Braitling: Valuation has never mattered less...

On the 23rd of May, eight fund managers will present their best ideas at The Future Generation Investment Forum. The line up this year looks exceptional and boasts a feature Q&A session between Magellan's Hamish Douglass and leading AFR journalist, Tony Boyd. It's an opportunity to hear some fresh ideas and to support the important work being carried out by the team at Future Generation. Livewire is proud to support Future Generation and ahead of the event we're publishing a series of in-depth interviews with a handful of the presenting managers. 

The first in this series is with Justin Braitling from Watermark Funds Management. Justin has some candid views on the current dispersion of valuations in the market and we also dig into some of the opportunities that are catching his eye, including a recent investment in Afterpay, a sector that is out of favour and his preferred pick of the banks. 

You often see it towards the end of a cycle, markets tend to become quite inefficient in the way they are priced. I can’t recall a time when valuation has been less important in determining the success of shares. Momentum is very much the winning strategy. 

Justin Braitling, Watermark Funds Management

1. Could you briefly summarise your investment philosophy and process?

We look to invest in the best companies we can find on attractive terms. We then hedge these investments by selling short the same value of shares in weaker businesses when they are overvalued by the share market.

As this is a fully hedged structure, our investors benefit to the extent the shares in the stronger companies that we have acquired (long portfolio) outperform the shares in the weaker companies we have short sold (short portfolio), irrespective of whether the share market rises or falls.

2. Give us the “elevator pitch” for market neutral investing.

This is a pure alpha strategy. Beta or market risk is effectively hedged out – investors can target more alpha than a traditional fund because they have the added benefit of a short portfolio. Two portfolios, twice the alpha. Or depending on the leverage it could be a lot more.

You end up with a leveraged exposure to the stock picker, and the value he/she can add, while removing your exposure to the share market.

The value in this strategy depends of course on the risks you see in the share market and the success of the stock picker in adding value. When the market is expensive and risky, a market-neutral fund is an attractive alternative. You can take advantage of mispricing opportunities in the share market, while avoiding the risks of the share market falling.

3. What are the big risks for the Aussie economy right now?

The Australian economy has proven to be remarkably resilient through external shocks, a mining boom and a now a property slump – it's a brave man to call the end to 27 years of economic expansion, so our base case is the economy slows and stumbles along.

The risks I see are with the all-important household sector. In recent years, labour’s share of the national profit pool has fallen, and household income growth has stalled along with productivity. If a Labor government pushes for wages growth without matching productivity gains this will squeeze margins and undermine business confidence, which is already fragile.

Another concern is with household debt levels, which are far too high in parts of the economy. This has become a structural problem and leaves consumers exposed to any adverse shock including a credit squeeze, which is clearly happening.

With an election pending, a key risk is with cross benchers, like the United Australia Party, undermining the parliament.

4. What is your current net exposure and what does it say about your views on the market?

In our directional funds we are slightly net short. This share market has all the hallmarks of a major top – on one hand we have a slowing economy, reflected in bond yields trading below 2%, and on the other hand we have excessive optimism in parts of the share market.

The current crop of market darlings trade on 50 times earnings, right where they were at the height of the dotcom boom almost 20 years ago. As the share market toils with a new high, I would caution investors to be careful. 

This looks more like a ‘bull trap’ than a launchpad to new highs.

5. You jumped into Afterpay in January. What's your view on the value on offer at this point?

The growth has been exponential. In Australia and New Zealand alone, Afterpay (ASX:APT) has 2.6 million customers, purchasing at a rate of more than $4 billion a year through 23,400 merchants. While we think that the rate of customer growth in ANZ may slow, the usage is set to increase – 95% of customers are repeat users. ANZ customer spend per month has nearly doubled to $400 since January 16.

The US platform added 1 million customers in just 10 months after launch. Extrapolating the recent growth rate, they should have more customers in the US than ANZ by the end of the year.

ANZ is a roadmap for how entrenched the product can become in the lives of millennials. The UK launch is scheduled to occur in the next two months. To put these markets in perspective, Australia has $30 billion of online sales, the UK has $130 billion and the US has $620 billion (~$310 billion ex-Amazon). This is online only.

APT expects to roll out to in-store in international in coming years. If the product is in any way as pervasive in the UK and US as it is in Australia, we would expect this to be the beginning of a new global payments platform.

The take up in the US is happening much faster than expected – the street is forecasting 2 million subs by year end. We suspect, based on the current run rate, the company could get there in half the time. 

Our modelling values APT at $35/share.

6. Are there any extra risks to be aware of when investing in popular stocks like Afterpay?

APT, ZIP (ASX:Z1P) and WiseTech (ASX:WTC) to name a few, are all disruptors. They have to get established before a better mousetrap comes along or before incumbents can respond. VISA and Mastercard are already feeling the impact of millennials shifting to instalment lending. Hopefully, they take you out. The Mastercard CEO made specific reference in an interview last week to the impact ‘buy now pay later’ was having on their business and the success of 'two Australian companies’. They have recently acquired one of Afterpay’s competitors.

7. The battery minerals sector is looking pretty beaten up right now. Is it starting to offer value?

The EV theme is very exciting, however, as with most emerging technologies it will probably disappoint up front but exceed expectations in the long run. The sector has been under pressure for the last 18 months following the early excitement as a flood of new material has come to market putting downward pressure on the lithium price.

