Paul Skamvougeras's inflation playbook

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Livewire Markets

Paul Skamvougeras has the privilege of managing Perpetual's Wholesale Concentrated Equity Fund, one of Australia's longest-running unlisted managed products.

As the fund approaches its 22-year anniversary, Skamvougeras - like his predecessors Peter Morgan, John Sevior, and Matt Williams - is confronted with a paradigm shift in markets unique for his time: higher inflation and rates.

“Thinking about that over the next decade is quite important because we could find ourselves in a rising inflationary environment, but also a rising interest rate environment. And we haven't seen that before.”

One of Skamvougeras's early bets has been to quickly overweight the fund into economically sensitive cyclicals and beneficiaries of a steepening yield curve, a move which has seen him crush the benchmark by over 900 basis points this financial year. So far, so good.

But with the Aussie market now at record highs and cost pressures coming to fruition in the real economy, Skamvougeras shares how he’s tilting Perpetual’s prized portfolio for the next phase of the inflation story and nominates a value stock making money hand-over-fist courtesy of BHP.


Edited Transcript

James Marlay: Welcome to Livewire's 100 Top-Rated Funds series. Today I'm going to be speaking with Paul Skamvougeras who is the Head of Equities at Perpetual. Paul, great to have you with us today. We're going to talk a bit about your background, about investing and where you're seeing opportunity over the medium and longer-term. But as a starting point, just to get inside your head, what motivates you?

Paul Skamvougeras: I like a bit of a challenge and I like to learn new things. I think those two things are things that drive me and I think that's why I enjoy investing so much and I'm so passionate about it, is because it fulfils both of those things.

What's challenging about being an investor is you might have a predetermined view on a particular stock or macroeconomic theme, but new information comes to hand. You have to analyse that information, and things can change. Same with a stock. Or you get a left-field event like COVID and then all of a sudden everything that you were thinking gets thrown on its head. So it's very challenging, but I find that motivating.

Also, on the learning front, there's always something new to learn. I've been in the market for more than 20 years, and I'm always learning new things, whether it's a new technology that's come out and trying to understand that, whether it's a new business model and trying to pull that apart and understand how they make money. So I find that quite motivating.

Also, working in a team. Perpetual has a big team of investors and analysts with different levels of experience, different backgrounds and different viewpoints. So I find that can really get you motivated thinking in different ways, which is really good. And also developing the young talent. My journey at Perpetual was coming through the team, off the dealing desk and working my way up and earmarking people that have potential that could potentially get there in time. I think that's quite rewarding as well.

The value of a conservative approach to investing

James Marlay: You mentioned that you started at Perpetual and have a 20-year investing career. You're now at the top. Was there an experience that shaped the way you think about investing?

Paul Skamvougeras: Well, my first job in markets was at Perpetual. So I had the privilege of working under Peter Morgan, John Sevior and Matt Williams all at the same time.

James Marlay: Perpetual royalty!

Paul Skamvougeras: Yes you could call them that. And I think one of the things that really shaped me as an investor was leading into the tech boom, we were value investors. We have a pretty conservative investment process and we were doing what we were supposed to do, picking good companies where we rated management pretty highly, strong balance sheets, good cash flow businesses, but it wasn't working relative to the market.

People were buying companies that didn't have earnings. And that was a tough period. But obviously, when the tech bust came, there was a period of outperformance that was fantastic for a long period of time. And it's actually probably what shaped me as a value investor. I would call myself a value investor, pretty conservative with a bottom-up view. And look, we've gone through that leading into COVID as a value investor, we've stuck to our knitting. And what we've seen is a huge rotation in the last six months, which is quite pleasing.

Positioning for a strong economy, higher inflation

James Marlay: Let's take the philosophy and get into the practical application. Take us inside the room at Perpetual. What are you and the team spending the most time debating at the moment?

