Last week the Bank of England put top executives at banks and insurers on high alert to vastly improve their planning for the long-term risks of climate change. The FT reports that several big banks have announced plans to reassesses their lending to high carbon-intensity projects, while promising to promote “green” investments.
In this deep dive interview Chad Slater, co- Chief Investment Officer of Morphic Asset Management, discusses the growing trend in ethical investing and answers the question, does ethical investing really work? Slater delivers candid views on the current investment environment, shares some great insights from his time working at the Federal Treasury, explains four factors that drive share prices and calls out one of Australia’s iconic businesses as a ‘short’ on ethical grounds.
Value means you have a margin of safety... We think when you're buying things on 13 times earnings in an upgrading cycle, that you get paid to wait. Patience works in your favour, if you get a good yield, and earnings are growing. You don't need the market to reassess you right away.
- Chad’s early days working at the RBA and how he can apply this experience to stock picking.
- Why macro matters but should be treated separately from fundamental investing.
- The key characteristics of the stocks he wants to own in the current environment.
- A fascinating explanation on the four different factors that drive share prices in stocks.
- The evidence that shows ethical investing can perform.
- A short thesis on an iconic Australian business.
- Two lessons, one from a successful investment and the other from a painful loss.
For more information and additional insights from Morphic Asset Management, please click here
James Marlay: Hi, there, and welcome to another one of Livewire's CIO interview series. My name's James Marlay, I'm a co-founder of Livewire Markets. My guest today is Chad Slater, co-Chief Investment Officer at Morphic Asset Management. Chad's a regular contributor to Livewire, and he is a global investor. He has some really interesting views on the macro environment right now. He also has a great perspective on ethical investing and how this can be used to find good investment opportunities on the long and the short side. We'll also dive into some of the investment lessons that he's picked up along the way. Our conversation starts with Chad telling us about his early days working in Treasury. So, let's get into it.
Chad Slater: Well, there's not many of us who are actually economists who go on to become stock pickers. The normal course of action is economists becomes strategists, might work at an investment bank. Half my peers from the RBA became strategists. So, when people think of economics, they normally think of what we call macroeconomics, which is how's the economy doing, etc. And that's very valuable. That quite clearly relates into ... Obviously, if the U.S. economy's growing, that's going to have an effect on earnings, all the companies that make it up. There's a lot of what you call top-down insights you learn as an economist. But I think the most interesting area that I would never have thought of that I could apply, is microeconomics. I didn't study microeconomics that much. I was more macroeconomist. And it turns out, a whole pile of microeconomics relates directly to stock picking. That's the area I probably didn't appreciate as much.
James Marlay: So, what's an example of microeconomics that applies to stock picking, what is it?
Chad Slater: Okay. So, there's a couple of them. The first one you can think of is what's called oligopoly models. There are two things called Stackelberg and Cournot theory oligopoly models. Stackelberg, what's called a leader-follower model. And guess which industry a couple of years ago looked exactly like this? Australian airlines. Got two airlines, and the leader-follower model means you have a higher percentage share in one than the other. But for that to work, you essentially need a game theory model, and you need to signal. And Qantas had never signalled that they wanted to stop.
So, one thing that was really interesting, why we got long Qantas at $1.20 ... We can talk about what we got wrong with that later ... Was that they were signalling through the press classic Cournot style and Stackelberg model, oligopoly signalling. They’d had enough of the price war. You don't need to collude, you can signal in certain ways. So, that was one and we actually wrote a piece up pulling in this theory. Unfortunately, we sold it at $2.20, thinking we're geniuses. That's another lesson in itself.
James Marlay: So, you did your time at Treasury. What was the next move? How did you go from that position and get into funds management?
Chad Slater: Well, I'd always wanted to be a fund manager, but there's not many graduate roles to go into. The advice had been to go work as an economist from someone I trusted, James McDonald, who went on to become deputy CIO at Hunter Hall. I think it was excellent advice. I applied for the grad programme at BT Funds Management that was one of the few places in the late 1990s, early 2000s that had grad programmes on the buy side and I remember the HR lady going, "You realise this is for new graduates, you've already got a job." And I said, "This is the job I want." And she goes, "Well, we don't think you're going to make the final round of interviews." And I said, "Well, I'll apply again next year." And she said, "Well, if you're that keen, actually come on down for an interview." So, the rest is history. I got offered a role there.
