Perfection doesn’t always make for good investments

Tech stocks, consumer ‘platforms’, and healthcare (among others) have all seen outstanding returns in recent years, with many of them now ‘priced to perfection’. That doesn’t necessarily mean that a major sell-off is imminent, but according to Nathan Hughes from Perpetual Investments, the future returns for many of these companies don’t look attractive.

“Every tech stock is a customer cohort business with enormous TAM. A lot of these things are all priced for success. They're all priced like the next Amazon when success rates are telling you, that's not necessarily the case.”

Some areas of his own universe – ethical and socially responsible investment – suffer from similar challenges. Passive flows to ‘ESG’ focused funds have increased significantly over the last 10 years, driving up the prices of some stocks that are perceived as ‘clean and green’.

In this fund manager Q&A, Nathan explains why he favours a value-biased approach to ESG investing, gives us his take on how Australian businesses are holding up in the face of adversity, and he shares one ethical stock with great prospects for growth. 

Why do you think ESG, sustainable, and ethical investments have come into vogue recently? And what do you do differently to some of these newer funds?

Clearly, there's a very big client demand for it. There's a younger demographic which is very keen on aligning their values with how they invest. They like having more insight and control over where their money is going and try to invest with a positive purpose. There's a lot of demand from large institutions as well, who are focused on things like the challenges we face in getting to net zero and looking after human capital. So they're pushing as well. Above all though, the performance of ESG or sustainable funds has been quite good. And that's been pretty persistent over the last five to 10 years. Off the back of that, as you'd expect, the demand flows.

Something worth thinking about though, is to what extent the flows that we've seen have been self-reinforcing. Some stocks that may be perceived as ‘clean and green’ or ESG leaders are priced at high levels now. So you have to think about where the valuations might go from here.

The fund's been around for nearly two decades now, and it's an extension of our core investment process at Perpetual. I don't think there's many ESG or sustainable funds around in Australia with a value bias. So that's something that's a little bit unique to us.

We also release our full holdings twice yearly. I think transparency is really important. Particularly as there are fears of green washing, and managers looking to capitalise on the extensive client interest. So we're always transparent about how our fund works. It's a combination of ESG integration, but also a negative screening. We've also started publishing things like our carbon intensity versus the benchmark on a quarterly basis. I think that's important, so people understand exactly what they're getting when they're buying a sustainable product.

Australian businesses seem to be doing well in the face of the latest round of lockdowns. What are you seeing and hearing from company management? Are they really holding up as well as we're being led to believe?

Reporting season has just concluded, which showed how strong the economy was pre-lockdown. I admit that we're looking at old news now, but I do think it's important because it gives us a good foundation to weather the storm and then bounce back on the other side. Even though things have changed, I think that strength that we had coming in is important and will help us on the way out.

In talking to companies over the last couple of weeks and through reporting season, there's some caution in the near term. Things are tough at the minute. People are dealing with demand restrictions. They're also dealing with additional costs and safety issues around COVID. 

A lot of retailers and importers talked about supply chain problems as well, both in accessing stock and also the cost of shipping, which is a little bit problematic.

It was interesting, there was no real guidance per se, near term, and an acknowledgement things were soft. But I still got the sense that people were pretty upbeat coming out of the lockdown into the second half FY22, which is somewhat reassuring. Most companies we spoke to thought on the other side of this, they’d still come out pretty well. I think that goes to the position of consumers after all the stimulus that we had last year, and some of that still being tucked away. The positive wealth effect from housing obviously is a big driver of consumer confidence. So management teams do feel pretty well-placed.

The other thing I'd add, and we saw it as a feature in reporting season, was just around the balance sheet strength of the listed companies. 

Gearing levels for industrials are at all-time lows. You could make the same case for the REIT stocks. So, balance sheets are in really good health. 

That gives companies confidence that they can withstand any bumps if things are a little bit softer than we perhaps anticipate, but also enable them to capitalise on the recovery. I expect to see continued M & A because balance sheets are in really good shape, and I think a lot of management teams are looking at '22 and '23 pretty favourably.

Starting at the end of last year we saw a big rotation from growth stocks into value stocks. Do you think that the current lockdowns threaten that rotation?

I'm smirking when you ask the question, because I feel like the rotation has been in a lockdown of its own since about March. It's been stopped dead in its tracks.

Firstly, I try not to get too caught up in value versus growth per se. There are always good reasons why a high-quality stock might trade a little bit more expensively. That's fine. But I think it's bigger than just the lockdowns. I think you still have this incredible divergence between the most highly rated quality stocks and some of the cheaper stocks. That divergence, notwithstanding the rotation we saw late last year and early this year, is still enormous. And no matter what metric you look at, the spread is extreme. I still think that will revert. But I can't tell you if it's going to be a snapback or another short, sharp rotation. 

Some of those stocks are priced to perfection, whether it be SAAS companies or high-quality healthcare, which are undoubtedly good companies. I just don't think they offer very attractive returns over the medium term. 

