TOL - 13th Feb, 2023
5 high conviction calls from 2022's top-performing fund managers
In this episode, Totus Capital's Ben McGarry and Merlon Capital Partners' Neil Margolis share their strategies for the year ahead.
It takes a certain chutzpah to stick to your strategy in wildly volatile markets. And for these two managers, it certainly paid off.
Merlon's Concentrated Australian Share Fund delivered a return of more than 22.30% over the past year, while its Australian Share Income Fund lifted just over 18.08%.
Similarly, alternatives manager Totus Capital had a stellar year, with its Alpha Long Short Fund delivering a return of 9.44% over the past 12 months, and its Alpha Fund a return of 10.52%.
So what did it take to be a top-performing manager in 2022? And how are these portfolios positioned for the months ahead?
In this thematic episode of Buy Hold Sell, Livewire's Ally Selby was joined by Merlon Capital Partners' Neil Margolis and Totus Capital's Ben McGarry for an insight into their strategies, as well as their highest conviction stock picks for the year ahead.
Note: This episode was filmed on Wednesday 8 February 2023. You can watch the video, listen to a podcast, or read the edited transcript below.
Edited Transcript
Ally Selby: Hey, how are you doing? And welcome to Livewire's Buy Hold Sell. I'm Ally Selby and today we're very lucky to be joined by two of the best-performing fund managers from 2022. That's Ben McGarry from Totus Capital and Neil Margolis from Merlon Capital. Today we'll be learning about how they did it, as well as some of their top picks for the year ahead.
Okay, let's dive straight in. I want to know what investors needed to get right last year to outperform. What did you do that helped you deliver that stellar performance?
What you needed to get right to outperform in 2022
Ben McGarry: So last year was all about multiple derate on rising interest rates. And the companies that had the highest multiples had the biggest downside and derating potential, and avoiding those was key to doing well in 2022. So tech and in particular, unprofitable tech, was the place to avoid and we had some shorts in that space in 2022. The other thing that you had to do well was pivot to value. Resource stocks did very, very well. And if you're an Aussie investor, the big four banks were a good place to hide.
Ally Selby: Do you think that's still going to play out in 2023 or is it a new environment for investing now?
Ben McGarry: I think we're probably in a new environment with higher rates and higher inflation than what we're used to.
And typically, it's unusual for the leaders of the previous boom to lead the next boom. I think people should be careful about just rushing straight back into those tech leaders because they're down materially. There's a good chance something different leads the next boom and we think resources is a reasonable candidate for that.
Ally Selby: Okay, over to you, Neil. What did you do right last year?
Neil Margolis: At Merlon, we value sustainable cash flows at long-term discount rates and that was richly rewarded last year as inflation triggered, as we all know, significant rises in interest rates. As Ben said, leading into 2022, low-interest rates had boosted the valuations, not the earnings - that's important - but boosted the valuations of long-duration growth stocks. Commodities were the other theme where you had recovering demand meeting an underinvestment in supply, which caused commodity prices to go above trend.
Ally Selby: And do you feel like that could reverse this year? What do you think could happen?
Neil Margolis: Well, interestingly, 2022 was the worst year in 100 years for both equities and bonds combined, they both fell double digits, which actually hasn't happened in 100 years. But then I look to the first five weeks of this year and it's the best year since 1987 for cross-asset returns, which means that both bonds and equities are going up.
I think it's more important to think about what's priced in. And I think this Goldilocks scenario, where inflation just magically glides back and we don't lose any jobs, is mostly priced in. The scenario where inflation sticks around or we need a recession to get rid of it is not.
The biggest blunders from the year just past
Ally Selby: Our readers love it when fund managers admit what they got wrong. I know you had a very successful year last year. Were there any mistakes that you made and what did you learn from them?
Neil Margolis: Mistakes are obviously important to learn from. I had a look through the portfolio, and the stock that performed the worst was only down about 15% over the year, which was Unibail-Rodamco-Westfield (ASX: URW). It is obviously the old Westfield malls in the US and Europe plus the Rodamco malls. And it had a very strong period leading in, I think it was up 44% the day the vaccine was announced, which was two years prior. The market's quite concerned about the high debt levels. So when there were fears over a recession, it underperformed. The way we look at it is it's on a yield of 10% to equity and trading on less than half book. So a lot of bad news is factored in and the debt is quite long duration. If that debt proves to be a problem for them, then the global banking system is in a much worse shape than Unibail is all I would say.
Ally Selby: Okay, over to you, Ben. Did you make any mistakes last year? And if so, what did you learn from them?
