Finding future leaders (and why we still like Altium...)
Fidelity's Future Leaders Fund recently made history when it won Morningstar’s small-cap Aussie equities ‘Fund Manager of the Year’ award for the second consecutive year. Following this impressive win, we recently dropped in to chat with the fund’s Portfolio Manager, James Abela.
In this wide-ranging discussion, James explains why he focuses on this part of the market and goes on to share the framework of his successful investment strategy, some red flags for investors to watch out for, and an important theme that emerged from the recent reporting season.
We also took the opportunity to ask why he’s still comfortable holding the fund’s core position, Altium, which is now up more than ten-fold over 5 years. Read on for the transcript of our discussion to get the full story.
Q: What are some of the most enjoyable aspects of your work?
I think the most enjoyable aspect is really the compounding of returns, that sustainable 10 to 12% return over time, over a five-year basis.
When we get to the upper end of that band and you're doubling your client's money every five years, that's a phenomenal return. In a world like today, where you've got 2% cash return and property is on the decline, to give a sustainable 10 to 12% return compounding over time for me is a great return for any investment, and that'd be a top quartile investment in the world. That's what keeps me excited.
The second one is really taking capital away from those that don't deserve it and giving it to those that do.
It's kind of a Robin Hood role for me, and something I really enjoy, especially in small caps. You've got a lot of storytellers, a lot of promoters and a lot of poor behaviour. It's very exciting, and it's all about new ideas. But there's a lot that come in and come out of that small-cap world.
The ones that are the future leaders are really, really amazing and you want to keep giving them capital, you want to keep supporting them, you want to be investing in those early.
So for me, you're taking capital away from those that don't deserve it and giving it to those that do. That is probably the one thing that I do still get excited about and drives me.
And that's really the most enjoyable aspect is the fact that me it's a bit of theatre, a lot of numbers, a lot of words, and a lot of ideas. And it's a real combination of all those things at the same time.
Q: You look after small to mid-cap stocks, why do you focus on this area of the market?
The top of mid-caps is around $10 to $12 billion, and the bottom of the small-cap range is around $300 million. That's pretty much what the market cap range is.
The big excitement for me is finding that future leader. If you can find something that is the future leader, that has for me the viability of a great returning business.
Sustainability is something that they're doing that's sustainable, and you have the credibility - a management team that believes that credibility, and integrity is important.
The management accounts are clean, and the reputation of the business and the management team is also very high. If you can have those three things, viability, sustainability, credibility, and you can buy a business like CSL, Cochlear, or realestate.com.au that goes up 100 times over a 10 or 15 year period. That's what I spend my life trying to find.
Since about 21, 22, I've spent my life providing tax and accounting advice to small business, and it's been 20 years of my life looking at small companies. So for me, I love it, because of the fact that you can find these future leaders. And to find those early is a phenomenal return.
Q: How do you also go about avoiding the bombs? Are there any red flags that you look for?
Over 20 years I've developed a series of checklists, and red flags will basically drive concern, will tell you the risk is going up. Viability, sustainability, credibility, is really my bottom up stock picking tool. And particularly the blow-ups you find come from that credibility side.
So it's either bad accounts, red flags on accounts, red flags on management. M&A, or bought growth, balance sheets where the biggest thing on the balance sheet is the intangibles is also another big red flag. And very poor management reputations, or very poor management or non-verbal communication behaviour. So whether it's arrogance, confidence, non-verbal communication which makes your left brain and your right brain think something's not right here.
That all comes from the credibility side. And those red flags, there's a long list of them, and they'll all just basically tell you the risks are going up. And you probably need to either exit the position, or dramatically reduce the position. And there's been countless blow ups in small caps, and they all have a very similar characteristic.
I think that the uncovering of low credibility, low quality management teams and accounting systems have really come up in the last sort of 12 months. There's been a lot of uncovering I'd say. I just think the capital is getting a lot tighter. Liquidity is getting tighter, so this sort of liquid easy cheap money for me ended about 12 months ago.
