Fund Manager Q&A

In the lead up to the tech wreck of the early 2000s Paul Skamvougeras was working on the dealing desk at Perpetual. The ‘value’ focused manager was struggling to keep pace with a market full of exuberance and momentum. Nearly two decades later Skamvougeras, now Head of Equities at Perpetual, says the same patterns and behaviours are becoming prevalent again.

Skamvougeras doesn’t shy away from the immediate challenges facing Perpetual and other value investors; however, he remains uncompromising on the quality of the companies he is willing to own and the price he will pay to own them. 

In this interview, Paul explains why there are certain ‘non-negotiables’ when it comes to buying stocks, shares a forgotten opportunity on the ASX and makes his case for why ‘value’ is not dead.

“Investors are very focused at the moment on what can go right, what’s the upside, focused on returns. They’re not really focused on the risks they are taking.”

Topics discussed

  • Investor psychology and examples of risk taking in the current market
  • Why ‘value’ performed so well in the 5 years post the GFC and why it is struggling today
  • Is ‘value’ investing dead?
  • Areas of the market that Skamvougeras is avoiding
  • Forgotten opportunities – a quality company the market is overlooking
  • Reducing exposure to Woolworths
  • A common trap for value investors to be aware of
Value investing is cyclical. If you have a look over a long period of time in history, value investing has outperformed growth. 

Available to watch or listen

Watch the video below or access a podcast of the discussion on SoundCloud or on Apple iTunes

Transcript:

James Marlay: I'd love to get a bit of background on influences with how you started investing. I heard a story about your early days on the dealing desk at Perpetual, which was in the lead up to the tech wreck. And you were working under Peter Morgan who is one of Perpetual's well-regarded head of equities. Could you share a few of your experiences and memories from that time in markets and what it was like being an investor at that time?

Paul Skamvougeras: Well, back then it was quite a tough period for value investing in Perpetual at the time. Given that we have a very conservative investment process and philosophy we were underperforming the market quite a lot. There were a lot of hot stocks that we didn't own, and News Corp I remember was, I think, the largest stock in the index at the time and one of the best performers, and we held no shares whatsoever. It was a very tough time for value investors, a lot of what we saw back then in terms of investor psychology and investor behaviour we're seeing signs of that today actually. What I mean by that is, investors are very focused at the moment on what can go right. What's the upside? Focused on returns, not really focused on the risks they are actually taking. Investing's about risk and reward and what we're seeing, a lot of people are focusing on the reward side of the equation and not actually taking account – properly, we'd feel – of the risks that are in the market at the moment.

James Marlay: Peter would have been a mentor of yours. What sort of things was he saying to the investment team, how was he handling, can you recall the sorts of things he was saying at that point in time?

Paul Skamvougeras: The investment process and philosophy, it's very rigid around ensuring we've got a very strong buy sell discipline around valuation, so valuation is really key. And at the time, there were a lot of stocks that were trading at valuations that we felt were not justified and so, from our point of view, we just kept on doing what we always did and that was to identify, try and identify quality companies that were representing value. At times it's absolute value and times it's relative value, and I think back then it was about identifying relative value, good solid companies, and strong balance sheets, decent management teams, could pay dividends through the cycle.

And that's what we're really focused on and even today we're underperforming as well, but that's where our focus is. We're not focusing on the things we can't participate in or the hot sectors where we feel that valuations are too rich and aren't justified.

James Marlay: So those things, balance sheet, management, valuation, they're the non-negotiables for you?

Paul Skamvougeras: Yeah definitely, the quality of the business is a non-negotiable. You always, you don't want to compromise on the quality of the business. Valuation – really key. We believe that the price that you pay for an asset is very, very important especially around your future returns and expected returns. Paying the right price is very important and also the other thing we think is very important is balance sheet. And the reason why is, you know, when the business cycle changes a company with a strong balance sheet has optionality. They can continue to pay dividends through the cycle, they can take advantage of opportunities within their industries. We think that gives you or affords a company a lot of flexibility, but also as an investor it keeps you out of a lot of trouble as well.