Ben McGarry: We always make mistakes, Ally. It's part of the process. We came into the year with a backbone of tech and we held onto some of those mega-cap tech names a little bit longer than we should have. Meta Platforms (NASDAQ: META) was probably one of our worst performers during the year. We thought that big-cap tech would be quicker and more aggressive at pulling the cost lever. They took about a year to get started on that. The other thing that we did was we thought the consumer would be weaker. The slowdown has been very slow. It's a slow-motion slowdown so far. So we were too early on shorting consumer discretionary stocks. And the big four banks, we thought they would do it tougher with higher cost bases and the housing market really starting to slow, but they've been super resilient. So let's see if they can keep that up in 2023.
What you need to get right in 2023
Ally Selby: What do you think investors need to get right in 2023 to be successful? You mentioned resources before. Is there anything else that you think investors need to get behind to be successful this year?
Ben McGarry: As Neil said, the market is pricing in a Goldilocks soft landing, a profitable recession kind of scenario. And if that happens, that would be a very unusual thing in history, with inflation above 5%. I mean, the yield curve is inverted. It's the eight from eight perfect indicator that a recession is coming in the US and this mortgage cliff with the expiry of fixed-rate mortgages in the middle of the year is a big deal for the Aussie consumer. So there is a good chance that we get inflation picking back up in the second half of the year, which means rates have to stay high for longer and that's not going to be great for equities. So be patient, you might get another bite at this later in the year.
Ally Selby: Okay. Are there any sectors you would be hiding in then in that environment?
Ben McGarry: Resources had a good year last year. We think they still look pretty attractive with very strong balance sheets, very clean accounting, and high cash generation. And the supply situation is quite different to what we saw in the last resources boom. It's very difficult to get new projects up and permitted and the ESG movement in energy, in particular, has made it super difficult to get new projects up. So the supply side is very supportive and if we do have a soft landing, resources should do pretty well this year.
Ally Selby: Over to you, Neil. Ben sounds a little bit bearish. What sectors do you think can outperform this year? What sectors do investors need to get behind?
Neil Margolis: Forecasting is very difficult and macro forecasting is even more difficult than forecasting at a company level. That's why I prefer to say what we think is priced in. I think Goldilocks inflation is mostly priced in. If that continues, there'll be a bit more upside for long-duration growth stocks and defensive stocks, which we don't have a lot of exposure to. But that's a scenario where everyone is making a lot of money. So I don't mind lagging in a more speculative market like that.
In the scenario where inflation proves more persistent, it is going to be a problem for earnings because there'll be a crunch on margins as well as multiples. Back in the 1970s, multiples were single digits when inflation didn't go away. So in that scenario, investors want to be focused on companies with strong cash flows and pricing power.
In the scenario where you need a recession to get rid of inflation, you still need strong cash flows, but you really want to be very careful of leverage. And the most leveraged companies in the market are the banks. So in that scenario where we need a recession to clear inflation, I don't think it will end well for the banks.
Sectors to avoid in 2023
Ally Selby: And what kinds of sectors do you think investors should be avoiding in that environment? Are there any stocks that you want to name or point out that you think investors should avoid?
Neil Margolis: Yes, as I said in persistent high inflation or recession where we need to clear inflation, you want to be careful of leverage. I think a crowded sector is property trusts. Even though they had a difficult year in 2022 and they've done quite well in the first month, they are highly leveraged. They're factoring in very low cap rates relative to history. The market is pricing them at about a 10% to 15% discount to what they're saying their properties are worth. But their cap rates are quite similar to what it costs a major bank just to borrow money and there's no spread for risk or property-specific risk. And the banks more generally, the banks ultimately only have $5 capital for every $100 loan. So if you do think there's a recession coming, it's not the base case, but it's not priced in, you just want to be careful of stocks with leverage like the banks.
Ally Selby: Are there any names that you'd want to actually put out there?
Neil Margolis: Within the banks, obviously there are two banks that are more expensive and two that are a bit cheaper. The ones that are more expensive are Commonwealth Bank (ASX: CBA) and NAB (ASX: NAB), because they've been winning market share, and the management teams are more highly regarded at the moment. So I suppose they would have both the earnings downside plus a potential fall in their stock market rating. So they'd probably be more at risk.
Ally Selby: How about within REITs?
Neil Margolis: I think we'd be probably avoiding the industrial REITs the most and the office REITs. At least the retail REITs already were pricing in some risk from online sales even leading into COVID. Whereas we feel the cap rates are very low versus history for the industrial and the office REITs and there's quite a lot of risk there.
Ally Selby: Okay. Over to you, Ben. Which sectors do you think investors should avoid in this environment and do you want to throw in some names there that you think could suffer over the next 12 months?
Ben McGarry: I'd be a little careful, like Neil said, on the banks. I agree with his point there that a housing downturn would be a risk. And we've got a short in Bank of Queensland (ASX: BOQ) where the CEO recently left and the chairman pointed out that two of the reasons that they were concerned or made a change was balance sheet and risk, which are the two most important things for banks. So they've gained a bit of market share in recent years. So Bank of Queensland we'd be careful of.
