High conviction: The purist's way to invest
In 2006, David Pace, Matthew Ryland and Marc Hester decided to leave their jobs at Merrill Lynch to found Greencape Capital. Less than a year later, the GFC rocked global markets. For most investors, the global financial crisis is an experience they’d rather forget. But for David and the team, this was the opportunity they'd been waiting for. Having just launched, and with markets at record highs, they had yet to fully invest their capital. Falling markets allowed them “to buy high quality ideas at better and better prices.” Of course, it wasn’t all smooth sailing – James Hardie, initially purchased at $9, quickly dropped to $3.50 – but outperforming the market each quarter certainly helped to ease the pain.
In this Q&A with David, we discuss his experience during the GFC and what he took away from it, the types of companies they like and what they’d prefer to avoid, and he shares two ideas that he has high conviction in today.
Q: Greencape Capital was launching just around the time that the GFC was hitting. What was that experience like and what were the lessons that you took away from it?
David Pace: We launched about 10 months ahead of the GFC. I'd say in retrospect, if anything, we felt more compromised launching at market highs preceding the GFC, where there was next to no fundamental value on offer. We found that process really precarious.
The great thing about an exogenous shock such as the GFC is that the fear trade takes over from what quite often is the greed trade preceding it. All of a sudden there's a whole heap of value on the table and selling of equities is pretty indiscriminate.
'"The GFC actually allowed us to construct a portfolio full of high quality ideas that were suddenly trading at material discounts."
Q: Is it safe to say that it was fortunate timing then?
David Pace: Yes, I would say it gave us an opportunity to invest with more conviction than we did on day one, where we couldn't see a lot of fundamental value in the market. Our portfolio got more and more concentrated as we moved further through the GFC and we were able to buy high quality ideas at better and better prices. For example, James Hardie (ASX:JHX) went into the portfolio at our inception at about $9. We finished buying that at $3.30 through the GFC. Today it's $30.
Q: Did you ever get pressure from your investors? Was it a stressful time or did your investors generally understand that, that's the market that we're in at the moment, and things are going to be tough for a while?
David Pace: We were lucky enough to be cranking out active returns most quarters, and certainly every year. So we didn't have clients on our back. Because we couldn't see the value in the greed driven market we weren’t full-weight Hardie's on day one. I'd say we weren’t full-weight anything. But the fear trade and indiscriminate selling and people running for the hills gives you that ability to average down at great prices and come out the other side.
The most pressure we felt was the pressure that we put on ourselves. We were three youngish guys without a big reputation, that had to prove their wares.
"We were in the office fighting for our lives day in, day out. There was something really great about that I've got to tell you. We learned a hell of a lot through that process."
Q: In the 13 years since you launched Greencape you've grown the team from three to around seven now. What can you do now that you weren't able to do then with the smaller team?
David Pace: It essentially allows us better depth and breadth of coverage. Company visitation is central to what we do. And we've maintained the company visitation register since our inception. But for the first three years, myself, Matt and Marc Hester were doing about 800 company visits combined each year. With a team of seven today, we do 1,600.
If you look at the top 100 ASX listed stocks on an equal weighted basis, a large proportion of their earnings are domiciled offshore. So we've got more manpower essentially today to get on planes to penetrate supply chains, and get closer to the right answers.
Q: What is it that attracts you to a high conviction approach? And what does high conviction mean to you?
David Pace: I draw a distinction between high conviction and highly concentrated. I'm not a fan of forced concentration, just because markets don't really afford you that luxury. In particular, it doesn't work at turning points in cycles. If we go back to the GFC, if you're running a 20-stock portfolio, evenly weighted, and the decision for me in buying James Hardie at inception is either to own 5% of it or none of it. I don't think we would've owned it.
Our High Conviction Strategy can own up to 40 stocks. But we typically run 90% of the fund in the top 30 names. The last 10% provides us with flexibility to manage in and out of positions in a disciplined way. But also to manage macroeconomic risks and cycles.
"This is what I like about the notion of high conviction investing. When you think about how you or I, or any other personal investor invest their money in the market, it's not done with reference to a benchmark."
