Pulling the trigger

James Marlay

Livewire Markets

Uncertainty creates opportunity but the best decisions rarely feel comfortable. For Vince Pezzullo, Deputy Head of Equities at Perpetual and Portfolio Manager of Perpetual Equity Investment Company Limited (ASX: PIC), the vicious sell off in March forced him to react quickly and buy oversold equities. 

At a time when there was maximum noise and an information vacuum Pezzullo says that it was critical, as a value investor, to go back to first principles.

“What I learned was to have that plan before trouble sets in, because it'll get you through. It'll get you to make some decisions, which in a couple of years you'll look back on and think, that was actually a decent decision that we made."

Cash holdings in PIC went from 16.6% in February to 3% in April and the fund has outperformed its benchmark by 12.9% since March. In this extensive interview, Pezzullo explains how a robust process allowed them to ‘pull the trigger’ and discusses where that money has been invested.

Topics discussed:

  • The current view on markets
  • Sector and stock opportunities
  • Can ‘value’ survive in a wash of stimulus?
  • Managing the cash balance in the PIC portfolio 
  • The investment case for Flight Centre
  • REITs - when they just get too cheap
  • Lessons from the sell off 

Click on the video player below to access the interview.

Edited Transcript

James Marlay: Can you tell me, how did it feel in those moments, pulling the trigger on some of those investments when there was so much noise and so much uncertainty?

Vince Pezzullo: There's no doubt, given where the market level is, it's consensus. Everyone's expecting this because markets have rebounded so hard, so everyone's expecting some normalisation somewhere. Now, it's quite peculiar to us that a lot of companies actually went and got more debt rather than de-levering this. It's going to be interesting to see how it plays out, because if you don't return to pre-corona levels, I suspect there'll be some interesting conversations with the banks.

We've actually been investing in retail in the last few weeks. They've become so cheap. So what I learned was to have that plan before trouble sets in because it'll get you to make some decisions, which in a couple of years you'll look back on going, "That was actually a decent decision that we made."

Right now, the market's rebounded pretty aggressively. We see the market's factoring in normalisation of some sort of the economy returns. There was a really small window of opportunity in March where there's a bit of information vacuum, governments hadn't reacted yet. Central banks reacted, providing liquidity, et cetera. So there's a very small window of opportunity where a lot of the market went on sale, big discounts, everything got thrown out, it was pretty much indiscriminate selling. That window was so small until the governments reacted. So if you hadn't done some work there and had a go at a few new opportunities or doubled up on your favourites, et cetera, you missed a bit of it.

The market's pricing that in today. We did have quite a bit of indiscriminate selling across the board. So good companies were thrown out with bad companies, out of this, some longer term structural issues were brought to our head. So it's going to happen quicker. Companies were forced to pull out their restructurings, to set their business up for a new paradigm. They thought they might have five years to get to somewhere but they had to do it in three months and work on a plan for the next two years.

So when it comes to our positioning, it's always determined by the value, where we're seeing the valuation support, where we can make some money by buying things, where the market's overly discounting the outcome. We looked for some sectors or companies that had short term problems, as in had a sudden stop in the economy. So consumption dropped pretty quickly in a lot of sectors.

We're looking at those sectors where there are short term headwinds, but the companies in those sectors were going to be the longterm winners, so that we're still in a good sector. And that company had good management, decent balance sheet, but they also use the market dislocations as an opportunity to press our advantage. So there's a bit of that setting up in the portfolio. But then also, as I mentioned before, the indiscriminate selling was quite broad in a lot of the cyclicals, as you would expect. And that set itself up where you could buy things which had fallen 50% in the space of a couple of weeks. And you didn't have to be very heroic about any sort of normalisation for you to make a return on your investment on those.

James Marlay: We'll come back and talk about some stock specifics in a little bit. I just want to stay high level just for a period of time. How are you thinking about the recovery process for the underlying economies, given that there's been the big stop and people are trying to figure out how much of the workforce comes back, which industries are most impacted? I'm just keen to hear what your views are on the parts of the economy that you think look okay, the ones that you're more cautious on, where you think that the road forward is a bit more difficult.