James Marlay: In the recent presentation that you gave to advisors and the team gave to advisors, you talked about the post, the decade post GFC being effectively a tale of two halves, two five-year periods. First five years, the Perpetual strategy and value actually perform quite well. The second five years it's been hard to keep pace with the market. What is it that worked during the GFC, what helped coming out of the GFC and why was it good for returns?

Paul Skamvougeras: I think coming out of the GFC, our focus on companies with strong balance sheets was really important. It helped us come out a lot sooner. The companies that we held were still paying dividends. They didn't have to worry about recapitalizing themselves or their capital structure, they had good balance sheets. They could take advantage of opportunities or competitors that were weak. But also value was in abundance back then. So that five-year period coming out of the GFC we performed extremely well and then the start of QE3, the next five-year period when interest rates were starting to fall and, at the moment they're artificially low but they're low and a lot of people say will be low for a long time, we've found that we've struggled to keep up. As a value manager, what we're struggling with is a lot of companies, sorry, a lot of investors are increasingly paying higher and higher multiples for the same earnings stream and justifying in all sorts and manners. For us that's an environment where when you have valuations that are elevated, we tend to underperform.

James Marlay: Yeah. Now, you might be able to, you can explain why that underperformance exists. No one really enjoys it and if the low rate environment has contributed to that, does the recent change in stance from the RBA or the renewed stance from the RBA and potential change of stance from the Reserve Bank, does that prolonging of the low interest rate environment, does it concern you?

Paul Skamvougeras: Yeah. It doesn't help if you're a value investor, that's for sure. Also, our investment process and philosophy, we focus on the balance sheet as I said, so, a lot of where we haven't participated in the rallies, for instance, infrastructure. A lot of infrastructure stocks have capital structures, too much leverage on the balance sheet, so typically they don't even make our quality universe. Now you look at as interest rates have started to fall and if they continue to go lower, they've been some of the best performing stocks and we haven't participated in any of that. So it is challenging from our point of view, but what I would say on the flip side is there's a lot of high-quality industrial companies today that are actually giving you, that have decent balance sheets, giving you a decent yield that's fully framed. And the market has almost forgotten about those opportunities.

James Marlay: I'm going to move on from the value investing discussion a second. What do you say to people that come to you with question marks about the viability of value as a style? You would've had advisors wanting to know from you, it's a common question on the market, what's your sort of short response to that?

Paul Skamvougeras: Well, I think in all of us, we're all an investor to some extent. Everyone, I believe is concerned about what price they pay for an asset. I don't see anyone, if you're buying a house and the real estate agent says "Well we want $5 million", you don't just turn up and say "Well I'll pay $5 million". Typically, people want to ensure that they're getting or buying an asset at the right price, at the best price. When you think about it in that view, is value investing dead? Absolutely not, because we're all concerned about the price we pay and we all want to be paying the right price.

Having said that more broadly, what does it actually mean where we are today? I think value investing is cyclical. And if you have a look over a long period of time in history, value investing has outperformed growth. It's been this last 10-year period where interest rates have been historically low where it's been a long cycle of underperformance for value. In a 100-year period it's been the longest period of underperformance for value. I would say it's cyclical. I would say low interest rates definitely have contributed to some of that but also the rise of passive investing, I think also plays a part in making value investing it a bit tough at the moment because passive investing is about buying the winners and as money continues to flow into passive investing you see these winners and passive investing is value-agnostic. They just buy what's the biggest in the index. That also makes it quite challenging for value investors today. Again, as I said, it's not broken it's definitely cyclical.

James Marlay: On the cycle, what do you and your team look at to get a sense of where we might be in the cycle? We talked about it being a bit prolonged, what are some of the things and the markers that you guys can look at to give you a sense of where we might be?