Paul Skamvougeras: There are a lot of issues around the table, but I think the one that we keep coming back to is inflation and whether we actually are going to see a period of rising inflation. If you listen to the policymakers, central bankers around the world, they say that it's transitory, nothing to really worry about, but there are anecdotes where you think, "Well, maybe we could be in for a period of rising inflation".

If I take it back to Australia, right now what we have in Australia is a very strong outlook for the economy. So consumer confidence is at 11-year highs. Consumer savings levels are double what they were leading into COVID, so the consumer balance sheet, in a great position.

The NAB Business Survey hit a record high in March, and then again in April. And that is the highest reading since the 24 years that it has started. So businesses confidence is very high. Forward orders for business are at all-time highs. Capacity utilisation is actually above pre-COVID levels, which suggests that there's actually, there's some fuel in the tank for this recovery. It's not just a rebound, it's a real economic expansion.

You've also got a government that wants to spend. Josh Frydenberg's come out and said we are going to spend. So all the signs are there for inflation to take hold. In Australia though, we're not really seeing much in terms of the readings yet. If I look at the US, we're starting to already see the readings in the US, and a lot of the anecdotes that you read is where commodity prices are. Commodity prices are very strong. Copper's up 100%. Corn and soy are up more than 100%.

We know where the iron ore price is at like US$215. There's a lot of input cost inflation that we are hearing about in the US, you're reading about in the papers. Warren Buffett came out and talked about his portfolio companies, how they're seeing input cost inflation, and they're passing it through to consumers without a lot of pushback.

And also the most recent CPI numbers that came out of the US were well above expectations. So we are a little bit concerned that, yes, central banks are telling you one thing, but when we look at the real economy there's the possibility that inflation is something to worry about.

How Perpetual is tilting its portfolios

James Marlay: So how does that take shape? How does that materialise in the portfolios that you're putting together?

Paul Skamvougeras: Yeah, it's a good question. So if we think about it, what we've been trying to think about from a portfolio perspective is, the companies that we own, if they are seeing input cost pressure, do they have the ability or the power to pass those costs on or are they taking that in their margins? So that's a lot of work. What we're thinking at the moment is which companies have the ability to pass on costs or a little bit of pricing power.

Commodity stocks are very well-insulated from that, but there are other companies where they are using commodities that we need to think about. Also, we're setting the portfolio for a rising interest rate environment, especially at the long end. We know that the central banks on the short end will keep it low for a while, but the market price is the long end. And so we've been positioning the portfolio more to those types of beneficiaries. So beneficiaries have that steepening curve, financials, insurers, and also economically sensitive Aussie domestic cyclicals because the Aussie economy is strong. We're also positioned there, so builders, construction, and retailers.

Managed Fund
Perpetual Wholesale Concentrated Equity Fund
Australian Shares

Reasons for optimism

James Marlay: 2020 was an interesting year. We had the big sell-off on the back of a really long bull market. The question we get a lot from investors is, how has that reset or changed the cycle? If we're to use a simple framework, going from sort of panic or through to scepticism, optimism, and then euphoria, where would you say we are in a market cycle?

Paul Skamvougeras: We're optimistic to euphoric. I think the outlook you can be optimistic about, especially in Australia and also the US. There is some euphoria. If we look at what's going on in say, Bitcoin or in particular sectors of the market, unprofitable tech where the valuations are just eye-watering, but on the whole, I would say optimism is the way I would characterise it.

Investing in a rising interest rate environment

James Marlay: I wonder if there's a longer-term investment idea or a trend or something that you think is really important to get right from this point going forward?

Paul Skamvougeras: Bond yields have actually been falling for the last 40 years. We've reached a point probably where they can't go much lower. So over the next decade, we're thinking about where could interest rates get to? Especially when you have monetary policymakers and fiscal policymakers, especially in the US and Australia, very much intent on creating inflation. And that's what we're seeing. Monetary policy cannot do much more from here. But now the governments are taking over and they're really, really spending.