But the space I wanted to talk about was lithium, which has been a very hot sector and has attracted a lot of capital. The producers are probably okay, they're generating lots of free cash flows with high prices, but it's the hopefuls that are trying to develop new projects in interesting jurisdictions. Some of them are trying to use new processes or less proven processes to extract the lithium. Many of them have got big market caps with no revenue and high CAPEX. So we've got shorts in AVZ Minerals (ASX: AVZ), Sayona Mining (ASX: SYA) and Lake Resources (ASX: LKE). So we'd be careful of that space.
High conviction stock picks for 2023
Ally Selby: Okay. I'm really excited for this. We asked our fundies to bring along their two highest conviction picks for the year ahead. Ben, over to you. What are your picks?
Ben's picks: Long Alphabet, short Australian Clinical Labs and Fortescue Metals
Ben McGarry: Okay, highest conviction picks... I'm going to use a US name that's off 30%, Alphabet (NASDAQ: GOOGL), a stock we've owned for almost 11 years now. We think that's getting thrown out a little bit with the overall tech selloff and there's a lot of hype around this ChatGPT, the new AI tool that Microsoft (NASDAQ: MSFT) has bought into. Finding great businesses when there's a question mark about their moat, Visa (NYSE: V) and MasterCard (NYSE: MA), when people were focused on buy now, pay later or FICO (NYSE: FICO) when people were concerned that AI was going to remove the need for credit scoring, turned out to be great buying opportunities. So we think Alphabet on around a market multiple off 30% from its highs and now having some discipline around cost is a good buy.
Ally Selby: And number two?
Ben McGarry: I've got a small-cap short and a large-cap short. Australian Clinical Labs (ASX: ACL) is a small-cap name that was a private equity float that listed during COVID. Now, volumes have collapsed. They haven't come to the market yet about margins. And we think that there's a reasonable downside for margins. We've seen that with Healius (ASX: HLS) as COVID testing has collapsed and private equity still needs to exit. So ACL.
And on the large-cap side, Fortescue Metals Group (ASX: FMG) has run very hard recently. We're concerned about the future industries' investment in hydrogen. We think that's a distraction and a big drain on cash flows. So Fortescue, as a hedge against some of the other resource exposures in the book.
Neil's picks: Long Medibank Private and News Corp
Ally Selby: Okay. Over to you, Neil. What are your two highest conviction picks for the year ahead and why?
Neil Margolis: We actually quite like Medibank Private (ASX: MPL), the health insurer. It's trading on around a market multiple, but if you break it down, it's less risky than the average company. It's obviously got annuity revenues in a recession. It's high return on capital and doesn't need a lot of capital to grow. It doesn't have much debt and it's quite high growth because the more you think there's going to be claims inflation, they actually pass it through in their prices and it gets aggregated at an industry level.
Now, any industry where the government is meddling is a risk. But I think in this case, there's a lot of political support on both sides for private healthcare to remain, it's one of the reasons we actually have a good public system. So I don't think the politicians will want to trash the sector. Now, why is it trading at a market multiple? Obviously, the cyber attack, which could lead to market share loss, it could lead to fines, and class actions, but the company's market value has dropped about $2 billion since that cyber attack was announced. And we think that's too much. So it presents a good opportunity to buy a low-risk, high-return on capital stock at a discounted price.
Ally Selby: Okay. And number two for you?
Neil Margolis: A stock we've owned for some time now is News Corp (ASX: NWS), which obviously is a long-held conglomerate that's traded at a discount. But we think finally the management is serious about unlocking that discount. Realestate.com, which is obviously separately listed and is one of the best stocks on the exchange. We only value it at around $75 to $80 compared to the $120 that it's trading at. But News Corp owns 61% of it. So even if you put in our lower valuation, they've got the online classified business in the US, realtor.com, which has been speculated they're going to sell for up to $3 billion, which we've only valued at $1-$2 billion. They've got Dow Jones, which is a very strong subscription news business, which is trading much cheaper than say the New York Times. They got book publishing, which is quite defensive. So it's a conglomerate that's always traded at a discount. But we are seeing some signs where they are prepared to unlock that discount and there's quite a lot of value on offer if you look through its holdings.
Ally Selby: Well, there's a lot of value in that episode. I hope you enjoyed it as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube channel. We're adding so much great content every week.
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Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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Livewire Markets
Buy Hold Sell is a weekly video series exclusive to Livewire. In each episode two fund managers give their views 'Buy, Hold or Sell' on five ASX listed companies. Not recommendations, please read the disclaimer and seek advice where appropriate.
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