Topics discussed

• Auscap's investment philosophy
• From good to terrible, how the pandemic hit the Auscap portfolio
• Optimising the portfolio in a period of panic for investors
• The quality stocks behind a big drawdown and an even bigger recovery
• Three lessons from the 2020 investing experience
• How Auscap is invested for the future
• Why inflation represents an opportunity for asymmetric returns
• Low cash rates and their impact on real assets

Access the interview by clicking on the player or by reading the edited transcript below.

Visit the Auscap website for more information.

Edited transcript

James Marlay:

Back in 2012, when you and Matt had just come out of Goldman Sachs and started Auscap there was a lot of interest in what you were doing, a lot of expectation, people were really interested. They'd heard about the 'dynamic duo' and were keen to follow the story of Auscap, which I've enjoyed doing over the past eight years. But, for people that don't know the background and don't know the firm, could you tell them a bit about your philosophy and how you think about investing?

Tim Carleton:

At the heart, we're just a value-based equities manager with a quality bias. It's a relatively simple concept. We're trying to work out what are the cash flows that a business is going to generate over its life, and we're trying to work out what those cash flows are worth today. Then we're trying to take it another step further by saying: we want to buy those cash flows at a meaningful discount to what we think they're worth. So it doesn't preclude us from buying growth stocks. It does preclude us from buying concept stocks, stocks that don't have any earnings, stocks that are 'flavour of the day' or popular, but don't generate any real cash. We're buying real businesses and we just want to buy those businesses when they're trading on sale.

• Why the quality bias? Well, quality companies tend to have a number of additional attributes. 
• They tend to have earnings that are more consistent over time. 
• They tend to be more resilient to shocks. 
• They tend to have sustainable economic moats that the management teams are often trying to enhance all the time by making those cash flows more sustainable and more predictable. 
• They tend to be higher cash producing companies. 

So, from our perspective, it's the most sensible investment philosophy. As a result, the whole team is invested in the fund and the portfolio managers have never owned any equities outside of the funds that we run, and that's very important to us. This is the way we believe you should manage an equities portfolio.

James Marlay:

Over eight years the fund has delivered more than 15% return per annum, while the market has done about 10%. We've talked about the wild ride, 2020, a lot of ups and downs, how was 2020 for the fund?

Tim Carleton:

Well, it was certainly a volatile year. The fund finished 2020 up 10.6%. So, about 7% better than the All Ordinaries Accumulation Index, which is the broadest measure for the Aussie market, so we tend to use that as a bit of a benchmark. We were delighted with that total return, but it was certainly a volatile year and it was a very difficult year. 

Easily the most difficult year of my investing lifetime and I think I can say that for the entire investment team.

James Marlay:

Take us back to the start of pandemic in February and March. How was the fund positioned and what were some of the impacts of that dramatic drawdown?

Tim Carleton:

Well, in hindsight we were positioned terribly. Australia had gone through a three to four year period where the housing market had endured the most significant downturn in recent history and we were just starting to emerge from that. So, we were positioned for an economic recovery and we had a lot of exposure to domestic cyclicals, to financials, to retail companies. In the February reporting season, a lot of companies that we were invested in were reporting far greater strength than the market had previously anticipated. We had forecast that would accelerate. Then, of course, COVID hit and everything changed. 

We went from being positioned well for the economic cycle to being positioned terribly. The companies that the market assumed would be hit the most significantly, were the same domestic cyclicals that we were overexposed to. 

We saw the risk around the pandemic and in the middle of February, we purchased puts on the ASX 200 to try to provide us with some downside protection, but that still left us pretty heavily invested in stocks that people suddenly became worried about very quickly.

James Marlay:

You've talked about being really well positioned to being horribly positioned. Talk me through how you deal with that.

Tim Carleton:

We were reasonably fully invested and the sell-off happened extraordinarily quickly. It was late February when the market was at nearly 7,200, and within a month it was at 4,400. So, we'd seen a 39% sell-off in the space of 22 trading days. How you were positioned in late Feb was how you were positioned late March. Yet at the same time, we were seeing all of these opportunities. 

We knew that there was panic in the market. We could see it. 

There was one day in late March when I had analysts in different stores within the Super Retail Group (Rebel, BCF, Supercheap Auto) and they were telling me that sales were extraordinarily strong. The stores were full. It was home equipment flying off the shelves. There were weights in high demand. People wanted running shoes. Yet on that exact day, Super Retail Group was down 40% on the day.