Paul Skamvougeras: Well, valuation relative to history is the key one obviously. But a lot of investors will tell you, "Well interest rates are low, so valuations are justified at being really high". And there is some validity to that argument, but having said that, investors are forgetting about the other side of the picture which is earnings. What are earnings doing? Well, if you have a look globally and also in Australia the earnings growth is starting to tail off. So, when you put it together, we're definitely late in the cycle so we've got really low interest rates, we've got a lot of leverage in the system, and corporates are highly geared but also households. Valuations are quite high. We would say you're very late in the cycle and we're seeing behaviour, investor behaviours in particular that are starting to concern us. So there is a bit of a fear of missing out. Investor psychology as I mentioned before is all about what can go right and not really fully assessing the risks of the downside. So we're definitely late in the cycle.

James Marlay: In terms of the companies and the stocks that you're not owning, the exclusions, you touched on infrastructure there. And if we think about things where you feel like there's a big risk to the downside, what are some examples of some of the sorts of areas of the Aussie market that you are really avoiding, and that give you concern?

Paul Skamvougeras: Well infrastructure because of our process. Also within our process we don't invest in stocks that haven't turned a profit. So a lot of the high-flying tech stocks that are yet to make a profit and have big valuations, we're not participating in those. Now, not all of those stocks are going to be around in five or 10 years' time. There will be some that will justify their current valuations and grow into their valuations, but there will be some that won't be around. So from our point of view, a lot of those techie-style sectors we're not really participating in at all. And that's part of our conservative investment process and philosophy that steers us clear from those hot sectors if you like.

James Marlay: Yep. There is this perception that the blue-chip market in Australia is a bit tired and boring, particularly when you put it against some of those racier names that are in that tech sector. But Telstra, which is about as tired and boring as they come is up 40% year-to-date. Are there some examples of some companies at the big end of town that you think are being overlooked and have some quality attributes and value attributes that sort of jump off the screen at you?

Paul Skamvougeras: Yeah, that's a good question. Boring is actually good as investors for us. We actually quite like boring companies that just go about their business and deliver dividends for shareholders and have a good management team that run it. One stock that does stand out for us, and we think the market has overlooked for a macro reason is Medibank. Medibank is one of the largest health insurers in Australia. The perceptions from the market is, and it is correct at this point in time, is that the private health insurance industry is shrinking so we're losing policy holders. Well policy holders are downgrading their cover because of affordability concerns. But why do we like Medibank? Well for the first time in a long time, the core Medibank brand has started to grow policyholders, which is very, very good. They're on top of a lot of their previous issues around customer complaints. They've invested heavily in the digital part of their business and are engaging much, much better and much better than all their peers on the digital front. It's a high ROE business, it's got a 21% ROE, it's got a net cash balance sheet, it's got the ability to increase its dividend payout ratio, and it has excess capital.

And this is all on a market multiple but the market has overlooked this because of the macro concern around policyholders shrinking. Now, we believe that Medibank is best in class, they're outperforming their peers and competitors with a lot of their initiatives around cost, around getting claims costs down, and they're well ahead of the industry. We think they will continue to be an industry winner even in an environment where the industry shrinks. So that's one we really like. Since the election, it has had a bit of a pop because the Coalition government is perceived to be better for private health insurance in the way of the government. But we still think that that's a high-quality business totally overlooked by the market.

James Marlay: Woolworths is a stock that, as a firm, you were backing, even having a look back I think 2015, 2016 around the time that Brad Banducci got involved.

Paul Skamvougeras: Yes, that's right.

James Marlay: And it was an unpopular stock – the story has worked out really well to the extent that I understand you've been lightening your position in Woolworths. I'm just keen to understand if the environment for retail, for the supermarkets, has something changed in the environment for them or is it purely a valuation piece? Just interested to understand how that thesis has changed for you.

