Platinum Asset Management’s Founder Kerr Neilson is a fund manager who needs no introduction. Kerr recently sat down with Platinum's Julian McCormack to discuss timeless investment principles, the big issues today, and what he’s excited about ahead. We have prepared the following transcript for you, with a link to the full interview below.
Building an investment view
Julian: If you were to explain investing, say to your daughter, how would you go about that?
Kerr: The really difficult thing for most of us to understand is that there’s a stock market which sets prices, and then there's a “here in business”. You have a business and it's priced differently through the cycle, but what you need to understand is, what makes the business tick? We talk about it in terms of the gap. The gap is the surplus you achieve by supplying a product or a service. That gap can be protected by a big asset base or just a lot of advertising. On one hand, you might have steelworks, which you have basically $700, $1,000 of assets for every tonne you produce, whereas if you're a Gucci, you have virtually no assets, but you spend a fortune on protecting it with advertising. What you're trying to explain to an individual when they start investing is yes, you can focus on growth, but what you should really be doing is focusing on cashflow.
“Yes, you can focus on growth, but what you should really be doing is focusing on cashflow”
The problem with asset-heavy businesses is that to grow, they need to put more money back into the business, so you as a shareholder don't get that. That's very difficult for most people to grasp because they say, "well, everyone's got to eat, or they've got to use steel," but the fact is, you are aware of that, but that doesn't help you as a shareholder. You're interested in what cash you get out of the business.
For example, let's double the capacity of our steelworks. We've got 700 million invested. We produce a million tonnes a year. Over the next 10 years, you might make a 10% margin, which will give you $70, 000 a year. If you want to double your capacity, you've got to find another 700 million in 10 years’ time, so all the money you've earned in the last 10 years is actually lost to expansion.
Whereas if you want to make Gucci bags, I don't make them. I get someone else to make them. I sell them, with a 50% margin. If I have to sell another bag, I don't have to spend a cent in terms of capacity. It's not the same business, so when we talk about something growing quickly, it's interesting but it's how much money you have to spend to create that growth. That's what distinguishes the great favourites at the moment. The Facebooks the Amazons and so on. They don't seem to need the same investment as your traditional companies making cardboard boxes or paper or whatever.
“When we talk about something growing quickly, it's interesting but it's how much money you have to spend to create that growth”
Julian: Do you start then with valuation, or do you start with understanding the business?
Kerr: You have to start with understanding the business. You might then say, "Well, I'm never going to buy a steel plant". The only problem is, you are then dealing with the concept and not the price. You've got to continuously look at the price in relation to the concept. When that steelworks goes through a bad patch and it sells at half its replacement cost, that starts making it interesting. Even though it's not particularly profitable, if you buy it at half its inherent cost, then it starts being interesting. Whereas if you start buying the holding company of Gucci and it's trading on 30 times, you're already building in a lot of anticipation in the share price. It is always about the share price in relation to the concept, the integrity of that concept because all the time, there is a competitor trying to knock you off.
“You've got to continuously look at the price in relation to the concept”
You might say to me, "oh, well, then, I'm going to have a monopoly. I've got patents”. The trouble with a monopoly is this. It damages the fabric of the company. After five years of having everything your own way, you don't listen anymore. As an organisation you start to decay internally because you stop hearing the market. You stop hearing customers and so on. There's no easy trick. It's all about understanding the business that underpins the share price. When you buy a share, as Buffett always says, you must think in terms of buying the whole company.
“There's no easy trick. It's all about understanding the business that underpins the share price”
Julian: How should people think about accruing the information? How do they find out about these businesses?
Kerr: That's key. You can listen to all of the blogs and what have you, but I suggest you go back to source documents produced by the company. Even better, the half yearly results will generally have an interview of the company with a pool of analysts. In that, they'll release the results, but the best part is when the analyst starts asking questions of the management. That's a valuable opportunity for you as an investor to get some insights because firstly, you can test with your own sense of judgement about the veracity of their answers, how full they are. But the great thing is you can see what's troubling the street. Those questions will generally be about what's troubling the street and what is exciting the street? That is the market.