By the time Super Retail Group came out on 26 March with an update, which said that sales had accelerated since the start of the pandemic, the stock was down 70% from where it had been a month earlier. Our response to this, given we were already fully invested, was to make sure that we were very active in optimising the portfolio. There were some stocks that were going to be called in to national service, the banks as a classic example. The politicians made it very clear that the banks were expected to step up to the plate. They just suffered through a Royal Commission, and this was their opportunity to redeem themselves. So their path out of recovery was likely to be a whole lot longer than some of these other companies. 

We were selling down our position in the banks to fund other opportunities that we just thought were extraordinary. 

You didn't need to be a genius to realise that there were amazing opportunities in the market. We were adding to our Nick Scali (ASX:NCK) position at five times last year's profit. You only needed to assume that people were going to buy couches again, because they were already in a net cash position. They already had property assets on their balance sheet. 

We added to our Eagers Automotive (ASX:APE) position on seven times last year's earnings. We'd already been through a three to four year downturn in the car market. So you only needed to assume that people are going to buy cars again, to realise that this was an extraordinary opportunity to add to that exposure. 

We bought into Stockland (ASX:SGP), which wasn't a position we held prior, at 0.5 of book and their largest exposures are retail centres. So you had to assume that people were going to keep going to the supermarket over time, people were going to continue to want to live the Australian dream and buy a house and land packages from them, to realise that this was an extraordinary opportunity, because that was a bigger discount to book value than Stockland saw during the GFC.

We worked very hard, we probably worked harder than we've ever worked in my investment career, at making sure that we understood the facts, that we were doing as much work on the ground as we could, and taking advantage of the best opportunities, the companies that we thought would see the fastest recovery, and had the most potential upside in terms of their share prices during recovery. We tilted the portfolio very heavily in favour of those companies. It was a reason that the portfolio recovered so strongly from being down a lot more than the market, which was obviously a surprise, to being in a position where the fund finished up the year 10.6%, a good 7% better than the All Ords Accumulation Index. 

It was the period when I was probably most proud of how the team operated and the fact that we worked to try and optimise the portfolio.

James Marlay:

You talked about those dominant businesses and strong balance sheets, good cash flows etc to my mind they're the companies you want to own in a sell-off. I was surprised by how big the drawdown was. What happened? Were you surprised by the volatility?

Tim Carleton:

Absolutely. I think we were surprised. I think our investors were surprised. I think observers were surprised. It was a very unusual sell-off. Most market sell offs, that we're aware of, are the result of some area of speculation that has built up as a result of people chasing whatever the hot stocks of the day are. As a fundamental value based manager, we don't get attracted to those areas of excess. We're never invested in the concept stocks or the stocks that are popular or growing revenues very quickly, but there's very little cash generation behind it, but this wasn't an unwind of a speculative excess. It was a forced shutdown of an economy. At that time, the more attractively priced stocks in the market happened to be those domestic cyclicals. That's where we were finding a lot of value. That's where a lot of value managers were finding a lot of value. That's where we were overexposed. 

They were, of course, the stocks that everyone threw out the moment the pandemic hit. As a result, value had its worst period of relative performance against growth ever. I mean, it was extraordinary the degree to which value underperformed in those first six months of the pandemic, but particularly the first couple of months. They were the stocks we were heavily invested in and those stocks declined the most. But that's where a focus on quality comes into it, because as I said, we knew these businesses. 

We knew how good the management teams behind these businesses were. We expected them to capitalise on the opportunity and emerge in a stronger position and that's exactly what happened.

James Marlay:

We're sitting here early February, you lived through 2020, a wild year. What did you learn?

Tim Carleton:

Well, I guess there are a number of takeaways. The one that helped us most through the process, is to make sure that you stay true to your process. A lot of mistakes are made when you have an investment process, but then, at either the height of irrational exuberance or in the depths of despair at market panics, you throw your process out. This can apply to an investor directly into stocks. It can apply to an investor investing into funds. What you want to make sure that you do is maintain your investment process, trust your due diligence, trust that you've done the work and stay true to that process despite what you're feeling emotionally. So I think we did that well. I couldn't be prouder of how the team handled the extreme pressure of Feb, March, April, because I think they handled it exceptionally well.

The second is  there are a few lessons for us. If you see risks on the horizon, reduce gross. We had too much exposure to markets going into the sell-off. We'd probably tried to be too smart in a way. We bought these puts that were very attractively priced, volatility was extremely cheap. In hindsight, it was the worst thing we could have done, because even our real estate exposures that were lowly geared, conservatively managed, great assets, fell faster than the broader market. So it would have aided us to simply reduce gross and not worry about doing smart things if you see risk on the horizon. 