So, that's how I lucked into it, to be honest. There were 2000 people applied for those five positions. They did final interviews of 100 people. And then there's a grad rotation programme of 20 people. So, I was extremely fortunate. Good outcome's a combination of luck and preparedness, I think in life.
James Marlay: You've gone on, set up your own funds management business with Jack Lowenstein, Morphic. Tell me, the process that you employ has a macro layer to it, you have a head of risk - someone in charge of looking at macro. A lot of the interviews that we do with fund managers, they tell me that they're purely bottom-up, they're stock pickers. Focus on the fundamentals. Why do you have that role for the macro person in your business?
Chad Slater: Yeah, it's a good question. When you start your own business, you get a clean sheet of paper. So, most people who join firms have existing processes and they have to adapt to those processes and it either works for them or it doesn't, they get sacked and move on. When you have a clean sheet of paper, you think about, "Okay, what would I like to do?" And this goes back to my experience as an economist, reality is, and I've got a lot of respect for people who are bottom-up stock pickers only, but those stocks exist inside an economy. An economy is a sum of all those companies. It is difficult to say that, that company operates in complete isolation to that. If you look at any quantitative analysis, about 70% of the stock return comes from everything other than the stock specific outcomes.
So, whilst that matters, to ignore the 70%, I think, does a disservice to investing. The hard bit is how do you take that and try and put it in a process? Because most bottom-up stock people aren't economists. They know companies, they know management. So, trying to force them to become macro investors is a bad way to do things. I saw that in a number of firms I worked at. Is it to say, “Look, since we can't escape macro and it matters, let's make it a completely separate role inside the business.” And then it feeds into decisions in the stock picking and let's separate stock picking from the macro role.
Instead of saying macro doesn't exist, let's embrace it and try and figure out how to build it into the process. So, ideally, what we do then is we find a good stock and then Geoff, in the head of macro role, the two line up, good macro, good stock in theory should work. Conversely, you like the stock, but you don't like the macro, that says you might want to consider hedging out some of the risks somewhere.
James Marlay: Well, you've got some good horsepower on your advisory board. With Gerard Minack, who is obviously very macro focused. As we speak now, we're at a point where bond yields in the US have spiked to a high that I think has caught a lot of people by surprise and we've seen selling in equities, particularly some of the high PE names, longer duration. What's your assessment and the assessment of your macro team and advisory on what's taking place in macro right now? How are you thinking about that?
Chad Slater: Yeah, what's happening in macro ... We just had our weekly macro meeting with Gerard Minack today actually. And we sit down and Geoff, as my Head of Macro then brings it in. None of the stock team attends the meeting because we separate the roles. I don't want the stock people having opinions on these matters. They focus on stocks.
The Fed, as we get towards the back end of the year. So, up until last year, you made money by betting against the Fed. So, the Fed never raised rates as much as they threatened to under Janet Yellen. For the first time, the Fed is on track to do what they say they're going to do.
Now, there's this interesting quirk that happens where basically people have calendar years in their heads, people are behavioural animals. And as we get towards year end, they start to think about 2019. So, there's this quirk where the market reprices either against the Fed or to the Fed in the final quarter of the year. So, what's happening is, you see, is that the Fed said that they're going to do three to four hikes next year and the market had one to two in there previously. As we get towards 2019, the timeline of the Fed, changing his mind now, has compressed to a very low probability at the moment. So, the market is being forced to the Fed view, so you're seeing the whole curve move up. Not just two years but 10 years of moving, but 10 years are also moving a little bit quicker as people accept that maybe real rates don't have to be below zero, so the neutral Fed funds rate is getting pushed into the curve.
And why does this matter for growth stocks? Growth stocks are what you call long duration, which means you don't make your money this year, next year or the year after, you're betting that in five, 10, 15, 20 years, the growth pays off. I think Tesla is going to be… all the cars going to be sold in the future. When you have something a long way away and you change interest rate, it has much more sensitivity on today's valuation. Whereas if you own a mining company and you've got 10 years of mine life, changing interest rates has less effect on that valuation of the business. So, that's why growth stocks are getting hit at the moment, because these rates in the long end are going up at the moment.
