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A rich vein of quality stocks in a crazy market

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As a global investor, Ned Bell of Bell Asset Management invests across the board but it’s the small to mid-cap (SMID) space that most excites him. Here he finds a rich universe of companies that are high quality from a fundamental perspective, inexpensive, and having seemingly fallen between the cracks as attention centres around the tech thematics. This is largely because institutional investors and ETFs have little interest in the SMID space, despite these complementing large cap stocks in a diversified portfolio.

In the Q&A, Bell discusses the process that goes into researching this asset class, the challenges of engaging with SMID management in a COVID world and the companies he likes. He also offers views on US tech stock valuations, what he learned from the dotcom boom and bust and how to go about having some exposure to technology stocks.

Key discussion points:

  • Market outlook (2:30)
  • Evaluating US Tech Stocks (4:00)
  • Expensive thematic tech versus well-priced, robust fundamental tech (8:05)
  • The case for SMIDs (12:58)
  • Stock and sector picks (21:55)

Watch the video or access the Q&A version of this interview below.

You said recently that earnings expectations in global markets are effectively pricing in a seamless return to normality in 2021. With that in mind, are you bullish or bearish about markets right now?

When we think about the markets looking forward, we're very bullish about certain aspects of the market, but we also have some concerns about certain pockets. Probably if I was to frame the way we're thinking, our concern is more around the achievability of earnings expectations for next year. 

Consensus estimates are implying that earnings next year will grow by 28% on this year, which would also imply that they would be 12% higher than 2019. And frankly, we struggle with that, with the achievability of that number. That implies very much a seamless recovery and we still feel as though obviously COVID is still in the background, and really hasn't been completely controlled.

We still feel like there's some risk there, but I think if I was to break down the market into two buckets, probably the biggest risks are in what we would call the overvalued growth stocks, and also the more economically sensitive value stocks. That's where we see more risk. From an opportunistic perspective, we'd probably say that the defensive quality names, they still are quite compelling. They have lagged, and valuations are pretty compelling, as are the small mid-cap names which have also lagged.

How are you positioning to reflect this view?

At a really high level, we are overweight that small and mid-cap (SMID) space. We've got about 37% of the portfolio exposed to small mid-cap stocks. It is pretty meaningful, and that is where we've been finding more and more ideas. At the mega-cap end, we're quite underweight. 

We're about 7% underweight those top 10 stocks in the index. If you break down regionally, we're quite underweight in Asia-Pac, a little bit underweight in North America, but our biggest overweight is actually in Europe. That's where we tend to be finding really good relative value. I guess from a sector perspective, it's probably the most notable divergences would be our overweight in healthcare and consumer staples, and underweight in financials and industrials.

In a recent report you said of tech stocks: “the current market frenzy is somewhat akin to the speculative investor behaviour of the late ’90s that culminated in the boom and bust.” Can you provide full colour around why you’re worried about the tech rally given the earnings power of these companies?

I think you're quite right in making the point that the quality or the earnings power underlying these, particularly the big FAANG stocks, it is very strong. It's much stronger than what it was in the late '90s. But it's more around the idea of the actual investor behaviour, and I actually started my career, I was working in San Francisco in '99-2000, so I was at the coalface. I saw the final hurrah of the dotcom boom and bust, and there were some similarities in investor behaviour between what I saw then and what I'm seeing now.

I think when you think about the tech stocks as a whole, as much as there are some really strong companies who are generating huge returns on capital, there are also a lot of others that are not particularly profitable, and the management teams are prioritising growth over profitability. And then from an investor perspective, I guess valuation has almost gone out the window. It's almost been irrelevant of late, and companies have been rewarded for again, prioritising growth over profitability. And it's really fuelled this, I guess this speculative frenzy where many investors, particularly in the US, they are buying themes, not businesses, and then it's pushing stocks to what I'd call probably nosebleed levels.

An obvious example has been Tesla, which has been ... It's an incredibly large company, but Elon Musk openly says that they are prioritising growth over profitability, and the way I think about it is these extremities or extreme conditions often have a habit of mean-reverting, and when they do, they come back with a thud. 

The other point or anecdote I point out was that back in 2000 when I was working in San Francisco, I distinctly remember a lot of market pundits claiming that Warren Buffett was too old to understand the tech sector. Fast forward 20 years on, and the latest reports are that he is buying gold, so I think Warren Buffett's definitely outlived some of his critics 20 years ago, and there are some familiar tunes ringing now.

Does it feel like San Francisco again today? Are we the 'last hurrah' stage?

COVID has brought forward a lot of the thematics and secular themes we've been talking about in these companies. The immediate earnings power is very strong. But I do feel like there is a ... the underpinning economically behind the market is still pretty fragile. I think that's probably what gives me the most concern, and I just think that we're approaching a point where the most speculative and the most expensive ends of technology and the growth stocks are just looking more and more vulnerable.

That's where we'd be a bit more concerned, about the other thing that's changed this time around, hasn't been in the past, is the amount of ETF buying and passive buying in these stocks, which has been absolutely enormous. And frankly, I just question who's the incremental buyer of those names when they come off?