The third thing is there were correlations in the portfolio that we'd never envisaged previously and so we used the sell-off to increase the number of stocks the fund holds. We were just lucky that it was at very, very attractive prices. We went into the crisis with about 30 stocks, we've come out of it with about 50 stocks. A lot of those businesses are businesses that we've wanted to own for a long time, but haven't had the opportunity and attractive price previously. 

So whether it's companies like Ramsay Healthcare (ASX:RHC), NIB (ASX:NHF), Atlas Arteria (ASX:ALX), which we've owned previously, but it had become expensive, Sydney Airports (ASX:SYD). I mentioned Stockland (ASX:SGP), Aventus (ASX:AVN)), there are quite a number of companies that we've liked for a long time and haven't had the opportunity to own at prices we felt were compelling. 

We think, in future, that slightly greater diversification will reduce some of the correlations to the extent that you do get a Black Swan event like this. 

It's not to say that we look anything like the index, because we don't, we look absolutely nothing like the index, but it will just reduce the possibility of a similar drawdown, something that we certainly never want to repeat.

James Marlay:

So the bounce back out of March for Auscap was exceptional. Top speed. As you said, you made up a lot of ground and more. What does the portfolio look like today and how different is it from 12 months ago? Maybe talk me through what some of the important decisions you've made and what you think is going to drive performance going forward.

Tim Carleton:

The portfolio doesn't look that different in terms of the stocks that we're holding. We still hold almost all of our stocks. In fact, I think there are only three companies that we have exited altogether. There's obviously a greater diversification, as I mentioned, we've gone from 30 companies that we're invested in to about 50. A lot of that is us being opportunistic about businesses we've always wanted to own, but we suddenly found an appropriate time to invest in them through the crisis. 

In terms of how the portfolio should carry us forward, to date a lot of the performance has been driven by businesses that did exceptionally well to consolidate their position through the period. They've emerged in a far stronger position than they were in going into the crisis. So we're still quite optimistic about those sorts of businesses, whether it's Eagers Automotive (ASX:APE), Nick Scali (ASX:NCK), Super Retail Group (ASX:SUL), these businesses should have considerable tailwinds for some time to come. There are other businesses that are yet to recover, but we are quite confident that as the risks around the pandemic recede and we're starting to see that with the rollout of vaccinations, the stocks should also experience quite a strong recovery. Then there are the new investments that we're quite excited about, many of which haven't recovered to their old highs, which we think will happen as their earnings start to exceed the earnings that they had pre-crisis.

James Marlay:

Can you give me an example of something that fits into that bucket?

Tim Carleton:

Well, I mentioned a handful of them. If I take one, NIB Holdings (ASX:NHF) is an example that at the moment has two of its smaller businesses heavily impacted and that is its tourism business and its inbound education business. Those businesses should see quite a strong recovery as we emerge from this. The underlying main business, the healthcare insurance business, has remained robust and we expect will continue to remain robust on a go-forward basis. So you're buying into that business at a price that's well below where it was trading pre-crisis. Yet we think that it should emerge from the crisis unscathed, because of it's sensible balance sheet, its strong management, and its position in market.

James Marlay:

Sentiment has swung from dire to quite optimistic in a short period of time, how much optimism is in the price of the market at the moment?

Tim Carleton:

Listen, it's always hard to say, I guess at a headline level, you look at the index today and we are 6 or 7 hundred points from where we were back in February a year ago. Yet the outlook from our perspective looks increasingly favourable for a very, very strong economic recovery. You have an economy which has extraordinarily accommodative fiscal and monetary policy. The government is running huge deficits and that has resulted in the fastest recovery in household balance sheets that we've ever seen. 

If you'd asked me a year ago what the greatest risk to the domestic economy was, I would have told you household leverage. Yet in the last nine months, households and small businesses have saved over $200 billion. I mean, it's extraordinary. 

So you combine that with low interest rates and an RBA that's also being very accommodative and it means that household servicing costs are back to where they were in the mid 1990s, which is an extraordinary change on where we were only a few years ago.