Paul Skamvougeras: It's predominately around valuation, so it's approaching what we think is a fair value for the business. So that would be the first point. Having said that, the environment for grocery retail is still pretty good, so we are in a very rational environment at the moment. We haven't seen food prices or grocery price inflation for a while and think that could start coming back, so that's a bit of a tailwind. Amazon has launched to much fanfare but has been a bit of a flop – now you can't get complacent about Amazon. They will be back and they will compete. But the structure of the market, grocery retail in Australia is a much better structure than you'll see anywhere else in the world. Predominately it's valuation for us.

James Marlay: The Royal Commission was a really big thing for, particularly for the banks here in Australia, and I think a lot of people, justifiably, feel let down by some of the things that came out of the Royal Commission. With that now complete, do you see a better pathway forward for these big institutions that are important for a lot of investors and a lot of Australians?

Paul Skamvougeras: Yeah, it's a good question. It can't get worse for them. So, incrementally the news flow, the negative news flow's gone away and as you've seen since the end of the Royal Commission there's been a few tailwinds for the bank. I think the biggest thing for the banks and their earnings outlook that you need to focus on is, and we've seen a bit of relief rally in the banks, what you need to focus on is the interest rates. Interest rates going down or being cut is actually not good for earnings because that really pressures their net interest margin and that's where all the leverage is on the earnings front. The fact that interest rates are lower probably means that bad debt, bad and doubtful debt charges aren't an issue and also probably takes out the, if you like, the downside scenario for the economy. So, on the whole, they've probably rerated to a point where they probably fair value. But I would look at the NIM, that's really your guide to the earnings outlook.

James Marlay: I want to bring us back to the roadshow presentation and one of the comments that you talked about was the team's desire to deliver better returns for your investors. The Perpetual philosophy sounds like it's pretty set in stone and something you return to. So if you've been executing the Perpetual philosophy what can you do differently to change the outcome?

Paul Skamvougeras: Yeah that's a good question. Well we're not changing the way we invest, that's number one. I think one of the reasons clients give us their money is they know what we are, and we are very true to labels. We focus on quality and value, but value being the key, and I think that's important. People know what they're getting with us and as it stands today, yeah, we haven't done, we're lagging the market. It's disappointing, we all want to be doing better as a team obviously. A lot of our team members are invested in the funds alongside our clients, so we are aligned with them.

What can we do if we're not changing our investment process or philosophy? What we're starting to do more of internally is we've been investing in our research capability internally. Even though it's been a tough time for value investing, we've grown the team and our resources and our capability, and we're looking to do more proprietary research in-house. We think that will give us proprietary insights or an edge relative to our peers. And so, we are investing in our own research in-house capability that we think will provide benefits in the medium to long term for our clients because we will be able to use those insights to better inform our investment decisions.

James Marlay: Final question, and this is on that I ask everyone that I sit down with who has been investing for a while. We all make mistakes along the way. Hopefully we make mistakes that make us better investors. Can you draw on a personal experience, something that hurt, something that stung, that sits with you today that makes you a better investor?

Paul Skamvougeras: Well, I can't recall a company but where I tend to make, and I make the same mistake, but it's always a different company. You compromise the quality of the business because of the price and you get stuck. Being a value investor, the one thing you have to avoid is value traps and typically as a value investor you always get lured to the price of something. You go, "Well that looks interesting" and then you make an assessment of the quality of the business and typically what you do is you overestimate the quality of the business and that's where you end up making the big mistake. And I've done that on a number of occasions and always think that I've learned my lesson for next time but find that it manifests in a different opportunity and sometimes you get the same outcome. So, that's the biggest mistake, compromising, I think, on the quality of the business that you're buying because the price is attractive.

James Marlay: Right. Well Paul thank you for taking a bit of time out of a busy day to have chat with us today. I really appreciate it.

Paul Skamvougeras: Thank you.



Comments

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Matt McDonald

Hey James. Can you turn this interview into a podcast? Love listening to them in the car. Keep up the good work

James Marlay

Hi Matt, yes I'm sure we can do that. I'll get it sorted on Monday.