“You can listen to all of the blogs and what have you, but I suggest you go back to source documents produced by the company”
Being an investor means you’re always an outsider
Julian: Do you generally find the street’s concerns are well-placed?
Kerr: They tend to be transient, so if there's been, some problem in the company, it tends to get too much attention because remember, you're always an outsider as an investor. The analysts are trying to break through to see if it's a fundamental deterioration in the business or just a transient one. As you know, at Platinum, we are most interested in identifying the distinction between the two, because when the market overreacts to a transient situation, you can get the price dropping like a stone, and that can be a wonderful opportunity to buy.
“When the market overreacts to a transient situation, you can get the price dropping like a stone, and that can be a wonderful opportunity to buy”
The big issues in markets right now
Julian: What do you think people are getting wrong in markets at the moment? What are people overlooking or mistaken about?
Kerr: The big problem is information overload. What you hear about what's happening at the moment, for instance emerging market issues and what have you, it takes on proportions that are crazy. It's an over-exaggeration of the problem because if you look at long-term returns from shares, they tend to be positive. Over a long period, the return from shares real has been about 5% compound. Then, you've got inflation on top of it, so shares have been one of the great investments of the last hundred years. The figure in the last 68 years has actually been closer to, including inflation, about 9%. It's been huge, and that's some reason to be cautious, by the way.
“The big problem is information overload”
Another issue, because everyone's had such success, they're madly keen on ETFs, which is appropriate because they're cheap to have. They serve you as an investor, very precisely with what you're looking for. We think they have an important part in the marketplace. The only trouble is that you as an investor have to make your choice of when to enter and when to leave. The problem with most lay-investors, because they're not 24 hours a day at the job, they respond to the excitement. They generally won't have as much discipline to come in when people are depressed and go out when people are elated. What you as an investor need to do is perfect your entry and exit level. Without that, the great records you've had over the last seven to eight years could be badly tarnished as we hit more uncertainty and the rapids of change disrupt our happy path.
“The only trouble is that you as an investor have make your choice of when to enter and when to leave”
Stock picking vs ETFs
Julian: Having talked about understanding businesses, how do you think people can understand an ETF?
Kerr: It’s an interesting point you raise because when we buy stocks, we build a portfolio one company at a time. We build an ownership, we build an integration in our own minds what we really own, stock-by-stock, whereas when you buy a pool of a whole lot of companies, you've bought that. When one of our companies goes wrong, we can see the reasons. When an ETF starts selling off, it's more difficult to really make those judgments and then to have some harbour of comfort. How do you build your confidence in your original idea? It's more transient whereas if you bought stocks with a lot of serious research behind them, you know exactly if they sell off by 10%, you know that's either a buying opportunity or something's going wrong. You check your numbers. You check your assumptions. Then, you can work your way through that, but you've got something concrete to fall back on, whereas the other is just an index.
“When an ETF starts selling off, it's more difficult to really make those judgments, and then to have some harbour of comfort”
Two areas on watch
Julian: Moving on to more specific things, what's exciting you in markets at the moment?
Kerr: There's quite a big divergence in valuations. One change is the uncertainty caused by the trend of rising interest rates particularly in America, the prospect of tightening in Europe and Japan. The other big change, of course, is Trump and his pressure on trading partners. The free flow of goods and services is under threat, so we've got some uncertainties here. What's that doing is causing people to drift towards what they think is certainty and pursue anything that has cyclicality.
In terms of the valuations, we would rather be down in the dingy part of the market. That’s because we can find companies that, because of what they're doing, whether it's innovative or whatever, we can see why, over the next three to five years, they should have profits that are higher than now. That's not in the price, whereas the perfection of an Amazon, it's pretty well-reflected. That's a stock that's gone up 80% since the beginning of this year, whereas a lot of these other companies have actually fallen by 20% or 25%.
“We would rather be down in the dingy part of the market because we can find companies that, because of what they're doing, whether it's innovative or whatever, we can see why, over the next three to five years, they should have profits that are higher than now”
Markets really show this in places like Japan, which is a pretty open trading economy. We're getting some of that in Europe and even in the States. Some of those cyclical companies have sold off a fair bit, so that's where we'd look. I don't think there's a huge rush, but I think that's where you might find some quite good value.
