What defines ‘good’, ‘bad’, and ‘ugly’ in Australia’s equity markets today? Each of these three panellists from this year’s Livewire Live has a decidedly different take.
To Philip King, Chief Investment Officer at Regal Funds Management, growth is good! In a growth starved world, companies that can grow regardless of the economy are a gem worth paying for.
Ben McGarry, Portfolio Manager at Totus Capital, prefers companies with conservative accounting. In a market where companies are increasingly capitalising expenses and being aggressive with account, a conservative approach helps to prepare companies for future turbulence.
On the other hand, Anthony Aboud, Portfolio Manager at Perpetual Investments, likes companies that take a smart approach to capital allocation. Buying back expensive stock, or issuing shares to make ‘accretive acquisitions’, is not the way to build long-term shareholder wealth.
In a world where growth is hard to come by, companies with organic growth are like "a nugget of gold", says King.
“It’s like watching the Wallabies beat the All Blacks – it doesn’t happen as often as it used to, but it’s very rewarding when it does happen.”
Equity returns come from two sources:
- Earnings per share (EPS) growth, and
- Price-earnings re-ratings (i.e. price appreciation independent of higher earnings)
Because there's so little EPS growth out there, he says when you find that, it often comes with a re-rating, and you get the double-whammy.
With many growth stocks being owned one third by founders, and one third by growth managers, neither of which are natural sellers, it's not hard to see why the share prices can appreciate quickly once passive investors get on board.
McGarry says that one of the key attributes he looks for is conservatively presented financial statements. What is conservative? One common example is expensing costs rather than capitalising them to the balance sheet.
"We like companies that are conservative about the way they present their accounts. It indicates to us that management aren’t having to stretch or pull levers to maintain a multiple or a growth rate that the market’s been expecting."
He shares one example in Smartgroup (SIQ). He says is consistently underpromises and overdelivers. The business is highly cash generative. Cashflow is always close to reported profits. Everything that can be expensed is, and management has skin in the game.
Aboud says he's looking for companies with smart capital management and strong balance sheets. He likes to see companies that avoid making expensive buybacks or burning cash on acquisitions at the top of the cycle, so that they're prepared when the going does get tough.
One example is AP Eagers, which avoided buying back shares or undertaking 'sale and lease-back' arrangements while times were good. At the bottom of the cycle, they were able to undertake a 'merger of equals' with Auto Holdings Group (AHG), a larger competitor.
"They wouldn't have been able to do that if they'd bought back stock at the peak."
McGarry believes that Ingham’s is a stock where "the chickens are coming home to roost.” It seems to cross all the boxes:
- The float was a result of a private equity sell down.
- Assets have been sold and leased back, making it more vulnerable to a downturn.
- Stock buybacks have been used to push up the share price and cash out existing holders.
- The CEO and CFO who were with the company at IPO have since left and sold their shares.
“You’ve got a company that’s probably more risky than the profit and loss, looked at in isolation, would suggest. That’s the kind of thing I would put in the “bad” – not “ugly” – but certainly it’s been dressed up, and in the avoid category.”
Aboud says they're a bit old fashioned at Perpetual: they like to look at net profit after tax (NPAT). He is concerned about the increasing frequency at which he sees companies instead focusing on ‘underlying EBITDA’, which excludes all kinds of important costs including depreciation, and share based compensation.
Some are even focusing on sales, or projected future sales.
“As we get further and further up the P&L, you have to get more sceptical about what’s going on.”
One other danger to look for can be overuse of fair value accounting, which he says is like an addictive drug. It brings future earnings forward to today, which can have ramifications down the track – as investors in Slater and Gordon found out a few years ago.
King sees valuation as a big risk for some stocks today, which is being further fueled by passive investing. However, this offers opportunities for active, long/short managers to take advantage of the index funds.
"It was announced last week that Zip would be going into the ASX300, there will be a lot of passive investors buying next week as we’re selling...
I often liken it to the example of being a hunter. The passive investors, they’re like animals. You know they have to come to the waterhole twice a day. We just lie in the bushes and wait for them to come and pick them off when they come.”
One sector that Aboud expects to struggle in the coming years is financial services. In particular, the platform companies such as Netwealth (NWL) and Hub24 (HUB). He sees increasing competition in coming years as capital flows towards the hottest sectors.
Platform companies face pressure on a couple of fronts:
- Increasing competition on platform fees.
- With lower interest rates, it’ll be harder to collect the spread on the cash component of accounts
“Netwealth is the value play, I think it’s on 56 PE. Hub’s at 100 PE.”
King warns that there’s "more value traps than ever before." He believes that anything that relies on the economy will struggle as the economy is likely to remain soft.
“It’s dangerous to buy value stocks, because often the value that you think is there, is not there.”
Two areas he sees a lot of value traps are old media, and old retail. In a fast changing world, many of the stocks in these sectors are uninvestable, even has apparently low prices.
Most of McGarry's most successful shorts have been ones that rely on external funding to survive or grow. A company shouldn’t need to be asking the markets for equity or debt funding constantly. This was one of the 'red flags' he spotted on on Blue Sky Alternative Investments (BLA) before its public blow-up.
"Where you find a stretched balance sheet and a problematic business model, that’s where you get the chance of outsized returns."
He shared the example of Buccaneer Energy. The company was formed by a group who came to Australia to raise money to develop an Alaskan oil and gas asset. The company flew Ben, along with other analysts up to the asset in Alaska not once but twice.
“It gave us an opportunity to see how little progress was being made on the ground.”
They were spending shareholder’s money “like it was confetti”.
“The company logo was a pirate ship with a Latin insignia around the outside. In the airport, I finally got up the courage to ask the CEO what the Latin insignia meant. He said it’s Latin for ‘take the money and run.’”
Needless to say, this was a successful short position.
Watch the full video
In the full discussion below, they delve into each of these issues in further detail, and share their views on the direction of the ASX over the next 12 months.
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