The individual doesn't say ‘banks are 30% of the index, so I'd better hold at least 25% of my money in banks.’ It's a risk-return consideration. High conviction investing gets you closer to that purist notion.
Q: Could you explain, using an example, how you might manage a macro risk using an allocation from that 10%?
David Pace: Here's two. We currently own Evolution Mining (ASX:EVN). I would say that sits in the tails of the product, again in that last 10 stocks. Personally, as an investor, I think gold doesn't have a lot of utility over time, but we're living in an environment of heightened geopolitical risk. We're not willing to go out on a curve with respect to that. So that gold position is an effective hedge against whatever Trump says from night to night. It's a hedge against Iran bombing US military bases in Iraq.
Let me give you perhaps a more pertinent and ongoing example. ‘Investment nirvana’ for us is to have a portfolio full of compelling bottom-up ideas. But when we sit down and pick the stocks that we really like, we often have a large residual exposure to the AUD-USD pair.
You think about CSL (ASX:CSL), you think about James Hardie, Aristocrat (ASX:ALL), they all have a big chunk of earnings domiciled in US Dollars. Now we're not willing to call the currency. That's not what we do. That's beyond our skill set. To control that we hold a larger resources position than we otherwise would. Generally, there's a strong correlation between the Aussie dollar and commodity prices. That's held true for a long time. By using the tail of the funds to control that risk, it allows us to think more purely.
I can paint you a scenario where we've done a great job picking stocks in the likes of James Hardie, CSL, Aristocrat, and Computershare (ASX:CPU). But the Aussie Dollar's gone back to parity and we've generated no active performance at all.
"The surgery is a success, but the patient died. If we can hedge some of that out, then we're not thinking about the currency, which will cloud the bottom-up call."
Q: There are a lot of different attributes and metrics that any investor will look at when they're considering an investment decision. What's one that you really like, but you think is generally a bit underappreciated by the broader market?
David Pace: In all honesty there's not a lot that is proprietary about the things we look at. Our three tenets are:
- Shareholder stewardship, which is a call on management,
- Business evaluation, the state of the business within that industry,
- Valuation, looking at the discounted value of future cashflows after accounting for franking credit.
Whatever managers look at, they all end up just going to those three.
I'd say through our company visitation efforts, we work harder than most to get those judgement calls right. It's about the quality of information, that goes into the process to get those calls right. The great thing about experience and being in markets for over 25 years, is that you get better at the qualitative calls. I think I'm better today at identifying good and strong management teams, and management teams that I know are aligned to shareholders, than I was 10 years ago, than I was 25 years ago.
Q: How has your investment strategy evolved and changed over your 25 years as an investor?
David Pace: When I started, I took a very quantitative approach. I was the guy that built models on first principles, I wanted to understand how the numbers work, how the P&L and balance sheet and the cash flow all pull together.
"What I'd say, and this is not a Greencape comment, this is a David Pace comment, is that over time I've become more qualitative in my approach and essentially backing better than average management teams into better than average businesses is a winning strategy. I've only gotten better at that."
At Greencape our process and our strategy has most definitely evolved over the years. A key attribute of our business is to critically analyse where we've gone wrong from time to time and learn from it. We've done that in spades.
It's become more and more apparent to us that we don’t want to invest in particular types of companies. These are companies that are effectively private, but under a publicly listed guise.
Something like Harvey Norman (ASX:HVN) for example, which is publicly listed, but this is a company where Gerry Harvey punts the balance sheet - he's buying dairy farms. It's a private company under a publicly listed guise. When there is that lack of alignment. Where we can see that a management team is being incentivised in a way that's at odds with shareholder value.
The other one I would mention would be Sonic Healthcare (ASX:SHL). They were building a global footprint in the pathology businesses. They were throwing hundreds of millions, if not billions at it. All through that process, management were getting paid only on an EPS growth hurdle.
Now the problem with that in an environment where you can borrow cheaply is you're generating EPS accretion, but potentially generating a return on invested capital that's below your cost of capital and destroying economic value.