James Marlay: It seems like the performance of these really exciting growth stocks and particularly this US leadership, this momentum trade, has been ... People have been wondering whether there's going to be a circuit breaker. You've written articles yourself about, is value investing dead? Is this change the reality of the spike in the long-term bond rate, is that the catalyst that's required to see a shift back towards value and maybe a derating or a deacceleration of the momentum that's been in those growth stocks?
Chad Slater: Look, we're not a growth investing house, we're a value investing house, as you alluded to just before. But, it is important to understand why growth has done well. Some of our peers in Sydney are just like growth over value, etc. We don't like that model, as in we prefer just to say, "What are the numbers behind it?" And growth has done well because it deserved to do well. So, earnings of growth stocks have come in as in line, if not better than what people thought they would. So, earnings of growth companies have actually done better than the earnings of value companies.
Value stocks have not delivered any earnings, so the market has been right to not price value stocks correctly. Or, not price like they used to. The issue is, growth stocks have gone up more than what they should have. And in particular, the early part of this year, growth stocks were going up, despite interest rates going up, which shouldn't really work. And that looks more like, I'll use this word carefully, a bubble rather than true fundamentals. It also looks a little bit like '99, where value stocks actually lagged and then you went into 2000 and growth stocks sold off. But value stocks didn't go down very much. So, with real interest rates going up, you'd expect value stocks to do better, but we are cautious that they just haven't delivered earnings.
James Marlay: So, just against that backdrop, what are you looking for in this environment at a stock level?
Chad Slater: At a stock level, hopefully, we'd have some sort of defensive characteristics and some certainty of earnings. So, there are factors in investing, which you call momentum, which is a trend. Things that are going up, there's value which we just talked about. There's growth and there's also quality. Momentum is a weird factor, it attaches itself to any of the other three. So, momentum can have value in them. Momentum can have growth in it. At the moment, momentum is full of growth and expensive stocks, so we're looking for quality, it’s actually not that expensive. Because quality doesn't have to be growing, so think of ... I'm trying to think of a business here in Australia that doesn't have a high growth ... A high growth profile, but it's ...
Think of Colgate-Palmolive, actually in the US. It's a quality business, but it's just not growing very fast, is to try and look for some quality with defensive characteristics.
We find them predominantly in Japan at the moment. Everyone talks about the world being overvalued. I'd point out that Japan's on a PE of 13. Even if earnings are 30% less than what you expect in Japan, that's still less expensive than what US current earnings are on. So, you find it. We think we find businesses like that, which are developed, not emerging markets so much that have some of these quality characteristics to them.
James Marlay: Yep. You're talking about some ... Buying stocks in some markets that are under pressure or have been out of favour for a long time. We've seen that the pressure that emerging markets have been in of late. What's the catalyst to see those markets start to perform well? Understandably, investors are sceptical about going into some of these lesser performing countries at the moment.
Chad Slater: Yeah, it's one of the hard things of value investing, while it's a good strategy on average, not always but on average. When you buy cheaper things, you have multiple catalysts. Jacob Mitchell at Antipodes says “multiple ways of winning”. I think it's a great phrase to describe what works for value is when you have more than one way. And value means you have a margin of safety, to use the Buffett phrase. We think when you're buying things on 13 times earnings in an upgrading cycle, that you get paid to wait. Patience works in your favour, if you get a good yield, and earnings are growing. You don't need the market to reassess you right away. When you pay a lot for a stock, patience can serve you poorly, because if it doesn't happen very soon, it's trading on a high PE, the stock will start derating on you.
So, I can give you a catalyst like ... If people think GDP... Like later this year, through to next year, globally is better than what they currently think it is, that should do better. If people come to appreciate that Japan's structurally reformed, it should come to do better. And in Asia, ex- Japan, where we do have some other stocks, if people appreciate that the earnings downgrades issue have not been that large ... there's a lot of money, I think, that can flow back into these things. But, patience serves you well when you're a value investor.
James Marlay: We'll stay on the idea or the concept of finding ideas. You run a number of ethical strategies. What's one example of a really compelling investment opportunity in the ethical space?
Chad Slater: Yes, so ethical investing means your money, my client's money, will not be invested in things that they don't want. And normally, and for us, this is characterised by coal, oil and gas stocks, as well as tobacco, nuclear, firearms, etc. They're the main ones. So, what we ideally look for is things that aren't in that space, that have some of the value characteristics and quality characteristics that we just talked about. The business that we really love at the moment, but it's coming under pressure at the moment is China Water. China, one of the biggest problems is the water, it's spread in all the areas that people aren't located in. And they've one of the highest loss rates from water and sewage. And that's been traditionally done by state owned enterprises, but they're not great at running sewage businesses.