Remember, you've got to start at the beginning and decide whether you're a long-term player, or you think you're a trader. It's nice to be a trader, but what do you really fall back on? What hauls you into a position? Whereas if you were an investor and have already done the work, you say, "Yes, the stock might fall 10%, but I'd actually be attracted to buy more then." It's a different mentality, whereas the traders is of nickels and dimes, often, to lock in his profits, but that can't even be as fulfilling.
“Some of those cyclical companies have sold off a fair bit, so that's where we'd look”
The most exciting areas
Julian: Anything else in terms of technology or other areas that excite you?
Kerr: There's a huge amount of change. That's what's so extraordinary. We've not had this level of change I would suggest for a long time. We've got the automobile industry under huge change, whether it's battery-operated vehicles or autonomous driving. Those are fundamental shifts in the nature and may result in fewer cars being on the road, by the way.
Then, you've got your medical technology and this imaging stuff. You know, we were looking at a dental supplier the other day. They take a 3D of your mouth. They then decide how your crown should look, and they can do it on-site, make a crown, bang it in your mouth and off you go.
Artificial intelligence is a complete game-changer. This will absolutely revolutionise shopping, our day-to-day involvement with any query. It's very deep-reaching, and I think it's even more significant than the mobile phone network.
“Artificial intelligence is a complete game-changer…and I think it's even more significant than the mobile phone network”
We'll see it creep up on us, and as it does, the demand for wafers, chips and chip-making equipment could have much longer duration than the typical cycle. There are a whole lot of implications here. That's why we can't get too miserable because we can see why the markets can have a bit of a rough time here, but this stuff is going to happen. It's not a question of economic downturns damaging investing in this area. Those who are in it have to invest to either get ahead or stay ahead, so it's not a choice they have where they can say, "oh, well, I'll just defer."
This is so rapidly changing. It does mean you have to put in a lot of money into these data warehouses, these IT centres.
Julian: You used the term earnings yield, how do you think about that?
Kerr: The price earnings ratio is looking at the price divided by the earnings, so it's one above the other, or you can look at the earnings expressed as a percentage of the price. That's what I use as earnings yield. What I like in earnings yield is it equates with interest rates more readily, so if you're think you're getting 3% from your term deposit, if you're getting an earnings yield, it starts at 15, but it's actually above trend, so you're already ... You're buying a company. Those profits are going to drop, but you think they're only going to drop 30%. You're then buying it on an earnings yield of 11. That's still pretty. That's three time what you can get from cash, and yes, there is risk, but it shows you that you've got a fair margin for error there and for risk.
‘Beautiful’ vs ‘Ugly’ stocks
Julian: You've got a contrast there between some of these capital light stocks and some of the dingier capital-heavy stuff in that area.
Kerr: There's a big difference. The beautiful stocks are selling on 25 or 30 times, and the dreary stocks are selling on 10 to 12 times. So the question is: If you buy a stock on a low P/E, let's say Samsung, which is on, it's about a 15% earnings yield. It’s a good start. Let's suppose Samsung doesn't grow for the next 10 years. It just continues to earn a 12% earnings yield for the next 10 years. What do you imagine you'd have to pay? What would you imagine a fast-growing company would have to grow to match the cash flows out of that business compared to Samsung over the next 10 years? It's got to grow its earnings by 26% a year compounded for the next 10 years.
That's the history of companies with a capitalization over a billion. Only about 2% of the market achieves that in the post-war period.
It's very seldom that you get a company that can grow because once you've got up to a billion capitalization. There's already an anticipation, but then, you've got to grow 26% a year for 10 years. It's rare. It happens. It does happen, but to pick those, you've got one in 50 chance.
“It's rare. It happens. It does happen, but to pick those, you've got one in 50 chance”
Watch in full:
You can watch the full video of Platinum's Investment Specialist Julian McCormack interviewing Kerr Neilson on the Platinum Asset Management website by clicking here.
A special thanks to Eric Nguyen for his work in producing this transcript.