Vince Pezzullo: So obviously anything travel related. It's going to take a bit of time and it's going to be very different within the sector itself, in that I suspect given that COVID is still roaming around in other countries that are just starting that phase of it, the global travel bans are probably in for a bit longer than we expect. And probably leisure will return. Funnily enough, domestic leisure will probably return quicker than business travel. So there's elements like that. That part will slowly improve, but parts of the discretionary sectors as well.

So you've seen some of the winners, JB Hifi and Harvey Norman have done well out of the work from home move, but some of the other discretionary retailers will get a steady improvement as people get out on the streets, start to shop. Gaming - we think gambling will rebound pretty quickly. I think the evidence, as live sports come back, is you're seeing betting pools rebound very quickly. But there's no doubt that this given where the market level is, is consensus. Everyone's expecting this because markets have rebounded so hard. So everyone's expecting some normalisation of some layer.

So what the real question is today is not the recovery. It is that some sectors will take a lot longer to recover, and that's where the work needs to be done. More importantly though, some sectors may never recover. So they might go back to 60 or 80% of pre corona earnings or sales, et cetera. So that's where the work needs to be done now because you've had the returns generated by a bounce in the market. You’ve got to try and work out if you're in the right stocks and that you're not overestimating the recovery in those sectors. So that's where we think we are now, that's how we're trying to position ourselves.

James Marlay: That's the underlying and the fundamentals. The other big part of the equation is what's happening with central bank stimulus and interest rates. We've had we thought they couldn't go lower. They found a new low here domestically, and there's all sorts of stimulus being pumped into the economy from offshore. How does that, as a value focus manager, knowing what was happening in terms of momentum and growth in the market pre the COVID crisis, does that trend start to emerge again? Does that factor into your thinking?

Vince Pezzullo: That’s why it was really important at the early phase of this to be aggressive when the opportunities presented themselves in March, especially in March, because at the back of your mind as a value investor, you know that there's the Central Bank sitting there providing stimulus and people are using any evaluation methodology to justify anything and you can, so to speak. It doesn't mean it's the right investment, but that's what was going on.

So as a value investor, pulling the trigger, when you thought things were trading at a 50% discount, you had to act pretty quickly. So we're of the view that we'd done enough, in that we've bought the right things at the right time, that it should outweigh those elements and that there are going to be some winners. There are going to be some structural winners out of this and there’s some structural losers. And as a value investor, for us more importantly, is to try and avoid the structural losers, because you get attracted to valuation and then occasionally you buy things where the earnings go backwards for the next 10 years, but the multiples are the same. For a value investor, you've got to try and avoid that sort of investment case because it can be quite devastating to your portfolio. But we're of the view that positioned our portfolio in two distinct camps. The long term winners that provide a real short term opportunity to get set, and some of the deep cyclicals where you're going to get a recovery and the mark was overestimating how bad it was going to be.

James Marlay: Can you go into some more detail on those two, maybe provide a few examples of some of the stocks that you own in those two camps that you’ve outlined there?

Vince Pezzullo: So obviously with the Perpetual Investor company we can buy some off shore stocks. So we doubled down on our Flutter investment. It's been a good investment, but I remember in March it had fallen 40 odd percent. Obviously there's no live sport given it's an online sports betting company, 80% of it is effectively online sports betting. Also there's going to be a revenue hit, but we know the quality of the business. We know that gambling returns pretty quickly. This crisis was not an income shock for the man on the street, given the level of transfer payments from governments. So we know that gambling will pick up pretty quickly. You'll be able to buy Flutter at half of what we could do in February. So we went pretty high. We doubled our exposure on that one.

Crown is another. It's been a core holding for us for a while, but it had fallen to a level down about $6, $6.50, where you're getting the assets at a big discount. And these are monopolistic city-based assets running for a long time and you're not going to get another one, typically built in the same city.

James Marlay: And there had been takeover interests in the past 12 months?

Vince Pezzullo: Yeah. There’ve been a couple of interested parties. Obviously again, we doubled down on Crown as well. And then you have Blackstone show up and take over the Melco stake of 9.9%. And if you look at Blackstone's history, they've done some transactions in North America, on casino properties where they lift the assets out and the management of the existing entity manages the assets for them.