And you can see that in the signals of the IPO markets and the secondary markets for placement has really, really come off. If you roll back about five years, you can see this degradation of returns in IPOs. Five years ago it was in the teens, then it became 10 or 11%, then it became single digit, and then low single digit. And then it started to become negative in the last year or so.
And when you start to get negative IPO performance, it's a very strong signal that basically the market's coming towards the end in terms of having the freedom, of having very liquid easy markets. So for me, that's why I do think that the actual presence and prevalence of this easy money outcomes is really, really reduced in the last 12 months.
Q: So how do you maintain conviction to keep holding Altium, given its current PE is at 53, and what would it that would cause you to either trim or add on to that position?
Look, I think of it as sort of three ways.
One is the quality of the business overall. So the viability, sustainability, credibility for me is still very, very high. There are not that many companies in my universe that have the strengths, in the viability, sustainability, and credibility. So for me, the VSC scores are really high, so that is unique in itself.
Then in absolute sense, if 50 times goes to 43 times next year, the company is actually growing. What I look at is actually the PE to the ROE ratio, and the ROEs are in the 30s. So actually if I look forward a year only, we're talking 44 to 30 is only around 1.3 times your PE to your ROE. And that's actually not that high.
The PE of the market is around 17, and the ROE of the market is around 14. So if you look at Altium in that sense, it doesn't look that high. Then if you look at it relative to the market in terms of what the ROE is of the market, the ROE 30 versus the ROE in the 14s or 15s, it's three times the market, and the PE is about three times the market.
So in the context of what it actually is fundamentally, a business which has grown organically and has an ROE of in the 30s. For me it is not a very, very high-risk valuation.
There are other businesses in technology that are at high multiples and have low returns, which I have trimmed. And that is a discipline I've learned when that PE to ROE ratio gets above three, it starts to get quite dangerous.
If the ROE is pumped up by accounting trickery, or accounting tools that are available such as capitalisation of interest, or deferral of costs, or intangibles amortisation, these are the things that start to increase the risk levels.
Altium is an organic business that has ROEs in the 30s, the PE to ROE ratio stands up. And it is fundamentally unique in the universe. I'm still comfortable. But if any of those red flags, or red flags of management start to emerge, then I will absolutely start to trim.
Q: What was one of the key themes to come out of reporting season?
I'd just say one of the key things was sustainability. I do think that sustainability is a factor that is now becoming a much bigger focus of the market. Because liquidity is going down, capital growth is going down, markets are getting harder. So I think that stocks that did deliver had businesses that were sustainable, and for me were generally rewarded. But the number of blow ups in the market have been rising. And one of the brokers sent me a report a few weeks ago to say that actually said it's going way above average, about 20 - 30% above average.
So that is a very strong signal to say that there is a bit of a wipeout occurring in terms of the companies that aren't sustainable. So that's what I think you need to just be very careful right now. Because debt availability and debt costs are changing, liquidity is going down, and those companies that aren't sustainable, organically sustainable with their own capital, are the ones that are going to get into trouble next.
Q: How to do you manage a portfolio that is highly sensitive to unpredictable changes in global central bank monetary policy? Do you see it as a risk or an opportunity?
I see it as an opportunity because for me it's mentally taking me back to 2011. But then, also the risk of 2009 reoccurring.
And the risks in 2011 were really you need to own defensives, because yield became very scarce. And then in 2009, liquidity was a big issue. In 2000 valuations became crazy. In the current environment, I'm sensitive to valuation, liquidity and yield. Which really sort of wraps up the concern about this notion of modern monetary policy, and is the government going to start moving away from that back into fiscal. But all that macro setting just leads me more to the bottom up.
What do I do with that knowledge? I focus on what is scarce. The investments that are going to work in the near term and then the long term are really all about scarcity. What's scarce now is growth, yield, and certainty, and they are the three tenants of what I'm focusing on.
And that for me encapsulates the fear about monetary policy, liquidity, growth, and the scarcity of yield. I think that's what's becoming more and more scarce as time goes on. As the market gets worried about monetary policy and slowing economic growth, those things are just gonna come more and more important over the next two to three years.
Q: So you own some gold in the portfolio. Is this based on your underlying view of gold, or valuation, or both? And if you have a view on gold can you take us through your thesis?
