Equities

For those of us who remember gathering around the warming glow of the wood-paneled cathode ray tube television to watch Sale of the Century back in ye olden days, here is a $25 Fame Game question courtesy of Firetrail Investments that would do Tony Barber proud.

Who am I?

I am an ASX-listed stock which in 2014 was unloved and famous for all the wrong reasons. I was featured on the front page of a newspaper which carried the headline: "Is this the world's worst CEO?"

That CEO still sits in the big chair today. I delivered a $1 billion loss, I had to suspend dividends, and was staring down the barrel of an emergency capital raising.

Fast forward to today, I've actually generated $1 billion in profit for the past couple of years, and I've reinstated the dividend (4.4% fully franked and growing). And no – I'm not a bank, even though I'm growing strongly on the dividend front.

I've bought back over 25% of my shares on issue and will continue to buy back shares going forward. In all fairness, from my lows I've already rallied around 400%, but today I'm only trading on a 9 times 1-year forward PE, so a 40% discount to the market and a 30% discount to global peers.

(Source: Firetrail)

The above stock (did you get it right? The answer is below) is just one example of the "uncomfortable opportunities" being sought out amid the economic dichotomy that investors currently find themselves in by Patrick Hodgens , Managing Director & Portfolio Manager of Firetrail Investments.

Firetrail's two-step approach for navigating the cycle focuses on uncovering undervalued growth and value companies, with no material earnings disappointments. Hodgens likens the act of investing in today's climate to trail running: "To get to that next peak or next summit you first have to run through the valley in between."

"And investing in today's volatile and uncertain markets is a lot like trail running – a lot of ups, but also unfortunately, a lot of downs," he says.

"And at Firetrail we believe we've just crossed that river - we're deep in the valley after a very tough performance last year, and we're now starting on that long, slow and grinding journey back up to that summit."

At a recent presentation in Sydney, Hodgens provided some insights into how he and his team are dealing with market volatility, and sought to answer the question of the current economic dichotomy: why are so many companies racing ahead, while there are also a lot of companies being left behind? What are the risks there, but also, what are the opportunities?

The economic dichotomy

"It's all about finding opportunities through the market cycle," Hodgens says. "We all know that equity markets are booming, both here in Australia and globally. But at the same time equity market valuations are at odds with current economic conditions."

"The tsunami of negative news is relentless out there at the moment and that's pushing a lot of investors into that perceived 'safety at any price'. And again, that comes with risks but also comes with a lot of opportunities."

Hodgens reminds investors that, at the end of the day, share prices follow earnings eventually. But what the chart below is telling investors is that the most recent market rally has got very little to do with earnings, but instead is all about valuation or PE expansion.

(Source: Firetrail)

"Despite what markets are telling us, economic conditions have softened globally. And really that deterioration in sentiment around the world has a lot to do with trade tensions, and it's not just the US and China these days – it's the US and about 14 other countries. And even South Korea and Japan are having their own version of a trade war," he says.

"And it really is this push to protectionism at all costs that really is spreading globally, very quickly. And one of the many things it does is it stops company management from having confidence and trust in governments. When they don't have that … they're less likely to invest.

"Simply put, lower investment by global management means lower global growth going forward."

Hodgens also endeavours to answer the question as to why central banks all around the world are cutting interest rates in what looks to be a "race to zero".

He believes the central banks effectively fear a sustained and significant global slowdown.

"And the theory is that he or she who cuts first, will be best positioned when and if that slowdown comes," he says.

But this is the dichotomy: at the end of the day, reducing interest rates are generally good for equity markets, but not if earnings are flat or falling.

"At the end of the day, as I said before, it's share prices that follow earnings eventually."

Get out of jail free

Hodgens points out that the Australian economy hasn't been immune from this downturn either. When looking at the consumer data from January through to May of this year, it was very clear to the team at Firetrail that the Aussie consumer was in recession.

"But post the election in May this year, we really do think we got our 'get out of jail free card' or a trifecta effectively – the RBA had two rate cuts (with probably two more in the way), we've had an easing of lending standards by APRA, and then finally we've got the tax cuts coming through in the next month or so," he says.