I think there's every chance that if you're buying those stocks, the returns you're going to get, are going to be ordinary over a prolonged period. I can't say whether it unwinds quickly or slowly. Every tech stock is a customer cohort business with enormous TAM. A lot of these things are all priced for success. They're all priced like the next Amazon when success rates are telling you, that's not necessarily the case.

On the flip side, there are a lot of good quality industrial companies, which perhaps by historical standards don't look cheap, but certainly with rates where they’re at today, they look perfectly reasonable and far more attractive than some of the higher valued names.

BHP recently announced it would be spinning off its petroleum assets and merging those with Woodside. For BHP, that means that they no longer have any direct exposure to petroleum. Does the removal of those assets put the company on your radar for inclusion in the portfolio?

Our negative screens are quite formulaic. So, we're looking at a revenue materiality of 5%, and obviously our screens include fossil fuels. With the divestment of those oil and gas assets to Woodside, they've sold an interest in an asset called Cerrejón in South America, which is thermal coal. They're trying to sell Mt. Arthur thermal coal as well. If all that goes to plan, then BHP will be out of fossil fuel production, and therefore it would then be eligible for inclusion in our ethical universe.

It's something I've thought about a lot, because BHP have improved or will be improving their scope one emissions, scope two emissions and emissions intensity of their production quite dramatically. 

But it's the old divestment debate. They've just given them to someone else. When people talk sustainability and ESG investing, sometimes there are no easy answers. Those assets are still going to be producing. They're just in someone else's hands. But sure enough, BHP looks a lot cleaner, and I would expect a lot of interest from more passive sustainability funds.

But it doesn't solve the challenges around scope three and steelmaking. Steel is one of those tough-to-abate sectors. On one hand, steel is critical to help decarbonization. You need to build wind farms, right? And it's one of the greatest materials we've ever invented, but there are the challenges around making it, and the emissions that it produces.

In future you'll see more electric arc furnace production as opposed to blast furnace production, and increased use of scrap.

Only one of the big four banks failed to make it into your portfolio - Westpac. Is that excluded on an ethical basis or did it not make the cut from an investment basis?

No, it's an ethical decision. We have a discretionary element relating to corporate misconduct and it's a judgement call. Westpac was removed off the back of the AUSTRAC revelations a little while ago. That's not permanent. We're looking for evidence of change within the company, be it accountability, changes at the top level, improvement in systems and things like that. But just at the time, based on what was made public and our discussions with the company, we took the decision to remove it from the universe.

Did CBA go through the same process of removal and then re-inclusion when they had their challenges with the regulators?

It did. Yes. CBA only came back into the portfolio part way through last year. That was out for a couple of years as well. It's really about repeated engagement with the company to try to understand what positive changes they've made. It's about trying to ascertain whether they've taken on board what they have to, and have they acted as they've needed to, to make positive change.

Could you tell us about a stock that's high quality, undervalued and passes your ethical screens?

Though the value is probably a little less exciting than it was a couple of months ago, I still think it's a really appealing stock – Medibank (ASX:MPL).

The ethical thesis is pretty straight forward. Medibank's purpose is to improve their customers' health. Historically it was a private health insurer, whereas now it's transforming to more of a holistic health company, albeit slowly. But it’s very much on that journey and they're all about improving the value proposition of private health insurance in this country and giving people outcomes at lower cost of care. So trying to extract costs from the system. That is a tremendous opportunity for them.

There are various studies you can look at where the cost of private care in Australia is not only high relative to other parts of the world, but even versus the public system there are large discrepancies. Medibank is very focused on trying to rectify that. As they drive costs down in the system, they can pass that back onto the customer, and you start to get a virtuous circle where they're improving the cost of care, that improves the value proposition of private health insurance in this country, and then that drives customer growth, and the cycle repeats. I think the company's done a tremendous job investing in systems and their customer service, and you're starting to see tangible benefits of that.

So not only has the industry had a positive uplift in participation on the back of COVID, but Medibank is taking share not just in the (discount) AHM brand, but also in the core Medibank brand. I think they’re starting to see tangible evidence that the changes they've been making have been working, and I think that can continue. I expect the company to continue to take market share off its competitors, albeit slowly. They’ve got good control of their claims costs, and things they're doing like rehab in the home or looking at providing no gap short stay orthopaedic surgical services, are all leading to greater value.

I think they'll continue to grow market share. I think they can grow earnings ahead of what the market expects. 

They've got a lot of surplus capital, so that will enable them to grow through bolt-on M and A or to grow partnerships like with the East Sydney Hospital and grow adjacent businesses. It's a company with a great purpose and has a really long runway ahead. It's more of a marathon, not a sprint. I don't think it's going to shoot the lights out, but I think can offer some really nice, dependable growth for many years to come.

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Nathan's fund aims to provide long-term capital growth and regular income through investment in quality shares of ethical and socially responsible companies. For more information, please visit Perpetual's website.