Yeah certainly. Gold's around 10 percent of the portfolio, which is not immaterial. The view is really driven by bottom-up analysis locally, regionally, and globally. It is both I'd say, it is an underlying view on gold, but also valuation.
I started to buy gold probably about two years ago based on valuation. Because yields were very high, the world was starting to get frothy in terms of equity markets and valuations, and gold's a good hedge if you're worried about valuations and equity markets generally as a traditional store of value.
I mean I have to be there at the moment given the world's getting more worried about equity markets and valuation. And then you've got inflation, so some bears on gold, and it's a true statement that gold mines don't generate a lot of economic value add in the world. But at the same time, they are a store of value. They do generate a lot of cash flow. And if the world gets concerned about currencies and monetary values, it will protect.
For me, it's been a two-year investment in gold. It's certainly got very, very hot especially in the last quarter. I had to trim some of the positions because they'd gone up exceptionally large amounts over the last two years, some of them over 120%. So there was a discipline to sell them because of their valuations themselves had got excessive. But I'm still invested in gold, I still think it's an important part of the portfolio today.
The other side of that is also REITs, I've also owned some REITs, it's another yield asset that's low beta, has similar characteristics to gold. So gold and REITs, I've been buying for the last 18 months, and they're sort of similar reasons.
Q: You sometimes talk about the QMTV structure (Quality, Momentum, Transition, Value) as part of your investment strategy. Can you outline what it is?
I think the 20 years of analysing markets, and being an analyst, and being a PM has taught me that basically that the risk correlation in your mind as an investor between these four environments is very, very correlated.
'Quality' is my love quadrant. Basically quality is a beautiful thing. It's like a long term marriage. When it works, it compounds, you can build families, empires, and amazing things on top of quality, and businesses that go up 100 times. It's a phenomenal thing when it works, when it holds together for a long period of time.
On the other side of that, markets are not like wonderful marriages, because wonderful marriages can compound for 10, 20, 30, 40 years. But markets are competitive, returns mean revert, consumers change their tastes, businesses get more aggressive, and there are price wars. So businesses and markets are not like a wonderful marriage, there's a lot more at risk, because there's a lot more at stake.
And because of that, my other side of quality is the blind love story. And the blind love story is you can't ignore the other side of it, which is competition, capex, mean reversion, and management complacency. And they're the things that you've gotta be careful of in quality.
Momentum: it's hot, it's cool, it's high return, but it's short duration. And it's very much the Kool-Aid, it's alcohol, it's fun, it's a party, everyone's around you, you feel good. It's hard to leave the party, but you do need to leave the party. It is something where the lights will eventually go on. Where it eventually becomes three or four o'clock in the morning and everyone starts to walk out. But it is fun, and you can make a lot of money in momentum. And momentum is kinda the consensus trade. It's what's hot right now, so sometimes it can be yield, sometimes like now it's gold. It has been tech in the past, it has been other sectors in the past.
Where you don't have great valuation support, but you got a lot of momentum, it's a lot of heat, a lot of alcohol, a lot of fun. But when it turns the other side, you've got basically the signals are peak earnings, peak multiple, peak sentiment, and the fact that it's a consensus trade. It seems obvious to be there, and you feel crazy by leaving the party at 2 o'clock or 3 o'clock in the morning, because it's still fun. But you don't want to be there at 4 o'clock, you want to but you know you shouldn't.
So it's this constant mental battle of it's popular, it's cool, it feels fun. But you're gonna leave early, and that's why it's momentum, and there's lots of books written about herds, and markets are all about herds. And if you're in the middle of the herd you'll get crushed, because as soon as that direction changes, you're right in the middle and you won't even see it happening. But if you're on the edge of the herd, your chance of survival is much higher.
Your chances of getting the grass first is a lot higher. So it's very much built on the psychology of night clubs and psychology of herds, and that's all momentum is. It's very much a herd mentality. That's what I call momentum.