How do you reconcile that view given IT makes up the largest sector exposure of the fund and Google, Microsoft and Facebook feature in the top 10 holdings?

We're not suggesting that you shouldn't have exposure to tech. We just think you need to be selective, and you need to focus on the companies that have got really good balance, earnings underpinnings and their valuations are sensible. Google, Microsoft, and Facebook, we think those companies are fantastic. We have a lot of conviction in them considering:

  • We still see on average, about 30% upside in those three names, looking out over the next few years and when we think about their growth rates.
  • They trade on an average PE of about 28 times this year's earnings, and from a growth perspective, we're expecting to grow their earnings in 17-20% range. That's pretty good value for money.

If those stocks can literally just hold those multiples, which we think are relatively fair, given the quality of the businesses, it's going to deliver investors pretty good returns looking forward. That's why we've got pretty big positions in those names. And also the balance sheets are incredibly strong. 

When you strip the cash out of the balance sheets, the actual earnings multiples are even lower than that, and the valuations are even more compelling. 

We're not getting sit here and say they're dirt cheap, but we are going to sit here and say using a base case scenario of these stocks holding their multiples and earnings compounding's going to be pretty powerful.

It's really discriminating between what I probably call expensive thematic tech, and well-priced, robust fundamental tech.

Which parts of the tech market don't you like?

Buy now, pay later! I mean, within the global equity universe, it's the stocks that are trading 50+ times earnings and have got relatively low returns on capital. They might be very quickly growing companies with great thematics, but they're so over-owned that they are a bit more vulnerable to earnings downgrade, so it's a multiple compression. That's where we're probably steering clear from.

As I said, there's a lot of thematic stocks that have dominated the market in more recent times. We're just steering well clear of those, and really just trying to drill down on the businesses themselves and looking at it from the perspective that we want to be owning really high return on capital businesses that are going to continue to grow. That steers us in the direction of those names we talked about earlier.

One of the unique aspects of your strategy is your ability and tendency to go overweight global small & mid-caps (SMID). What’s the thesis behind investing in these companies as opposed to purely large caps or buying the S&P 500?

As an all-cap manager, we can invest across the board, but we have added a lot of our alpha over the years in the small mid-cap space. And we find that there's generally not nearly as much crowding in this space, but there's a very rich universe of companies that we think are very high quality from a fundamental perspective, but really importantly, they're not that expensive. They seem to have fallen between the cracks somewhat.

To some degree, I would suggest that's a function of the fact that institutional investors don't make big fundamental allocations to this space, and there's not a lot of ETF buying. I should just highlight how we define SMIDs, because it's a little bit different. The MSCI use the bottom 28% of the MSCI World Index. We take that approach, and that leads us to a range of about $1-$30 billion market cap.

Again, so that's a pretty rich universe of companies in there, and many of which, they are growing very nicely and they can complement large-cap stocks really well. We think it's a fantastic part of the market, but most investors don't have that much exposure to. There are some very high-quality businesses in there whose earnings are very much a function of their franchise, and a lot of them are generally not as cyclical as maybe investors would think.

As a Melbourne-based fundie who has unfortunately endured lockdown mania, how do you find global SMID opportunities?

It's a good question. The two main ways we think about it:

  • Firstly, you need to wear out the shoe leather and do lots of travel. In a pre-COVID environment, we've been doing a lot of travel. We're doing about 500 research meetings a year. I'd say about 70% of those 500 engagements would be with small mid-cap companies. We've built up a pretty deep and rich library of views and theses on these companies.
  • Secondly, we've got a pretty well-defined process. For example, we screen for companies. They have to have return equity above 15% for three consecutive years. We judge them based on things like management strength, franchise strength, their profitability, balance sheet strength, ESG, and business drivers. We ultimately end up with a refined list of about 150 companies that we've built up over 10-15 years.

Has the process changed post-COVID?

I wouldn't say there's a change in investment process. It's more the change in how we engage with them, is really the main thing. For example, the conferences that we would typically attend in person have all become virtual. They're still there, but the benefit of COVID, which was a bit of a surprise to all of us, was that the companies themselves, particularly in small mid-cap, because they're not travelling from conference to conference, they actually have more time available to spend with us in this type of environment, so we can do calls and video conference calls with management teams, almost at a moment's notice. Which is terrific, and to a large degree, I would suggest it probably levels the playing field between, as you quite rightly pointed out we're based in Melbourne, so we're about as far away from a lot of these companies as you could possibly be. 

But a lot of other managers, whether they're in Europe or the US, they're in exactly the same boat. It hasn't really had a materially big impact on the way we think about the companies. I'd say that, as I mentioned earlier, having the background and the history on the companies is a huge benefit. Learning companies from scratch now, being so far away, not seeing them in person, is quite problematic. Especially given the change and the backdrop, and just the sheer level of uncertainty.

I would say that it'd be quite hard to pick up this asset class now, in this environment where you cannot travel. If you didn't have much history with a company, it is harder to learn companies on the hop in this type of environment, because often they are at their worst. That's where you can frankly, probably make some mistakes.

Can you provide some colour around valuations of SMIDs in the context of other market capitalisation ranges?