So we always thought that there's value in the assets and that did such a discount to the value of those underlying assets. We thought there's a real opportunity for us there, but then you have a look at, on the cyclical side, you had industrial metals, Oz minerals, those sort of businesses, they filter such levels that the replacement by the assets again were not called into question, but the market was assuming pretty bad outcomes.

James Marlay: So on that cyclical bucket that you're able to buy at discounts, do they remain long term positionings within the portfolios or was that opportunistic style investing?

Vince Pezzullo: There is an element of opportunistic there, but some like the Oz minerals, is a good business in general. It's hard to get copper exposure, particularly where they're growing their reserves, et cetera. They're in the middle of the CAPEX, nearly finished it, et cetera. Oil, especially is another one where we put some money to work. Negative oil prices, I suspect was quite stunning to most people, whether it was a real, I don't know, but again that noise provided an opportunity to buy some very cheap oil exposure and energy has been on the nose for quite a while. So we still think there's some value to be had in a lot of those names.

James Marlay: I was listening to a webinar recently and you described corporate debt as the elephant in the room right now. Could I just get you to explain in a bit more detail what you mean by that and why it's something that needs to be thought about?

Vince Pezzullo: So, the four quality filters. We look at all companies through a decent balance sheet - lowly geared balance sheet is preferred and demanded by us. It does tend to keep you out of trouble when things like what we just went through occurs. It is interesting - up into February the market was at record highs, companies were doing buybacks, borrowing money to do the buyback, leveraging up. And then once it hit, companies cancelled dividends, stock buybacks, it was a cashflow hit. So we had complete cessation of all cash funds in some businesses.

So then debt became a problem because you had the bank your interest payments. So you're leaning on your banks to extend terms, et cetera. So it suggests to us a lot of companies weren't preparing for a rainy day. Now it's quite peculiar to us that a lot of companies actually went and got more debt rather than de-levering this. Infrastructure, which is quite a defensive sector. But this, corona, was very specific to that sector in that travel had stopped and they were working from home, less movement et cetera. So a lot of those companies, rather than de-lever like Auckland International Airport de-levered. They did a raising. A lot of the Australian ones did not and they've extended terms and put more debt on. Now, the risk here is, when you put more financial leverage in those assets, they were all highly financially levered anyway because it's a hugely stable business. Just ask the question, what happens if we don't return to normal levels for five years? All of a sudden you've got more debt to service with less earnings compared to the last cycle. So all it does is introduce another business risk and people tend not to consider it when rates are low.

James Marlay: So what you're saying is the response of this opportunity was to be more conservative. There's been low interest rates and the appeal has led companies to go and get more debt. And it's just incorrect. It's amplified the risk that was already within them.

Vince Pezzullo: Yeah. So they've thought, okay, this is a short term event, so I will add. We need access to liquidity because cash flows dissolved effectively. So we need just access to liquidity, pay the bills, et cetera. For us it's going to be interesting to see how it plays out, because if we don't return to pre corona levels, I suspect there'll be some interesting conversations with the banks.

James Marlay: Vince, when I look back at the cash holdings that you had in the portfolio for Perpetual Investment Company, pre and post crisis, you pushed up towards 16% in February. Keen to understand what dictates the cash level to come back down? Obviously you've seen some opportunity to put it to work, around 3% last time I looked. What caused it to get up to 16% and how do you think about managing that cash?

Vince Pezzullo: So cash is sort of like a bit of an outcome for us. We assess everything on both an absolute basis and a relative value basis. So when we're seeing better opportunities in the fund on an absolute basis, we'll deploy the cash pretty aggressively, and you wait for those moments. But in February, the market was pretty heated and we were really struggling to deploy the cash. We were having to make choices where something was less worse than something else. So I'd rather not make those and in the peak we can go up to 25% cash.

But also what we did is, in January, the cost of protection was quite cheap because volatility was so low. So we'd bought some deep out of the money puts on the market, very cheap for us. And that extended for a certain percentage of the portfolio. It gave us a little bit more cushion with so when March hit, it gave a real cushion to the portfolio. So it's typically opportunity lead when we think about managing our cash levels. And we've got a big team internally, so we're constantly scouting for new opportunities, whether it's domestically or internationally.