You combine that with other things that we're seeing, we've got record commodity price. I mean, the Aussie dollar iron ore price has never been higher than where it's been of late. That is very, very favourable for our terms of trade as our largest export. We're seeing a strong recovery in most soft commodity prices in a year in which the drought has broken. So we should see a very, very strong harvest this year, at the same time that we're seeing very strong, soft commodity prices globally. You're seeing household property prices increase. We expect that that will continue given where interest rates are, which should be positive for domestic consumption. We're seeing a domestic tourism boom, because people are stuck at home. What a lot of people don't realise is that Australians spent more abroad than people abroad spent in Australia. So actually the closed border issue is not a problem for the domestic economy.

There are small pockets of continued stress and obviously outbound tourism is one, inbound education is another, but as a broad-brush picture, the setup to us looks extremely favourable for a very, very strong economic growth recovery. That should translate to a significant growth in corporate profits. So is the market pricing that in? Well, I don't think the analysts are yet pricing in the strength of recovery we might see in earnings that we're forecasting. If that plays out, then equity markets could have a reasonable time.

James Marlay:

Now, you use your monthly newsletter to go into some depth on topics of interest to the market. One of the recent ones was around inflation, which is front of mind for a lot of people trying to get a pulse on what inflation might look like. Is it going to spike up? Talk me through your views on that and how it might make its way into the thinking around your portfolio?

Tim Carleton:

The most recent newsletter was just an observation and the observation is fairly straightforward. We're seeing central banks and governments around the world increase the money supply quite dramatically. At the same time, we're seeing a lot of asset prices move north quite considerably in a short period. So you're seeing rising equity prices. You're seeing rising house prices, not just in Australia but in most major developed economies. You're seeing rising hard commodities. So we're very focused in Australian iron ore, but it's not just iron ore. We're seeing rising soft commodity prices. We're seeing rising precious metals prices, gold and silver a lot higher than where they were 12 months ago. You're seeing rises in alternative assets like Bitcoin.

It's not a farfetched idea that the rise in the soft and hard commodity prices at some point filters through into the cost of goods, because ultimately they are the input goods into a lot of finished products. Whether that trickles through to higher inflation, we will see, but the market certainly not anticipating inflation being more significant than it is today. If we moved into that sort of environment, I suspect a lot of the value names would do quite well, because they are in sectors where inflation would be a real benefit to their earnings growth, whether it's the banks or the miners or the consumer discretionary retail players, they should all benefit from an inflationary environment, but we'll see.

James Marlay:

So it sounds like you spent some time thinking about inflation and I was wondering if you could give me a bit more detail. You've touched on a few sectors there. How are you specifically catering for inflation in the portfolio? Is it a central thesis? Is it a fringe thesis? Just give me a bit more detail on how you cater for that?

Tim Carleton:

Well, it's not central, but it's always important to consider a variety of outcomes when you're investing. Where you can get outsized returns is when you see a factor that everyone is assuming will be A, but actually B eventuates, because it provides you with an asymmetric payoff. So we like quite a lot of our investments in sectors that would benefit from inflation, even if the market is right in assuming that there will be effectively no inflation for quite some time. If we're happy with the total return offered by investments in those companies on the assumption that there is no inflation, if we suddenly get inflation, then they should do a whole lot better, because the market's currently under-invested in those sectors, because they don't see the opportunity that might come in terms of earnings growth for those companies if we do move into an inflationary environment. 

Having an awareness of what the market is thinking about in relation to these sorts of aspects is important, because sometimes it provides an investor with the opportunity to invest with an asymmetric payoff. 

In other words, you're happy if the status quo continues with the total return that that particular company offers you. But if we move into an environment that is more beneficial, that will lead to an even better outcome.

James Marlay:

So give me a sense of where that is in the market. You touched on banks, you talked about resources, what's an example? Just give me a bit more detail there.

Tim Carleton:

So banks are obviously a beneficiary, because if we move into a high growth environment, that's beneficial to their portfolios. Retail is an obvious beneficiary, because they tend to hold on to more margin in an inflationary environment and we are seeing some of that at the moment. You mentioned the miners, they're an obvious beneficiary, because if commodity prices are higher and moving higher more quickly than their cost structures, then they make more money. So all of the traditional havens for inflation are currently at the more attractively priced end of the market on the assumption that either there'll be no inflation, and that a lot of the increases that we've seen, for instance, in the iron ore price, will revert over time. 