So, the stimulus that was injected into the global economy to offset COVID was 15% of global GDP. That's $20 trillion across the globe that's been pumped into the system. So, there's very much an intention. You can see from what the Treasurer says that they want to create inflation, in particular, wage inflation. Now all policymakers will say, "Well we like a little bit of inflation." Everyone likes a little bit of inflation. The question is, will it be a little bit of inflation or will it be something that gets out of control? We don't know that. But I think getting that question or thinking about that over the next decade is quite important, because we could find ourselves in a rising inflationary environment, but also a rising interest rate environment. And we haven't seen that before.

I mean, I've been a fund manager for 20-plus years, and I haven't experienced that. There's a generation of fund managers that haven't invested in a rising interest rate cycle. So it bears thinking about what are the implications? Well, let's think about this. So if we are truly at an inflexion point for rates, and rates, the outlook is higher for rates, then returns probably will be muted because we're going to start seeing discount rates going up. That will impact equities and property and the like.

If we think about long-duration assets - they're heavily geared, so the cost of debt will go up. For high growth assets, where all the cash flows are in the future, what you might find as discount rates go up and interest rates go up is that investors actually want cash flow today and will value that more than cash flow in the future.

And also unprofitable companies. As the cost of capital goes up, you might find investors allocating less to the promise of profits in the future, and actually allocating more of the pie to profitable companies today. So they're some of the things we're thinking about.

Skamvougeras' biggest tip: Understand what you're investing in

James Marlay: You've obviously got the brains trust of your team at Perpetual with all that experience. For our investors and for the people that are watching this video, can you share with them one practical tip that could help to make them a more successful investor?

Paul Skamvougeras: Always do your own work and try and understand what you're investing in, try. I see too many people today, everyone's a Bitcoin trader - and everyone's made money on Bitcoin by the way - I don't know who the loser is, but everyone's made money on Bitcoin. And it seems like everyone is treating it as an investment. But when you actually ask people, "Can you explain it to me?" There's not a lot behind it.

I think it's very important to understand what you're investing in. Do a little work. Also, understand what your risk tolerance is. Are you open to volatility? Are you a risk seeker or are you more risk-averse? That's also really important to consider.

Deterra Royalties: A high quality, undervalued asset waiting to be recognised

James Marlay: I really enjoyed hearing about some of the thinking that's going into the portfolios and how you think about investing. I was wondering if you could talk to me about an investment idea or a stock, something that's ticking your conviction boxes at the moment?

Paul Skamvougeras: My idea is an interesting company that recently spun out of Iluka Resources called Deterra Royalties. It's a mining royalty company. Deterra owns revenue royalty over Mining Area C in the Pilbara, WA, which is one of the big iron ore provinces where BHP produces its iron ore.

Now, why is it interesting? We think, in the work that we've done, it's probably, arguably, the best royalty that you can own globally and one of the highest quality. Reasons being, it's mine life, it's probably 50 years, if not more. In terms of counterparty risk - your counterparty is BHP, that's who you're hoping will pay you. We think that they can meet those obligations.

In terms of producing over the cycle. It doesn't matter whether iron ore is US$220 or US$25, the production from BHP is going to keep coming out because they're very, very low on the cost curve. And there's no capital to spend, so the royalty owner doesn't have to spend any capital, increasing production.

And where we are right now, Deterra is going from 55 million tonnes of production out of the Mining Area C province to 145 million tonnes. Now that will be ramping up over the next two years. That's all paid for by BHP. In fact, for every million tonnes extra that they produce out of that province, Deterra gets a million-dollar check, plus the royalty on top.

So we think it's just a great asset. It's a single asset. When we look at overseas, those assets - the royalty companies that are more diversified trade at two to three times NPV, Deterra is trading below our NPV. Our NPV is $4.78, which is struck off US$65 iron ore and 70 Aussie cents. And we know where iron ore is, it's at US$217. So we think that's a very interesting opportunity and the market will slowly come around to understand the quality of that asset.

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