Fund Manager Q&A

The rationale for investing globally is irrefutable: access to a far larger, more diverse and potentially less crowded set of opportunities. Currency tailwinds are an added bonus that could only grow stronger if QE happens. 

It takes an upgrade of the skillset and perspective that works for local stocks, so to give you a treasure map for global investing, I ran a Q&A past highly regarded managers Jordan Cvetanovski and Steven Glass who run Pengana International Equties (PIA). We covered a lot of ground, and I've isolated 8 of the key ideas that emerged along the way. 

I also took the opportunity to ask about the aggressive measures they are taking to close the discount on the LIC, which include a dividend offing a 4.6% yield at current prices, and the ability to crank up their recently commenced buyback by a huge 24.3 million shares if required.  

Read on to hear about what the elephant in the room is for markets, why free cash flow is all that matters, and the greatest opportunity of the next few decades.  

Q: Could you start by boiling down PIA’s investment philosophy for someone new to the fund; what can investors access from you that they won’t get elsewhere?

We aim for our investors to be invested in great, growing quality franchises around the world. Where we are different is in two primary ways:

Firstly, we are obsessed about lowering volatility and potential for significant drawdowns.  We feel that our unique approach by segmenting the fund into three types of investments, namely core, cyclical and opportunistic allows us to have a consistent and acceptable level of risk in the fund.  Within these parameters, our team of experienced stock pickers are able to generate capital returns for our clients.

IDEA #1: BE OBSESSED ABOUT REDUCING VOLATILITY

Secondly, we are very deliberate about the companies we include in our fund and how these companies businesses pair up with each other.  In other words, we are constantly looking to buy companies that have minimal correlation with their core drivers. We focus strongly on what are the key external drivers of a company and make sure we don’t overlap excessively.  In order to do this successfully, we must be very diligent and thorough from understanding the company itself but also understanding its wider environment. This is how we define diversification and what has ensured a smoother ride through the more turbulent periods in the market .

IDEA # 2: DIVERSIFY BY COMPANY DRIVERS

Q: What was the last stock to go into the fund, and what were some of the key characteristics that matched your investment criteria?

We have pointed out over the recent several quarters that the US equity markets appear quite expensive to us on many metrics.  In particular, companies that have dragged the US markets higher over the last years namely “steady growing” technology companies and those that benefit from lower interest rates.   

Therefore we have broadened our search and our last two purchases were in Europe. Both companies are what we consider to be “cyclical”. 

Ever noticed Ferrari's signature red disc brakes? They are made by Brembo (BRE.MI), an Italian brake disc manufacturer with a 3.5 billion Euro market cap. It is cheap by most conventional measures, and in terms of free cash flow yield (the only measure that matters to us), it is very attractively priced at roughly 7%. The company is well managed, has been gaining global share, and has grown circa 10% p.a. over the last 10 years. 

Putting all this together, assuming they can continue to average 10% growth over the next 10 years we get all our initial investment back in 9 years in cash and then theoretically own the business for free. Not bad in a zero or negative interest rate alternative (eg buying nestle bonds in Switzerland will guarantee you a loss).

IDEA #3: FREE CASH FLOW YIELD IS ALL THAT MATTERS

Q: As a global fund you get to select your 30-50 stock portfolio from a vast pool, however, are there any stocks within the ASX that would likely meet your investment criteria (or are in fact in the fund)? If so, can you provide an example and outline the thesis?

We currently do not hold any Australian companies.  Broadly speaking, Australia is roughly 2% of global markets and similarly in terms of GDP.  Therefore as a global manager, we tend to look outward as there are thousands of opportunities beyond our shores.  In addition, we find that “quality” companies in Australia are generally well held or in other words quite expensive.  

This might have to do with a big pool of money chasing few investments or something else that is particular about Australia.  In any case, we are aware of some companies that would pass our quality criteria but in general, they would need to drop substantially to meet our valuation criteria.

IDEA #4: AUSSIE STOCKS DON'T PASS MUSTER TODAY

Q: You divide stocks into core, cyclical and opportunistic categories, the latter being “unique, company-specific situations that offer attractive potential upside”. Could you elaborate on this, and provide a live example?

One example that is live at the moment is Huazhu Group (NASDAQ:HTHT) in China. We purchased the shares in the midst of the trade war and it is classified as an Opportunistic investment. The stock tends to trade poorly on weak Chinese related sentiment, and these are periods that we identify as buying opportunities.

Huazhu group represents the branded hotel market in China, and with 4500 hotels, has reached almost half of the total market.  Huazhu's hotels boast an occupancy rate of over 90% and they achieve this due to its vast network of over 100mn members that use its hotels on a regular basis. Huazhu is cheap, has many years of growth ahead of it and does not require vast amounts of capital to grow.

IDEA #5: NERVOUS MARKETS CREATE OPPORTUNITIES 

Q: With 2020 fast approaching, what will be the one thing that investors can’t ignore next year? Why is this so critical, and how are you thinking/positioning about it?

Clearly the big elephant in the room is what do we do if Elizabeth Warren is named as the Democratic nominee and ends up winning the presidential contest in November of 2020?  We believe that her success would have some clear implication for the broader market. 