Transition is the environment of the no-man's land, it's the environment of neglect, where you know there's something but you're not really sure. But you've definitely got some components where there are some milestones for improvement. There's either a strategy or a plan to cut costs, a strategy or a plan to improve the business. A plan to fix the balance sheet. There's actually a plan, and that's the difference: value and transition. It is in transition, it's no man's land, but there's a plan. But it's also no man's land because the fallen angels from quality and momentum have come down into transition.
And they do sit in no man's land until the market works out which way they're going to go. Are they going to go into value or are they going to go back into momentum.
And then value is the environment of complete neglect. There is very little hope, and the market's view is this is a bad business forever. It's a long duration negative without hope, and that's what you call the hopeless quadrant. But if you can be an articulate pessimist as Jeremy Grantham has said, then you can basically cede that there is hope. Although the market says hopelessness, you see hope. And you see that there's someone who wants to improve it. And then once that becomes a plan, then it becomes a transition stock. But if you see cash flows, you see yield, you see clean balance sheet. You see hope, you see change, that's when you know that that's a value opportunity you want to own.
On the other side of that, the value negative side, is structural losers. Businesses that have balance sheet problems, and that's where you'll find bankruptcies, that's where you'll find the companies go from poor credibility in any of the environments. Poor credibility, into value, then you've got a major credibility problem, or a major balance sheet problem. Then you've got a business that's bankrupt, and that's how they go through.
So for me the structure is set up to basically keep myself very self aware at all times. And it tells me where the risks are on the positive, and where the risks are on the negative. So it saves me a lot of time, but also directs me on where to look. Because where you are in the environment tells you where to look and that's the key thing.
Q: You recently received Morningstar’s Domestic Equities Small Cap manager of the year award - for the second year in a row. Can you outline what this means for you and the Fund.
So, first of all, it was really a reflection of the resources at Fidelity, the 150 analysts in the world, it's a big resource base that we heavily invest in resources, and research. And that means we get it right more often than not, and that's the goal is just to get more right than wrong. But that resource is huge, and that's really what I rely on every day.
Number two is the collaboration between the analysts and the portfolio managers, is what really makes this a 24/7 real-time, get-it-right-business for clients, and that's really what it fundamentally means.
And then lastly it's really the process. Which the QMTV process as I've just outlined for me is a risk-controlled return and behavioural science-based process, that keeps me self aware all the time, and keeps me very risk aware all the time. So it's a great risk-return for the client. We've had very smooth outcomes for clients in up markets and down markets. The fund’s outperformed in bull markets and bear markets, and that's a function of the process, and all the information and collaboration that I have at my fingertips within being part of the Fidelity family. And that for me is basically what it means to win the award.
I'm very proud as a small cap manager to be in that top quartile group because those are fund managers that deliver that 12% return that I mentioned for our clients. And if you can do that in the world that's a great return to compound and double your client's money over a five-year basis, that's a great return. And the nominees in that award, and the nominees last year as well have achieved that 12% return over a five-year basis. So for me, I'm proud to win the award for Fidelity and for my process. But as a person in that asset class, I'm also very proud.
Q: Final question - can you share with us a book or a report that you've read recently that really impressed you, and what were the key takeaways that you got from it?
Ray Dalio's 'Principles' book for me is a real stand out as a piece of literature and a thought.
And the two key things, one is radical transparency, because I think for me as I've gone through life and investing, radical transparency for me is kind of the truth will set you free. Especially in finance, and with accounting and numbers. So radical transparency is certainly a very strong belief that I have.
And then also the fact that lessons are basic and failure is how you learn and develop.
And reading Dalio and being a big fan of Michael Jordan has certainly led me to a place where in my mind failure, as both of them say, is how you learn. And your ability to handle failure determines the probability of you being successful and learning. And then your ability to culminate that learning into being successful is the key.
And then once you are successful, your ability to manage your ego, manage your temperament will basically drive the duration of how long you will be successful for.
And that for me is what I've learned from Dalio and being a Michael Jordan fan for years. Just that lessons learned become probability for success. They're the ingredients, but your ability to be successful and hold that success for years or decades, is a function of managing your own ego and self-awareness, and basically personality and temperament. And that allows you to be successful for a long period of time. So for me that book had a lot of brilliance in it, and I recommend it to anyone it's great.
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