Anyone who’s followed the writings of the team at Montgomery Investment Management over the years would’ve noticed that for a long time the firm was decidedly negative about Telstra.

But about 18 months ago things started to change.

After several years of price falls it seemed that the gap between price and value had not just closed but reversed altogether. In June 2018, Portfolio Manager, Tim Kelley said that the issues, while real and material, were “fully priced in to Telstra shares.”

With Telstra having returned more than 45% since then (including dividends), the obvious question is whether there’s still upside on the table for Telstra. I recently got in touch with Tim to find out if things had gone as expected and for his current view on Telstra. He also shares one beaten-up Aussie mid-cap that he thinks could have better times ahead.

Hi Tim, thanks for talking to us today. Could you summarize your view on Telstra last year? Did it play out as expected?

In years gone by, Montgomery Investment Management has been reasonably critical of Telstra as an investment candidate. It often appeared in our presentations as an example of a company whose growth prospects fell far short of what was implied by its share price; the sort of thing our investment process led us to steer clear of.

In mid-2018, however, our position flipped. In June of that year, with Telstra having delivered the worst total return of any ASX top 20 stock over the previous two years, we found ourselves crossing to the other side of the fence. In particular, we had come to the conclusion that the various problems faced by Telstra at that time were well-understood by investors and fully factored into its share price, but that some potential longer-term upsides had been overlooked.

To quickly recap, in mid-2018 we had identified three potential sources of upside:

1. We thought that there was scope for Telstra to surprise on the upside in terms of cost reduction initiatives;
2. We thought that the NBN earnings hole may ultimately turn out to be smaller than anticipated; and
3. We thought that the transition to 5G mobile had the potential to drive significant growth in mobile services over an extended period.

Given the share price appreciation since then, does it still look like an attractive investment proposition?

In the period since, Telstra shares have performed well, and it makes sense to now ask what remains of the original investment thesis, and whether grounds can still be found to hold the investment into the future.

Of the three points listed above, it is fair to say that only the first has so far come to pass. Shortly after we set out the thesis, Telstra announced its “Telstra2022” strategy, which had cost reduction as one of its four pillars. More specifically, Telstra increased its productivity target to $2.5 billion from a previously announced $1.5 billion of cost-out by 2022. In the time since that announcement, Telstra appears to have made solid headway in delivering on this target.

This part of our original thesis is accordingly ‘spent’. We no longer have a view on productivity that is significantly different to the rest of the market, and a case for continuing to hold Telstra needs to be found elsewhere – potentially in the remaining legs of the original thesis, if they still hold, or in other new insights that have developed over time. Given the strong performance of Telstra shares over the past year and a half, this may be asking a lot.

In relation to the other legs of the thesis, our view today is broadly similar to the view we held in 2018: we continue to believe that the economics of NBN resale are unsustainable for Telstra and other NBN resellers, partly due to high NBN wholesale prices, and that this will ultimately be resolved in some way, potentially by NBN lowering its wholesale prices or by Telstra and others using 5G networks to bypass NBN at better profit margins.

It will be some time before we have clarity on the outcome for NBN, and in the meantime, the uncertainty provides some basis for continuing to own Telstra shares. If the thesis ultimately proves sound, then Telstra shares stand to benefit as the profitability from this part of the business surprises on the upside.

In the case of 5G mobile, it is also too early to tell what the outcomes may look like, but there are some reasons to feel increasingly positive. Firstly, the proposed merger of TPG Telecom and Vodafone Hutchison Australia (and the resulting challenge to the merger from the ACCC) has provided an unexpected benefit for Telstra shareholders. Regardless of whether the merger is allowed to proceed, it seems likely that the ability of Vodafone/TPG to effectively plan and execute a mobile strategy has been severely curtailed by the intervening uncertainty. We think that this has happened at a critical time and has allowed Telstra and Optus to more readily secure leading positions in rolling out 5G networks.

Further, at its investor day last November, we saw Telstra management projecting an increasingly confident outlook for 5G, which included expectations that the market leaders would have greater opportunity to differentiate on the basis of network quality, and that industry pricing discipline should improve following the large capital expenditures required to build 5G networks. These dynamics should contribute to improved economics from the most important part of Telstra’s business – its mobile network. This benefit lies outside our original thesis, which contemplated volume growth, but did not anticipated material improvement in unit economics.

If the anticipated improvement in economics can be combined with good growth in mobile services driven by new technologies (such as Internet of Things) and increasing numbers of connected devices, Telstra could find itself enjoying a period of unusually healthy growth in profitability in the years to come, and this allows us to take a more positive view on Telstra’s value than we might have held otherwise. However, we note that the anticipated boost to mobile benefits may only apply while 5G technology is new. Beyond that period, it would be reasonable to expect a return to the familiar pattern of aggressive price competition in mobile telephony.

Putting all of this together, we see that some aspects of our original thesis appear to have had some merit, and for others we are yet to find out. We also see that we have benefitted from some unexpected good fortune in relation to structural and competitive developments in the mobile market, and this has certainly driven part of the share price rise we have seen.

The question now is whether there remains enough juice in the thesis to warrant a continued position, or whether the share price today gives a fair account of the potential upsides. Our view on this is that it continues to make sense to hold Telstra shares, particularly in a market where good value is not easy to find. While the share price performance has undoubtedly been strong recently, this needs to be viewed in the context of coming off a very low base after many years of dismal performance. While the heights it reached in 2015 may be out of reach, we see reasonable grounds to expect Telstra to continue to outperform for some time yet.

Are there any other stocks out there where you think the market is overemphasising the downside and ignoring the upside?

Finding beaten-up stocks with unappreciated upside can be one of the most rewarding things an investor can do. A stock that has lost favour with investors can get pushed to unreasonably depressed levels, and the recovery from those depressed levels can produce some spectacular returns.

Of course, buying beaten up stocks can also be one of the riskier things an investor can do. Stocks that are out of favour tend to be out of favour for a reason, and the fact of a low share price is not enough - you need to have a good reason to stand against the tide.

With that caution in place, one stock that we think may enjoy better fortunes in years ahead is Healius Limited. Over the years, owning Healius has generally been a miserable experience for its investors, with a host of market challenges, operational missteps and earnings disappointments testing the faith of the most patient shareholders

However, there are reasons to think that better times may be ahead. In particular, we believe that the new management team, under CEO Malcolm Parmenter, has the right skillset and the right strategy to significantly improve the performance of the business from the ground up. There are many aspects to the turnaround program, with process, behavioural and IT infrastructure changes needing to be made across multiple business units, and this complexity means it is likely to be a slow and difficult process.

It is also the reason an opportunity may exist. Investors who own the stock today have no guarantee that the turnaround will succeed. However, waiting until the success of the turnaround is apparent means waiting until it’s too late.

Thanks for sharing with us today Tim.

Read more of Tim's thoughts on Healius here.