And then you had the event. So everything was on sale, a lot of the market was on sale. So as you said, we went down to about 3% cash. That's how we drifted back out of it. We've started to take some money off the table and prepare maybe for some other opportunities down the road.

James Marlay: Wouldn't mind talking about a couple of specific areas in the Australian market. Some you’ve had exposure to, some where you've had none. Flight Centre, a company that was under extreme stress, and still hasn't fully rebounded. You participated in the recapitalization of that business. Talk me through the thesis on a business like Flight Centre, that's in an industry that looks like it's going to be so heavily impacted by travel restrictions.

Vince Pezzullo: So Flight Centre has always been within our quality universe. It's always the four - good management, good business, good balance sheet and a profitable business. So it's always been in our universe, but we've had some issues with some of the structural headwinds that potentially could occur. In particular it can be a quite cyclical business. And when you're running a negative working capital business, when the top line falls, you can run out of cash really quickly. But it's a well managed business.

We could see they were making some choices to restructure the business. So what the corona crisis did for them was it allowed them and, you could tell they had a plan ready to go because within the space of a week or two they had announced an accelerated restructuring programme, which was exactly what they should be doing. Spot on. And they acted pretty quickly. And then they said, right, let's buffer the balance sheet as well as build up an ability to make these structural shifts. They're now really well positioned, I think for the medium to long term. They set the business up to actually survive what we're going through now, and probably be stronger on the other side as they're very structured in the right areas. So you take advantage of those opportunities when they arise.

We've been looking at it for a while and when the placement came about, it was a great opportunity for us to enter into the business because we'd already done the work. And we knew what they needed to do, but obviously having a management team that's been through it before, they’ve been through a few cycles. So it does help that they realise when there's a problem, that they act pretty quickly.

James Marlay: That stock hasn't rebounded in the same V-shape that the broader market has. Do you feel like there's unrecognised value there still?

Vince Pezzullo: If you're entering in at the place where prices rebounded you’re doing quite well because obviously it doubled. So that's our first position in the stock. So we think there's still value to be added. But from here, it's going to take execution on the restructure and some tailwinds from a recovery in global travel. So again, it's what I talked about - a medium to longer term, but there is value to be had in Flight Centre still.

James Marlay: Yeah. So let's talk about exclusions AREITs and property. What's your view on that sector? You didn't have an exposure to it pre COVID, but things get so cheap. Is there a price that everything gets on the table and is worthy of the consideration? Talk me through your thesis on rates.

Vince Pezzullo: Given low rates, so as you said before, it is one of the sectors where everyone had an allocation or parked money and rates. We struggle when rates are very low, because it doesn't give you a lot of room to manoeuvre if something goes wrong. Discount rates go up, et cetera. And the economy is pretty buoyant. So everyone was assuming low vacancy rates forever in some of the REITs. And we sort of struggle with that because there is cycles, but we've actually been investing in REITs in the last few weeks.

There's definitely going to be a renegotiation and a resetting at some level in retail and maybe in office, I'm not too sure, but that's a conversation that's being had. But the way the market was pricing some of the equity was that it was going to be devastating, like 30% drops of NTA and rental will fall by half, et cetera. That's pretty extreme.

So the market was sort of giving you an opportunity to buy into the REITs on a multiyear basis. I'm quite happy with some of the prices we paid for some of the REITs we've been buying, because I think we're going to make a good, decent return on investment over the next couple of years. So as you said, never say never. The opportunity arose because of the extreme moves. When you think of the sectors that have performed the worst it was energy, financials, some discretionary, industrial cyclicals and REITs, and typically REITs would perform quite well in a market meltdown, but it was such a specific event, the market turned pretty quickly. So you use those opportunities to add value when you can.

James Marlay: The sub sectors within the REITs. You've got your office, you've got your retail. Have you been selective about the exposures that you want within the REIT universe?

Vince Pezzullo: We've been buying a bit of office, our exposure to some office, and we've been buying a company that sits across a few sectors, not massive over others, but it has a developer in it as well. So we sort of suspect that housing is going to be one of the things the government's going to try and maintain some sort of stimulus. And obviously with immigration being really low, potential for the next 18 months, two years, you're thinking about the second order impacts on housing and development. But we think that the owner occupied market will probably dominate most of that market the next few years. And you can see the programmes the government is bringing about from direct transfer payments to individuals to be a bit more targeted to sectors, to sort of stimulate that growth. So yeah, it would be very specific. We're not really in retail exposure at the moment. Our preference is for office and so it's a bit more broader than that.