So, China Water is one of the smaller listed companies there. And then what they're doing is they're working with third and fourth tier small Chinese cities to fix the pipes and plumbing. Not a particularly sexy business, it's not like Tencent, but it's a necessary business and they're very good at it. ORIX owns 25% of the business. So, ORIX is a large Japanese corporate and we think they've got a large loan growth profile. Market capitalisation of 1.3 billion US dollars. It's under the radar. We don't think the Chinese are going to change regulations on water and sewage that much. It's just they want people to fix their water and sewage. These guys don't earn an excess return. They're not a threat to the Chinese Communist Party, whereas Tencent might be deemed as that. That is an ethical business that we like, that's quality, and growing. It pays me dividend yield of 3%. And it's growing its earnings at 20% a year.
James Marlay: Essential services.
Chad Slater: Yes.
James Marlay: What about on the short side? Is there something… Does an opportunity get created in an ethical fund to short or sell things that you think are A) going to perform badly and B) that because they don't meet the ethical criteria?
Chad Slater: So, if you take a step back, the IPCC climate change report came out the other day. It's fairly well agreed, apart from our government, that to hit the numbers, to not get one and a half degrees of warming, we can't emit more than a certain amount of CO2. Now the problem is, if we continue on our current path, we're going to blow through that. That has all sorts of other ramifications. If we assume that we try to hit it, what does that mean for these businesses? So, it has all sorts of interesting outcomes. So, certain high cost producers in the energy space aren't going to work under these scenarios. If you price carbon, coal, actually may work under certain scenarios. Instead of taking a “coal is evil, coal is bad”, whatever in there, you look for the losers under certain scenarios. So, one thing that we've been short this year and done quite well for us, is we've been short Qantas.
Qantas is obviously a heavy user of oil and fuel. And it provides a nice offset to our portfolio because we don't own any oil and gas. So, if oil goes up, Qantas does poorly, but we don't own any other stocks. That's one way of benefiting from that view. Qantas is about to encounter a regulation change in jet fuel pricing in 2020, which is what you call an ethical change. The UN has changed the amount of sulphur that can be admitted from diesel and diesel and jet fuel are almost the same in oil refining industry. And that's sending margins up, on top of oil prices. So, we think Qantas is a stock that has issues with being exposed to carbon pricing, has issues exposed to regulation, and we thought it was an overvalued business at $6.50.
James Marlay: Chad, I know from reading your articles, that you're very big on having evidence to support your views, whether it be on bigger market trends. Is the compelling evidence out there that says ethical investing can add value or at least keep up with investing that doesn't have an ethical screen to it?
Chad Slater: I think the idea that they can't add value is one of the biggest furphies out in the market at the moment. And I think it's spread by people who they take it from a “I just don't like it” view rather than an evidence-based view. Last year we reviewed 50 papers and the sum of them is ethical, or ESG or SRI, depending on which phrase you want to use, does not destroy value. Now, how much value it adds, sort of varies by region, by style, etc., and stuff like that. But it doesn't detract just by doing that. That doesn't mean it's always going to add value. That doesn't mean I'm always going to pick good stocks. I can still get stocks wrong and we often do get stocks wrong, is that there's nothing inherent in the process that will stop you from making money.
Now, I think the best paper we reviewed last year was… The people who don't believe in ethical investing go, "If you look at tobacco and what they call sin stocks, alcohol, they've outperformed. If you don't own those, therefore you must underperform." I think it's a fallacy of composition. Just because you know that, therefore you've made a conclusion, that it goes to the end that therefore it must make sense. The paper pulled this apart and what it showed was correct. The assertion that sin stocks outperform is true, by the way. But, ethical investors tend not to own certain other types of stocks. They may be ethically dubious, but they're not in the sin category. Those stocks underperform, so they naturally owned stocks that outperform, call that a tail wind, but they don't own the sin stocks, we call that a headwind. When you stick the two together, you come to a small positive number. It's a great paper because it decomposed the issue and showed you how it works.