It's a good question. This is where we're seeing one of the biggest opportunities in small mid-cap. 

  • The forward-looking PE of SMIDs is at about 22 times earnings, and that's depressed earnings this year. That's about a 10% premium to the market, which is in line with the five-year average. You're not seeing huge multiple expansion in SMIDs, as you have for example, in large-cap growth. 
  • Large-cap growth stocks are trading on a PE of about 30 times earnings, which is about a 45% premium to the market, and it's probably the biggest premium to the market they've been in 10 years, which is no huge surprise.

We do feel like there's a pretty compelling relative valuation argument with SMIDs, and then more recently, they have lagged. I mean, in the last 12 months, SMIDs have lagged by probably about 6.5% to the end of September, and about 4.4% per annum the last three years. That lag has not been a function of poor fundamentals. They just haven't kept up with this very narrow universe of massive companies. 

But what we do think is there's a likely scenario looking out over the next two years, where that performance will mean revert. You'll see very strong outperformance in small mid-caps, and what we've actually done is we look back historically through two previous earnings troughs, the two biggest earnings troughs in the last 20 years being post the dotcom boom and post the GFC.

What we saw in the subsequent five years was that small mid-caps outperformed massively in the next five years. They outperformed in the MSCI World Index, but also large-cap growth. That's a function of really two things, but one being just the sheer earnings leverage. Once you get through the other side of whatever the disruptive event is, but also PE re-rating. 

We feel like now we're in the third of these earnings troughs, and then if we look out into probably the second half of early next year, that earnings level in SMIDs will pick up quite a bit, and we will get this mean reversion. There's a really terrific opportunity to make really strong money in the small mid-cap sector.

What are 2-3 themes within SMIDs that you are most excited about right now?

So, I think at the moment, given the very unique backdrop we're going through, probably two of the most interesting things I would point out would be that:

  • First of all in terms of the US consumer exposure in a post-COVID environment, we've actually seen maybe not that surprisingly, but some of our companies have done really well. Like, they've done incredibly well by virtue of the fact that consumer behaviour in the US has changed a lot. Because people, they're not travelling, they're not going out for dinner. They're staying at home, and their home has become where they live, where they work, where they holiday. You get companies like Poolcorp, which is the biggest pool services company in the US, doing incredibly well. Because the new holiday destination is the backyard. Companies like Techtronic, which is big in the power drill market, tractor supply which is a really unique retailer. It's a little bit like a regional, mini Bunnings type retail concept. And then Yeti. Yeti, who are the makers of a drinkware and coolers and that sort of thing. They're benefiting from the idea that the way in America, the way people are holidaying, they're camping, they're going on fishing trips, so they're buying all this Yeti gear. Those companies, it's quite counter-intuitive, because the economy's been shut down to a large degree, from a continuous perspective, yet these companies are recording record earnings, which is fantastic. 
  • The second one would be the healthcare space. We actually find most of our growth stocks in small mid-cap in healthcare. Unlike what you see in large-cap where most of the big healthcare names are regarded as being quite defensive and probably a bit more value, we've got companies like Ambu, Align Technology, Straumann, IDEXX Labs. They're all growing their earnings of 13%+ per annum. So, it's a different pocket of growth, we think is quite interesting. And to some degree, underappreciated, and definitely under-represented in portfolios.

Boiling it all down into some stock ideas, what is 1 large-cap and 1 SMID stock you like right now?

Large-cap: Alphabet Inc (NAS:GOOG)

In the large-cap space, it's actually Alphabet. Alphabet, we still feel like, like we were talking about earlier, it's one of these well priced, very high-quality companies. It's on a PE of about 26 times, it's a pretty modest premium to the market. It trades on a 7% premium versus a 28% premium on average the last five years, but it's growing its earnings by 16%. Very profitable, return on capital of about 17%, and net cash position of about US$105 billion, which is about 10% of market cap. Again, when we look at, we still see in the vicinity of 40% upside in Alphabet. Given we're near the top of the market, 40% upside of anything tends to stick out. I think Alphabet's probably the main one there,

Small/mid-cap: Yeti Inc (NYS:YETI)

Yeti we think is a really interesting, growing lifestyle brand in the US. We think it's got the potential to be the next Lululemon. It's very much in its infancy. It's only got 4% of its sales outside of the US. It was founded by two brothers in Texas. Big in the hunting and fishing types of community, but really growing, becoming one of these real cult brands.

You look at that company, it's a US$4 billion market cap. We think it'll grow its earnings by 15-20%, and again, it's already very profitable. It already generates a high return on capital. They've been very diligent about how they grow. They're not trying to grow too quickly, which is important. They've got some new distribution partners through Lowe's in the US, which is really just starting to kick in. Again, the other beneficiary they've got from COVID is that their online sales through their website have become a very large part of their overall distribution network. With that comes terrific margins. That's a really interesting brand we think is very much in its infancy.

Learn more about Bell Asset Management

Ned believe's that a portfolio of very high quality businesses will deliver above average returns over the medium to long term. For more information on where he is finding the most compelling opportunities, use the contact form below or visit Bell Asset Managements website

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