Growth stocks like Afterpay, Appen and Nearmap that are making waves offshore have been dominating the leader board. Meanwhile, domestic cyclicals have been struggling as deteriorating economic conditions weigh them down. How are investors supposed to invest in this dichotomy, in which growth stocks with overseas success look ever more expensive - while the local cyclicals look cheap, but keep getting cheaper..?
We put this thorny issue to the professionals - how can investors position a portfolio in such an environment. Read on for the experts’ view, including 7 stock ideas, from Steve Johnson at Forager, Chris Prunty at QVG Capital, Matt Williams of Airlie Funds Management, Mark Arnold at Hyperion Asset Management, Natalie Tam at Aberdeen Standard Investments, Arden Jennings at Ausbil and Weimin Xie at MX Capital.
A ‘meet’ is the new ‘beat’
Chris Prunty, QVG Capital
How to position in the current market is the $64,000 question... The outlook for the domestic economy is not good. Reflecting this, consensus positioning would appear to be:
- Very underweight retail, media, financials and anything to do with housing
- Overweight everything else with a focus on offshore growers.
Most money managers must be fully invested, so in this environment, they’re looking for growth stories with large addressable markets and no structural or cyclical headwinds.
With only a handful of companies meeting these criteria, those that do achieve extreme premiums. With a handful of exceptions, we’d prefer to pay a fair or full price for a high-quality stock, rather than a ‘cheap’ price for a domestic cyclical, which may face structural or cyclical earnings headwinds. To review this positioning we’d need to see an increase in global and domestic interest rate expectations.
If this were to happen it would have a dramatic impact on relative sector performance as the multiple would compress on the high growth stocks on one hand and – if increased rates were accompanied by inflation and growth – aid the more cyclical businesses in terms of their earnings outlooks.
Having said all this, typically we just position the portfolio in stocks that will have earnings beats and largely ignore the macro – but in this environment there are so few stocks having earnings upgrades that a ‘meet’ is the new ‘beat’.
Two opportunities in this challenging environment
Matt Williams, Airlie Funds Management
It’s clear that 2019 will be a challenging year for the consumer. The daily headlines on house prices, car sales, tightening credit, elections and regulatory changes are having a reinforcing loop.
In this environment, we’ve looked to tilt the portfolio away from poorly positioned consumer-exposed stocks. Which companies are poorly positioned? Those that sell goods and services that are easily interchangeable or are in a highly competitive industry.
An example of a company that is not poorly positioned is Bunnings (owned by Wesfarmers). Sure, Bunnings’ sales growth is slowing but it dominates the hardware segment in Australia and will be untouched by disruption (whether it be technological and regulatory).
The balance to this view, though, is that a lot of consumer-facing stocks are attractively priced – sometimes up to a 50% valuation discount to the broader market averages. So there are opportunities.
One of those is Nick Scali, the mid-market furnishing retailer. Nick Scali will not escape a slowing housing market and falling residential completions. But taking a slightly longer-term view, the company is still part way through a store-rollout strategy (from about 55 stores now to 75). Management has made the necessary investments already to service this expansion. Over the past 10 years, profits have compounded at 15% p.a. The balance sheet is strong so it can withstand a poor environment while the company is forecast to payout a dividend equating to an 8% dividend yield (about 11% gross!). Clearly, the market is sceptical about Nick Scali maintaining that level of dividend, which may be correct to some extent. However, we believe it’s worth backing management to navigate through this tough period as Nick Scali has done successfully since its IPO at $1 in 2003.
Every positions must fight for its spot in the portfolio
Arden Jennings, Ausbil
Globally scalable businesses models with large addressable markets experienced significant earnings multiple re-rates during reporting season, and justifiably so with strong growth delivered in the face of softer economic activity globally, unresolved trade tensions and a complicated Brexit.