We used to hold Sonic and I was lobbying them to change that. They did ultimately change it once they had completed their acquisition spree, but two years later they changed it back because they wanted to spend more money. So we have no appetite for that.
Q: Could you tell us about a couple of the positions you’re invested in currently where you feel you've got particularly high conviction today?
David Pace: The first one would be Lendlease (ASX:LLC). Lendlease have established world's best practice in urban regeneration development. The best reference point is Barangaroo in Sydney, which was an industrial wasteland and has now become a really vibrant retail, commercial and residential precinct.
Lendlease continue to do a wonderful job using Barangaroo as an effective display home to win contracts globally. They've done that in a really compelling way in London, they've done that in a compelling way in the US. They've done that through Asia.
One of the things that I like about Lendlease is it’s developed a great capital recycling model. They will acquire the land, then develop and construct. They will ultimately vest the finished product into a Lendlease fund where they take on capital partners, which liberates capital for future projects. This is a very long-dated value-adding strategy. Currently they've got $100 billion in the development pipeline and about 50 to 60% of that is urban regeneration projects.
"The last big deal they did, not trivial, was with Google, late last year, to build an urban precinct in close proximity to their main campus in California. That's a $20 billion deal. And Google sought Lendlease out."
The problem with Lendlease in the last 12 months has been its engineering and construction business. It’s very different to what I consider their core urban regeneration business, and a couple of projects have blown up. They're in the process of selling the engineering and construction business entirely. Once they do that, then the core franchise will attract a materially higher multiple. That's a very long, long dated idea that we think will continue to add to our fund for years to come.
The other one is James Hardie (ASX:JHX). It's important to look back and think about what the company's achieved and how they've gone about achieving it. Hardie's went into fibre cement siding in the US in the late '90's, at the same time that a mob called CertainTeed did. Today Hardie's have over 90% of that market. CertainTeed have less than three.
Fibre cement didn't exist when they went into that market. The category was nil and their market share was obviously nil. Today they sit at 20% of the category share. When you think about the total siding that goes on the homes in the US market, 20% of that is fibre cement and Hardie's have an excess of 90% share.
They've done an exceptional job building that business. They've also taken price increases every year, including the year of the GFC. That tells me that there's something very proprietary about the product. Otherwise it’s just a commodity and they’d have been cutting prices at that point in the cycle.
What's really interesting about Hardie's today is that they bought a European business called Fermacell about 18 months ago now. Fermacell makes fibre gypsum. Fibre gypsum competes with plaster board as an interior product in the European market. It's a higher quality product than plasterboard. It's more eco-friendly, it's fire retardant properties are much higher. But today, it's market share is 3% and the category share is less than 5%. We expect James Hardie to be at the forefront of category growth over time.
When you think about that in the context of what they've achieved in the US, I can now see the next wave of growth coming through James Hardie. Which will build out profits five to 10 years from now. The problem with investing in Hardie before the Fermacell acquisition was their target was 35% category share and 90% market share in the US. So they're rapidly approaching a point of maturity in that market. They probably still have a good five years, but this now provides the next wave of growth.
One of the real difficult calls with Hardie's was regarding their change of CEO about 12 months ago. Louis Gries, who'd been with the business 20 years, was one of the best CEO's I've had the pleasure of backing. The incoming CEO is Dr Jack Truong, who couldn't be more diametrically opposed in style.
Louis was a bottom-up guy. He drove the business really hard. We did a lot of background checking on Jack, based on where he'd worked previously and then monitored his progress through speaking to different people in the Hardie's organisation in the first three to six months. The judgement call we made reasonably early, is as good as Louis was, he effectively grew the business beyond the point that his style continued to be effective. Because the business was just too large to be micro about it.
Jack is very systematic. He's very process orientated and we took the view that he's the right guy to take the business forward. It was a difficult call because he felt entirely different to Louis, and Louis had a lot of disciples both within the business and within the funds management community. As it turns out, Jack's got that business humming. He presided over the Fermacell acquisition and we're happy to back him in to deliver on that.
That's the end of our questions. Thanks for taking the time to have a chat with us David.
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Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.
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