The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In part 2 of this edition, Sam Granger, Founder of Equanimity Partners, reveals why these 2 leading international shares recently made it into the Equanimity High Conviction Fund.

Motley Fool: In part 1 of our interview, you mentioned that the Australian market is looking quite expensive for high-quality businesses, and you're finding better risk/reward profiles overseas. Which international shares look to deliver strong performance?

Sam Granger: New high conviction positions initiated in the fund over the past year include German listed meal kit business HelloFresh SE (ETR: HFG) and subscription streaming service Netflix Inc (NASDAQ: NFLX).

Both businesses are led by exceptional founders, have long runways for growth, and are inexpensive relative to our estimate of their future earnings power.

MF: What else stood out for you in regards to HelloFresh?

SG: HelloFresh has carved out an extremely strong market position in a highly profitable niche of the massive global grocery market. HelloFresh entered the fund about 6 months ago.

What attracted me was their market dominance. They've got really strong market share and are actually taking further share from competitors while achieving industry-leading margins. In terms of outlook, the grocery market is huge. And HelloFresh still has a very low penetration of households, and they're only taking a very small percentage of the grocery budget of those households. So they can grow users and they can grow revenues per user in that massive market.

MF: And what else about Netflix looks particularly strong?

SG: Netflix provides a remarkable customer value proposition with access to $15 billion worth of content spend for a $12 monthly subscription. We believe this provides them with substantial scope to grow subscribers and revenue per subscriber over the next 5 to 10 years. Their cost base is largely the fixed cost of content and therefore we expect high incremental margins.

Netflix has been a small position in the fund for a couple of years. We've long admired the business model and founder CEO Reed Hastings. After some share price weakness surrounding a period of softer subscriber additions, we took the opportunity to substantially scale up our position in June this year.

MF: Which sectors are you likely to avoid in 2022?  

SG: We avoid sectors where we don't think we have a good handle on the key long-term value drivers of the businesses. This includes resources, oil and gas, and biotechnology. We have a very strong bias towards simple businesses, ideally offering products we use in our everyday lives, because we believe this limits the unknown unknowns in investing.

We're also avoiding putting new capital to work in sectors where valuations have gotten ahead of business fundamentals. As an example, we've historically had quite large and profitable positions in enterprise software but are increasingly finding these valuations stretched.

MF: If the market closed tomorrow for 5 years, which stock would you want to hold?   

SG: I would say Microsoft Corporation (NASDAQ: MSFT). It's a business we've owned for 2 years and remains the largest position in our fund. When we purchased Microsoft, it was trading at market multiples on near-term forward earnings for a demonstrably better than market business.

Microsoft stands out for the quality of its revenue streams and the diversity of its earnings drivers. It has 2 enormous growth businesses in its Office productivity software and Azure cloud computing service. Both of these benefit from substantial customer lock-in and economies of scale.

On top of that, it owns a cash cow in Windows and a collection of very high-quality, fast-growing smaller businesses including LinkedIn and various gaming assets.

MF: What are your thoughts on Bitcoin (CRYPTO: BTC) and the rise of cryptos in mainstream financial circles? 

SG: We have no investments in Bitcoin or crypto more broadly. There is clearly a huge amount of speculative activity in the space and as students of financial history, it's hard not to see the parallels here with some of the great manias of the past.

That being said, we do think that it's important to stay open-minded on new and potentially disruptive technology, particularly from a risk perspective. We are slowly learning about the space and watching to see if real-world applications for crypto emerge so that we can assess the impact this might have on the business models of various listed businesses.

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If you missed part 1 of our interview with Sam Granger, you can find that here.

(For more information about the Equanimity High Conviction Fund go here.)

The post If markets closed tomorrow for 5 years this is the share to own: fund manager appeared first on The Motley Fool Australia.

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. 

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