James Marlay:

Looking at the recent performance in the Perpetual Investment Company, it's been a good period. Obviously you don't want to bank on the past returns, but the last few months have been particularly strong. Aside from things that have worked can you talk me through things that haven't gone so well? Just talk through some of the things, maybe in the context of some lessons, like what are some of the things that haven't worked out so well that you've learned along the way?

Vince Pezzullo: So if I think about one of the off shore stocks, which didn't work, so Lloyd's Bank in the UK, big retail bank, multiple brands in asset management as well as insurance. And the thesis there was it looked very cheap to us and we could see a change in the conditions of the underlying economy. So you had years of austerity in the UK and you had a Brexit where there was complete uncertainty. And then in the space of six months to 12 months, you had a majority conservative government get voted in whose mandate was to grow the economy and spend some money go very anti-austerity.

And Brexit was effectively cleared up. The deal is going to get done at some point and there'll be a bit more clarity on the other side. So you could see that the UK economy could make it really, really re accelerate its growth from just removing one of the handbrakes, which was austerity. So Lloyd's is right at the centre of that. It's a retail bank and you can see how they manage through the period of really soft trading quite well as a bank. And were sort of through most of the regulatory issues regarding mis-selling, et cetera. But when a crisis hits far enough, and you'll find this in all banks and financials, is correlations of global financials go to one. It didn't matter if you owned a bank in the UK, U.S. Australia, or Europe, they all traded exactly the same. So your investment thesis, the original investment thesis went out the window pretty quickly. So that's one that hasn't really worked.

Another one which hasn't worked for us has been event hospitality. Again, a hotel cinema operator in Australia, complete travel lockdown, no one's moving around, no business travel as well. So it can be quite extreme. That's an extreme hit for a business like that, but it's a high quality business, great assets, a fair chunk of them is on balance sheet, really good management team, and a good balance sheet to sustain some subpar trading for a while. That's one of the stocks we added to in the sell down, because it fell quite a lot, almost 40 or 50%. So that's a really high quality business. It didn't work, but I'm pretty confident about the longterm for that business.

James Marlay: I think we get cinemas opening in July. So maybe a positive tailwind. Outside of the individual stock stories you've talked through there, each crisis is a little different. You've probably invested through a few in your career. What are a couple of lessons that you've picked up from investing through the past few months?

Vince Pezzullo: I know nothing about epidemiology. That's all right because everyone became an overnight expert basically. So it didn't really matter whether you knew about that at all because the second thing I learned is to have a plan when things go wrong. And that revolves around your investment process. Have an understanding of how are you going to react? What companies you're looking at? That when they get to your valuation levels, where there's enough of a discount, and our team went through every company and worked out, worst case scenario, what's the valuation? Take 20% off that, if there's enough margin of safety, we should be buying these names.

Because at the time there was a lot of noise, but no real information. So you had to rely on your investment process to get you through. And as I mentioned before, pulling the trigger is the hardest thing to do particularly in that environment. And we're all decentralised as well. So information flow may not have been as good, but we worked through it. So what I learned was to have that plan before trouble sets in, because it'll get you through. It'll get you to make some decisions, which in a couple of years you'll look back on going, that was actually a decent decision that we made.

James Marlay: Can you tell me, how did it feel in those moments, pulling the trigger on some of those investments when there was so much noise and so much uncertainty, can you recall the guts?

Vince Pezzullo: That's an interesting period because you're going if this goes longer than I think, this could be a career ender, but we've got a pretty robust process. You’ve got seven, eight investing professionals to rely on. So you defer to the team. You're trying to do a few things at the same time and everyone was working in the same direction. So it actually became a lot easier to free your mind a bit when you had a team looking at all the angles on particular stocks. So it allowed us to be a bit freer in our decision making. And we pulled the trigger, but it was difficult. I can remember in the third or fourth week of March, you had to make some choices.

James Marlay: Great. Well, thanks for your time.

Vince Pezzullo: Thank you.

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James Marlay
Co Founder
Livewire Markets

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