The other way you think about it is, I've got to build a 30-stock portfolio, give or take. If you look at the investible universe, excluding the oil, gas, and things we said we don't own, is about 900 names of those. Which leaves me about 7,000 names in the world. The papers also show, and our experience is the same, building a 30-stock portfolio out of 7,000 names, you're not constrained in optimisation. So, if I was to try and do it long only in Australian large cap stocks and remove resources and all these, then trying to optimise 30 stocks out of 70 or 60 becomes a very difficult problem. UBS had a very good paper on the optimisation issue as well. So, there isn't any evidence that supports those assertions. And I think investors are right to say you can do good, feel good, and make money.
James Marlay: Great headline.
Chad Slater: Wish I'd thought of that one.
James Marlay: Chad, we always like to hear about the lessons that investors have picked up along the way. So, I'm going to give you two questions to finish up on. First one, a painful investing experience that you've been through that's made you a better investor today?
Chad Slater: So, for that, I'm going to go all the way back, before I started my professional investment career, when I was an amateur investor. So, at university, a friend of mine, Tim Searles who worked with Steve from Forager, when the two of them were at Intelligent Investor. We were doing some investing. This is the career we wanted to get into. We were ... So, Tim's been over with Steve to Buffett in Omaha. And we're looking for moats and we found this business called Melbourne IT. This is going back to '99. It floated, it was overpriced. We're not going to buy. In the middle of the dotcom crash, it came back to what we thought was fair value. Buffett always says, buy when there's blood on the streets. So, we thought, "Yes, we're going to do this." We bought into the stock and promptly lost 80% of our capital.
And the lesson for me there was we caught a falling knife. Melbourne IT still exists today. It was probably never as good business as we thought it was, but it took us four years to get back to break even. Time value of money matters. So, Tim and I are still friends, but what we took ... I took on more and Steve has his own investing style. For me, that changed me into understanding momentum, timing matters, time value of money. And that started me down a path to incorporating more what you'd call trend investing into value. I'm never going to be a growth investor, but value and trend are possibly the best combination of factors to stick together. And I learned that the hard way by dusting a lot of my PA money before I started.
James Marlay: Alright. Well, let's finish on a bright note. Can you tell me about a successful investment that you've had a rip screaming, like out of the park investment that you've had and the lesson that you took away from that? That you can learn from your winners as well. What's something that you can repeat from a successful investment?
Chad Slater: So, possibly a thing that ... And this is true for most investors, is the distribution of returns is they make most of their money out of a couple of stocks and they give it back on the rest, basically. When I was working at Hunter Hall, and this is a little bit about how investing works, I met with my broker and we're talking about a stock in the portfolio. And I said, "Well, is there anything else?" He goes, "I've got this business called Herbalife. None of the street like it, none of my clients like it. They all think it's a bit dodgy. But, I think this is a great business." "Wow, let's hear a bit more about this." So, it was when the stock was trading at about $15 and we looked through it: great returns on equity, really fast growing business, and now changing their business mix.
And one lesson that came out of that, which has been told to me by another friend, Simon Gresham at MFS here in Sydney, is you always look for businesses where you have a small division or smallish division at say 20 or 30%, that's growing at 20%. Because even if the overall business is only growing at eight, if that 20 keeps growing at 20, it's going to accelerate the top line growth of the whole business. But no one's going to value the business correctly. They were switching over their model, to the way they do things with shake clubs, etc., and stuff like this. And we met management. What was interesting about the meeting with management was they've done all their DD on me. They knew where I'd worked previously. They knew how much money we ran at Hunter Hall. It's very rare to do a meeting with management where they've scoped you out beforehand.
And what's interesting there is a lot of people still hate that stock, Bill Ackman tried to short it. He’s been proven wrong. That was a four bagger for us, at Hunter Hall. And I probably felt appreciative of that lesson, and what I learned that there is: find a division at 20 or 30% that's changing inside of business and people don't adapt their expectations quick enough. So, if every quarter that came in, the earnings beat ... And they go, it can't happen again next quarter, it happened again, happened again, happened again. So, the stock just continuously outperformed for the better part of three or four years. And I think that Bill Ackman giving up on it showed there was a genuine interesting business, that had great barrier ... Like very high barriers to entry, it was not priced correctly. So, my lesson there was look for businesses changing and the names of our firm's Morphic, to change.
James Marlay: Right. Well, Chad, always good to catch up.
Chad Slater: Thanks man.
James Marlay: Love having a candid chat. And thanks for sitting down with us today.
Chad Slater: Cheers. Thank you.