgrades. We care about value and we want to make sure that those upgrades are sustainable. So, we care about the quality of those upgrades.
Succinctly, we invest in quality, undervalued companies in an earnings upgrade cycle. You can find those kinds of stocks in any part of the market cycle. We're not style dependent.
Sometimes you'll find earnings leadership in the market in defensive stocks, sometimes it's cyclical, sometimes it's growth or value.
For us, it's always about the earnings.
What kind of market cap are you aiming for?
We tend to stick to S&P/ASX 300 Index (ASX: XKO) stocks for a number of reasons.
One, that's where our competence lies. There's this view that you can't get alpha out of larger-caps, but we disagree. We've done that for a long, long time.
Two, there's liquidity. We're of a scale where we want to ensure we can create alpha for our clients and get in and out of stocks when we need to.
Now, there are some exceptions.
An [initial public offering] IPO might come out that's outside the index which may be particularly compelling to look at. For example, we were one of the original investors in Life360 Inc (ASX: 360), a little tech company, through their IPO.
So, we'll take those opportunities when we see them. But it's at the margin of what we do.
Are you still invested in Life360?
We are; it's a great business. It's a smaller holding for us, but we think it's something quite different to what you can get elsewhere in Australia. And it has a fantastic management team, really executing well. Their potential is huge.
What triggers a buy signal for you on a potential ASX share?
We always start with earnings. Is this company in an earnings upgrade cycle? Is it more than likely to be in an upgrade cycle going forward? Has something changed around earnings is really the trigger.
We aren't a fund that will buy a cheap company and see if it turns around some time in the future. Our view is let's take all that guess work out. Earnings will tell us where things are going in this business. And once you get an earnings upgrade in a stock, you're more likely to get another one, which is again likely to be followed by another one.
So, a change in earnings direction, a change in earnings expectations, is a real trigger for us.
Value is rarely something that causes us to buy a stock. You have to have something that's going to be the catalyst as to why you want to invest in that value.
On the other side of the equation, what triggers a sell for a particular shareholding?
Once a stock starts to get earnings downgrades, typically you'll find the supporters of the stock say it's just a bump in the road, and it's all fine long-term. But, on average, that's actually not right. Something's actually changed in the business, and more than likely you're going to see more downgrades.
Value's not a great signal to buy a stock. But it's actually a decent signal to sell a stock. Particularly if you have some kind of earnings momentum in your process, you need ways of selling out before earnings turn. Because when they do turn, that's not a great time to be the last one in line.
If you see the quality of earnings change, that's a great sell signal. When management is stretching to make their earnings targets by doing interesting things on the balance sheet, that's a signal that those upgrades are not sustainable.
What ASX sectors look promising to you over the coming 12 months?
The sector level isn't what we concentrate on, more the individual stocks bottom up. But there do tend to be trends in the market that come through sectors.
One of the few sectors left getting earnings upgrades is insurance. It's traditionally quite a volatile sector, because you can get big hits every now and again. But they're experiencing some of the best conditions they've experienced since the early 2000s. A much better pricing environment coming through is helping grow the top line, and then you get this expansion in margin.
For a company like QBE Insurance Group Ltd (ASX: QBE), which has had some real issues in the last 10 years, this has come at just the right time for them because they've gotten to the point where they've really cleaned the business up and gotten rid of all of the bad business. And having that efficiency cost out program just at the point where you're now getting a much better pricing environment, you should be able to see that leverage come through the business in the next few years.
Closer to home, Suncorp Group Ltd (ASX: SUN) is a similar type of story. There's a bit of a turnaround happening that's just starting to bite. And it also gets a bit of benefit from COVID lockdowns. When fewer people drive their cars, fewer people crash. And when more people are at home, fewer houses get burgled.
If people don't like the risk you can get with some of the insurance companies, you can still get the benefit through an insurance broker.
Steadfast Group Ltd (ASX: SDF) is one we really like. Where you get the benefit of the pricing that's happening in the market but you don't have the risk of large claims from big events happening. They're brokers, so they sell insurance. But they're also rolling up smaller brokers into the big parent and then they give them the technology and the means to become much more efficient and then grow that way.
Are there other ASX shares you believe will potentially outperform?
We quite like Medibank Private Ltd (ASX: MPL). It's an insurance company, but health insurance, so a different kind of market. That's another business that's really been transforming itself since it listed. It's taken some really strong leadership in terms of sorting out a number of issues in the market around claims and what was happening in terms of healthcare costs going up materially. They've worked with the industry to try to contain pricing and therefore grow the industry.
Macquarie Group Ltd (ASX: MQG) is one we've held for a while and we think they're just getting better. It's an incredibly adaptable company to the market conditions, and they've reinvented themselves a number of times. The operating environment we're in is fantastic for them. And demand for their services is better than ever at the moment.
Knowing you're not very sector specific, are there still sectors you're likely to avoid over the coming months?
There are parts of the market that are really expensive, both at an absolute and historic relative sense, which is being largely pushed by low interest rates. And that's mainly in the high price-to-earnings (P/E), high growth part of the market.
In an environment where the pressure is more for interest rates to go up rather than down in the future, it makes it harder for that part of the market from a valuation perspective.
There are parts of tech that are getting upgrades and other parts are getting downgrades.
If you're getting situations where earnings are being downgraded at the same time, that would be tough. Think about the Appens [Appen Ltd (ASX: APX)] and Altiums [Altium Ltd (ASX: ALU)] of the world, that makes life harder for them.
So, we largely try to avoid those high P/E growth stocks where we can't find a positive earnings story at the same time.
If the market closed tomorrow for 5 years, which ASX share would you want to hold?
I think Macquarie is the perfect stock to own for the next 5 years. Ironically, if the ASX closed for the next 5 years, the demand for their services would probably go up.
A really interesting part of their business, which I think still isn't properly priced in the market, is their exposure to green energy. They're a developer, a manager, a funder, and an owner of green energy assets. And that area of the market is just getting bigger and bigger. Macquarie is right in the centre of being able to make money out of that [clean energy] transition.
What do you see as the biggest threat for ASX investors over the next year?
Probably the biggest one is interest rates and the yield curve.
We've been getting earnings upgrades in the Australian market. But when you delve into it it's been really narrow. It's mostly been resource companies, particularly iron ore, and banks. So, it looks like the market isn't that expensive because those sectors are a big part of the index, they've been getting upgrades. But if you strip those out the market begins to look a lot more expensive, and any rise in interest rates is going to be a big headwind.
The other potential big threat for Australian investors is the geopolitics around China. It hasn't had a major, direct impact on the market yet. But you can't rule that coming out of left field.
And what's the biggest opportunity for ASX investors over the next 12 months?
One is the reopening of the economy into next year. We've watched what's happening in the US and the UK and parts of Europe, and that's going to throw up a lot of opportunities and potentially growth surprises.
The other one is the freight train that is ESG [environmental, social and governance] and sustainable investing. The weight of money coming into that sector is enormous. That means money gets directed more and more to certain types of industry and investments and less to others. Boards and management start to pick this up and start to change their practices, and that also changes what works and what doesn't work.
Trying to take advantage of that presents a potential opportunity. Not just for the next year, but for the next 5 to 10 years.
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(You can find out more about Alphinity's funds here: Our Funds – Alphinity)