There are numerous risks to be mindful of outside of this obvious one such as the astronomical buildup of debt in the system and the ineffectiveness of central banks to steer the cycle.  US corporates are clearly experiencing a slowdown due to China tensions and general global economic malaise. 

Having said all this, although we are mindful of everything that is frightening around us, we continue to work hard and discover companies that have high-quality franchises, operating in a vast array of end markets and hence are us uncorrelated and generally not dependant on many external factors.  

IDEA #6: STICK TO YOUR PROCESS 

One big potential positive impact on markets would be governments globally announcing fiscal stimuli to boost their economies. This would benefit greatly the companies we have recently acquired that have been sold down very aggressively due to general economic fears. One such example mentioned previously is Brembo in Italy or provider of renewable solutions in packaging, Stora Enso (STERV.HE).

Q: You screen for stocks that score badly on an ESG basis. Do you think following an ESG mandate is ultimately a headwind or a tailwind to performance?

We believe Environmental, Social and Governance (ESG) considerations should be thought of as an additional quality screen as it screens out businesses that are ultimately unsustainable due to their negative impact on the world or are risky due to poor corporate governance. This additional quality screen helps us avoid problematic business while still enabling us to invest in the lion's share of the equity markets. 

The aggregate contribution of all the companies we won’t invest on ESG grounds is approx. 15% of the global equities markets. While not entirely immaterial, that figure is many times smaller than the 85% of the global markets that we can invest in. 

IDEA #7: ESG GIVES AN ADDITIONAL QUALITY SCREEN

Q: What’s behind you overweight EM (Asia) positioning. Do you have a view on who comes out on top (US or China) from a protracted trade war, and how Australia fares as a result?

Emerging markets globally offer the greatest opportunities over the next few decades.  They have a dynamic, young and growing population that is increasingly moving up the wealth and consumption curve.  With these consumers growing in number and aspiring to consume better quality products (better nutrition and better-known brands) and services (such as healthcare) we are backing the companies that will benefit strongly from these trends. 

Of all the emerging markets, Asia is moving rapidly in this direction and we are investing and actively looking for opportunities across the continent. We currently have numerous investments in the major markets of India and China and aim to expand to neighbouring South East Asian countries where another billion of consumers reside. 

IDEA #8: EM IS THE BIGGEST OPPORTUNITY OVER THE NEXT FEW DECADES

Q: What was the last research, book, report etc that really stunned you, and can you summarise the key points within it?

Prisoners of Geography – this book explained why so much of the global economy and political turmoil (including war) is often explained simply by geography.

Take Russia for example. The terrain from Ukraine to Moscow is relatively flat making it easy for ground troops to attack Russia from Ukraine, which is part of the reason that Russia is so interested in Crimea.

From a more economic perspective, the book explains why the US has unique geography that virtually guarantees success, for example an extensive waterway though its heart that facilities trade.

A final example is that Andean nations, particularly Colombia is separated by multiple mountain ranges, making trade difficult, hindering economic growth.

Q: The LIC has been trading at a 15% discount to NTA, could you talk about what you are using to close this, e.g.: the buyback program (e.g. what has been bought back to date, and how much more might be bought).

It is disappointing that the Company’s share price has not tracked the NTA despite the positive initiatives undertaken over the last two years. 

The Listed Investment Company (LIC) sector as a whole saw a widening of discounts in the second half of the 2019 financial year. There were many factors that contributed to the widening discounts including general market uncertainty, a broad share market sell-off in late calendar 2018, additional LIC listings absorbing capital and the Labor Party’s controversial proposed reform to dividend imputation credits. 

Regardless, we continue to be focused on various initiatives to bring the share price more in line with NTA through investment performance, capital management and increased promotion of the company, to retain existing shareholders and to improve demand for PIA shares. 

The buyback is one of many capital management tools of the Company and not in itself a price-setting mechanism. Rather, it enables the company to acquire shares at a discount and hence benefit those shareholders that remain invested in the company. Since the buyback commenced on 10 September, 453,995 shares have been bought back, at an average discount of 14.5% to the last reported NTA on trade date. PIA has the ability to buy back an additional 24.3 million shares and at the time of writing, PIA shares were trading at a 14% discount.

Q: In August PIA foreshadowed a reset of the annual dividend to 5 cents per share in the financial year ending 30 June 2020. Based on the current price of $1.08, that is a reasonable annual yield, is this part of the strategy to close the discount as well?

The payment of dividends is another element of capital management and the Company is very much aware of the importance of the dividend to many shareholders. In the absence of unforeseen circumstances, an annual dividend of 5 cents per share should be sustainable over the short term (particularly in light of the lower growth outlook for the global economy) and provide a base from which shareholders can look forward to growth in dividends and capital over the medium to long term.

Hear more from Pengana

Steven recently published a 'Fund in Focus' presentation on Livewire, explaining their unique process for identifying opportunities, talking through some of their holdings and discussing why PIA's evergreen approach is designed to perform through any cycle. You can access that here





Anne Bell

What are " breaks " ????