Iron ore is an interesting case study, because we look out and we see the potential for an increase in demand. You're obviously seeing elevated demand out of China at the moment, but the rest of the world is still consuming less iron ore and less steel than they were pre-crisis. So we would assume at some point that that will normalise and potentially even exceed the level of steel consumption that we saw previously, because we're likely to have a global infrastructure and residential boom, if we're not already seeing the start of that. If you were moving to an environment where there's excess demand and not a lot of supply coming on board and we're not seeing a huge number of projects in the iron ore space under development, that's an environment for higher prices, not lower prices. Yet everyone is assuming that at some point reasonably shortly, the iron ore price will revert to where they expected to be long term. That right now looks to us to be somewhat unlikely, but we'll see how things play out.

James Marlay:

Another topic, which I think is really interesting at the front of a lot of investors minds is the cost of carrying cash. Why is cash, in your view, an expensive asset class to hold?

Tim Carleton:

Well, it's not necessarily an expensive asset class. I'm a conservative person by nature. So I think having cash to take advantage of opportunities is generally a very good idea. That's why I said earlier, we wished we held more cash going into the crisis, but we're just noticing that you're in an environment where if you have your money in cash, you're earning nothing, because interest rates around the world are at close to zero. There's an extraordinary amount of money in cash accounts or in government bonds or in bond portfolios earning next to nothing. Yet you're in an environment where central banks and governments are printing a lot of extra cash.

So is it a good idea to hold a lot of cash in an environment in which you're effectively seeing the debasement of fiat currencies across the globe? The answer is that at some point investors potentially realise that and decide that whether it's because they want a higher return or they don't like the idea of the value in real terms of their cash declining, that they start deploying that cash into alternative assets. If that starts to take place, then it could be quite good for other real assets like equities.

James Marlay:

Do you think there's a case for people turning their backs on cash as an asset class and start to force them out of that into the riskier assets?

Tim Carleton:

Well, at the moment, you're seeing record levels of money in cash accounts and with bond managers earning very little. It doesn't need for them to turn their back on cash entirely. It just needs for them to make a decision that there is either a better return available elsewhere and they're less worried about the risk associated with those other assets or that they realise that the real value of their cash is declining. In other words, that the cash that they're holding will earn less or be able to buy less assets or less goods or less services in the future for them to start to reallocate some of that cash towards other markets. If that's the case, then you might see other markets gain quite considerably.

James Marlay:

Tim you've talked about it a few times, the fact that Auscap has a value focus to investing. It's been a period where growth has had some significant outperformance over value when the styles lagged, what's a catalyst? What would it take for that to turn around?

Tim Carleton:

Well, identifying catalyst is always a difficult proposition. The value versus growth debate we think has become a little bit distorted in a way. As a value manager at the start I said, "We're just trying to work out what the future cash flows of a company look like. Once we've done that, we're trying to work out what the present value of those cash flows represents. Then we're trying to buy that cashflow stream at a discount to what we think it's worth." Many growth managers, I think, could classify themselves as value managers. The corollary to that is we have quite a number of companies in our portfolio, which we think will double earnings over the next five years. So we're not averse to investing in companies that are growing quickly. It's all a function of the price you pay versus the value that you get.

I think too often the debate gets bogged down in price to earnings multiples, or discounts to book value. That's not how we think about investing at all. 

They are two inputs along with a variety of others, the growth of those cash flows being a very, very important one. However, it does preclude us for investing in things that don't generate any cash. In our experience it's very few companies that can switch from unprofitable to profitable at some level of sales. At the moment the market's very fixated on revenue growth and most of the businesses that are growing revenues very quickly are doing it without any consideration of the bottom line. In past cycles, we've often seen that this has been the case, but when it comes time for those businesses to try to start generating some cashflow for their investors, that transition is a lot more difficult than they might have previously anticipated.

During these cycles, a lot of people start investing on the basis of a whole lot of other things other than valuation, whether it's momentum, whether it's popularity of the stock, we just steer clear of all of those sorts of names. We think that ultimately that is the most sensible way to be invested.

As to when the cycle turns in favour of value, I don't know. But I am confident that these things are cyclical in their nature. People forget that, because some cycles can be quite long. Growth has been out performing value now for seven or eight years. In fact, in the US it's been outperforming since the GFC. That's felt like a very, very long cycle for people, but at some point the cycle will turn and a focus on the cash generation of the businesses will come with that. In that instance, we think the fund is very, very well positioned. To be honest, given the growth in earnings that we anticipat in the portfolio in the coming years, irrespective of the value versus growth debate, we're quite excited about how the portfolio is positioned and quite excited about our current investments.

James Marlay:

Well, Tim, really appreciate the opportunity to sit down. It was good to hear the stories from last year. So thanks for having me in.

Tim Carleton:

Thanks, James.

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