However, with the reward of share price rerates comes the need for vigilance. A key feature of our portfolio management approach is to ‘trim the hedges and pluck the weeds’. We believe progressively lightening winners is prudent, particularly with high-priced global growth stocks, while maintaining an appropriate position size given further potential for positive earnings revisions. Disciplined removal of positions that have missed expectations, or where our investment thesis has changed, warrants disposal to recycle capital into better investment ideas. Each position must fight for its spot in the portfolio.
Going forward, we remain unconvinced that we have seen the bottom of the earnings downgrade cycle for domestic cyclicals, suggesting many of these companies may not be as cheap as current earnings multiples imply (that is, they may be value traps). The negative wealth effect of declining house prices, highly indebted households, reduced credit availability, political uncertainty surrounding the NSW State and Federal Election outcomes, and the rising cost of living without commensurable wages growth are some of the key challenges facing consumers. These headwinds would need to subside before considering a meaningful shift to domestic cyclicals.
There are exceptions, however, that justify their positions in the portfolio given strong bottom-up fundamentals. City Chic (CCX), for example, has an industry leading 40% of sales online and is successfully expanding online in North America and Europe.
Keep the powder dry for the trough of the bear market
Weimin Xie, MX Capital
Our view is we are at the very last stage of a long bull market and the next bear market is not far away.
While the growth stocks all have strong business momentum, the market is ignorant of their risks and disregards the importance of valuation.
Since the start of the year, our portfolio has been running on average 35% cash and a further 50% short position on equity indices.
Our defensive stance has a major drag on our recent performance, but our defensiveness should protect us well during the inevitable downturn. However, every dollar of hedging expense and profit forgone today to protect our capital is going to worth substantially more at the trough of a bear market.
Investing in Appen and other future leaders
Natalie Tam, Aberdeen Standard Investments
We’ve been tilting our portfolio towards companies that we see becoming the next generation of leaders. Companies like Xero, Vista Group International and Appen are benefiting from substantial long term tailwinds as technology shifts to cloud and AI applications.
Weakness in consumer confidence has impacted domestically focused stocks, like Bapcor, which is looking cheap relative to its historic trading levels.
The question we ask ourselves is whether the headwinds facing a stock are cyclical or structural. If the issues are largely cyclical, then there is an opportunity to buy something at cheaper valuations on the view that in 2-3 years’ time, the cycle will have turned.
Structural problems are harder to overcome and require more confidence in management’s ability to navigate around problems, which isn’t easy.
Buy fundamentally strong companies - regardless of the environment
Mark Arnold, Hyperion Asset Management
The current market is challenging for investors - low growth and low interest rates make for difficult business conditions and the current unprecedented levels of market volatility makes it hard for investors to not get caught up in market sentiment.
We do expect growth, rates, and inflation to rise moderately over the next 12 months but in the medium to long term, both economic growth and rates will remain subdued, making it more difficult for businesses to succeed.
Hyperion is a long-term investor, so regardless of the economic environment we always seek to invest in businesses we believe are fundamentally strong. In this respect, the positioning of our portfolio does not change.
We invest in companies with quality business propositions, strong management, and large and growing addressable markets because these businesses are more likely to produce predictable, sustainable earnings growth.
Having said that, portfolio construction does play a role in long-term success because it contributes significantly to overall risk-adjusted returns. It is possible to take a long-term view, but also to take opportunistic advantage of short-term share price volatility – and shift stock weights and up and down. In practice, this often means buying when individual share prices are weak and selling when they are strong.
Just keep focused on total return
Steve Johnson, Forager Funds
If I look through the cycle and out the other side, what is my total return going to be, and how does that compare to the returns on offer from the expensive defensives?
To answer those questions you need to take a stab at how long, how deep and how impactful the cycle is going to be.
Unfortunately, I think the market is doing a pretty good job of weighing up the two.
It’s not clear to me that the domestically focussed companies are cheap enough to justify investing yet. And those with offshore or defensive earnings are generally trading at premium prices because of it.