  LIT:US, the ETF that tracks stocks in the sector, has halved since the sector peaked in 2017 and the lithium carbonate price has more than halved settling at around $US10,000 tonne.

Industry leaders that focus on the long-term outlook and plan accordingly are taking advantage of this weakness with Mineral Resources (ASX:MIN) selling half of its interest in Wodgina to Albemarle Corp and Wesfarmers (ASX:WES) bidding for Kidman Resources (ASX:KDR). This is a big strategic growth sector, there aren’t that many high-quality deposits out there, and while the market looks over supplied in the short term, the transactions we have seen to date would suggest there is value in the sector.

8. What's your view on the quality of the big banks' recent results?

Bank results have been messy, in typical fashion. Australian and New Zealand Banking Group's (ASX:ANZ) result impressed at the headline level but this was largely due to a gain on sale recognised above the line and an uplift in trading revenue following the ‘Fed pivot’ in March. The trading income led to a solid performance in the institutional bank, but we consider it less sustainable.

Alongside this, the core Australia franchise deteriorated significantly, with cash earnings declining 8% half on half. Mortgage arrears continue to tick up also but are yet to translate into bad debt charges. We were a bit surprised with the share price reaction on the day and see the stock has pulled back a bit since.

National Australia Bank (ASX:NAB) delivered a more vanilla result, which reflected some momentum gained in mortgage lending. It took a much-needed dividend cut, but the stock still has some issues to address – the appointment of a new CEO and finalisation of remediation provisions.

Our preference is for NAB given the strong valuation support and the significant opportunity for a new CEO to lift NAB’s performance. 

There is a reason NAB’s shares are still trading where they were 20 years ago – it's not because it’s a bad business, it’s a fine company that has been poorly run. We see this as a significant opportunity. 

The bank has a strong, experienced Chairman. Hopefully, they can secure the right banker for the task.

I don’t like to point the bone at any particular company. We look to maintain cordial relations with all the companies we follow. I will say though, the valuations in the tech sector are ridiculous, which makes them very risky.

The top five names in Australian technology are, on average, 30% more expensive than global software/cloud peers. The international leaders have the same growth but generate two to three times more cash flow.

Take Salesforce.com for example, led by its founder Marc Benioff. It occupies the leading position by far in the fastest growing enterprise software segment, customer relationship management (CRM). Its Software-as-a-Service (SaaS) tools allow enterprises to gain a 360-degree view of their customers via its ‘Sales Cloud’. It is unquestionably the world’s pre-eminent SaaS company. It has explicitly guided to double revenues in the next four years, with profits likely to multiply by a factor of four or five times.

Salesforce.com is currently trading at half the price of our Australian tech basket. Salesforce trades at 5.4x TEV/revenue versus the Australian basket at over 10x. And it generates three times more free cash flow per share than the Australian basket. All for the same revenue growth opportunity of around 20% per annum.

The scarcity of high-quality growth assets in Australia has resulted in domestic investors paying ludicrous prices for the few assets that offer a promising “story”. This has nothing to do with the companies or their business, but everything to do with investor attitudes to risk-taking and the abundance of easy money.

As we know too well from prior cycles, when complacency and excessive risk taking are so prevalent, there is little to no room for error, either at a macro or micro level. Buyer beware.

In the spirit of the prior question on lithium, I think Orocobre (ASX:ORE) offers exceptional value. Unlike the other listed players, ORE is fully invested and producing at capacity.

The Olaroz mine is in the lowest cost quartile on the industry cost curve, it generates very high margins and has a net cash balance of US$150 million. The business is currently developing the 25kt Phase II project, which will come online late next year and has potential for a Phase III operation.

With new management at the helm, we are looking for higher production volumes coming through later this year. At steady state, Olaroz can generate solid margins with a 40-year life and the valuation should reflect a higher multiple. We think ORE is worth $5.60/share, offering 50% upside, and is the best positioned lithium stock on the ASX.

11. Watermark is a pro bono fund manager for Future Generation, why did you get involved?

It's a very personal issue. We experienced a terrible loss some years ago and one of the charities that Future Generation supports is there at our bequest. We've supported that charity for many years. I think Future Generation is a great cause but it really resonated with us because of our experience and our desire to get this charity onto the panel.

12. How significant has funding from Future Generation been for the charity?

The charity is Debra, they help people with a condition called EB. It is a terrible debilitating condition and in many cases it is terminal for sufferers. This charity was just living hand to mouth, they would have charity events and balls trying to raise money. But they could never make longer-term investment decision around staffing and resourcing the charity correctly to help the sufferers. This money has allowed them to take a longer view and invest where they need to. It has made a huge difference for these sufferers that really need the help.

Hear Justin's best stock idea at the Future Generation Investment Forum

The Future Generation Investment Forum on Thursday 23 May is your chance to hear Justin and other leading Australian and global fund managers present their best stock picks. 

Don't miss out on the actionable investment ideas and the exclusive interview between Magellan's Hamish Douglass and the Australian Financial Review's Tony Boyd.

Visit the Future Generation website for more information: (VIEW LINK)