"All of these are incredibly stimulatory to the Aussie consumer, at least in the short term. And right now, there are some great opportunities in that segment of the market. But right now, it's trade tensions that are dominating sentiment."

So, with all this uncertainty, where should investors be looking?

"Well, the vast majority of investors appear to have been pushed into that perceived 'safety at any cost,' whether it's growth, whether it's yield, whether it's REITs, infrastructure and the like," Hodgens says.

"Now, some of that is actually rational behaviour – if interest rates fall, the value of longer-dated and stable cash flows that are derived, say, from infrastructure and REITs, actually go up … some of that does make sense.

"But we believe it's just all too far. Some of these sectors of the market … are just incredibly expensive for us. We can't find much value there."

However, when looking at the other end of the spectrum, Hodgens finds that industrial cyclicals – and a lot of financials – are trading at recessionary lows and at incredibly low multiples versus their history.

It appears that the whole market is steering clear of cyclicality at all costs – and this is what excites the team at Firetrail.

"This is where some of the absolute outstanding opportunities are right now. But you need to be patient and you need to be long term," Hodgens says.

Uncomfortable opportunities

But the big issue confronting Hodgens now is that low rates are driving investor sentiment. So how does he navigate the cycle?

Hodgens points out that over the past 15 years, there have been five distinct value versus growth cycles. Right now, we're deep into a growth cycle, and from 2017 to where we are today growth companies have outperformed by around 15% per annum.

"But value also had its time in the sun post the GFC, where value outperformed for a number of years. The style or the cycle of the market we're in has a serious impact to an investor's performance through time," he says.

"Right now, we are deep into a growth cycle. Now we don't know when that cycle will change or revert, but when it does – and trust me, it always does – it will happen very quickly, without any notice – and it's our responsibility to navigate that and position portfolios effectively for that.

"And how do we do that at Firetrail? We're all about uncovering great opportunities and investing in an eclectic mix of stocks that are undervalued in both the growth segment and the value segment of the market."

It is this approach that allows Firetrail to, at any point in time, position the portfolio into one style or the other.

"So, right now we have a very slight value bias and because most of the outstanding opportunities are in that segment of the market. We would expect that value bias to gently increase during the rest of this year," Hodgens says.

And this leads Hodgens to the area of what he dubs "uncomfortable opportunities". He says many of the best opportunities over his several years investing have been the most uncomfortable ones, "the ones that no one wanted to invest in, that were undervalued by the market as a whole".

One such uncomfortable but great opportunity is the answer to the Fame Game question above – Qantas (ASX:QAN), "the world's best airline".

(Source: Firetrail)

"We value Qantas at over $10 a share. It operates in a far superior industry structure than its global peers, but it trades at a 30% discount. Its only competitor in this market, Virgin, is still not profitable today," Hodgens says.

"That allows for rational competitive behaviour between the two, and as a result, we've all experienced increased ticket prices through time, which increased profits clearly."

But the one big positive driver that Qantas has going for it at this stage of the game is its Qantas Frequent Flyer program, Hodgens says.

"It's Australia's best and probably one of the world's best customer loyalty programs."

In the past, Hodgens says it has always been hard to value the frequent flyer program, given that it was a great growth segment within Qantas that grew EPS at 10% per annum year in year out, but was attached to an industrial cyclical.

But now that Virgin's Velocity frequent flyer business is about to get IPO'd, by placing the same proposed multiple that's on the Virgin Velocity business on Qantas Frequent Flyer, the latter is worth over $4 a share, or over 75% of the target share price.

"It's a great stock for us – it's far too cheap across all metrics, whether it's the peer group globally, its own history … and the enormous optionality on that frequent flyer program," Hodgens says.

It's clear that low rates and fear are driving investor behaviour and that there are risks on the horizon, so investors need to tread carefully. And while there are a lot of opportunities out there, they're only for patient and long-term investors.

As Hodgens says, "It's the uncomfortable opportunities that we believe are the best long-term opportunities."

Every company is different. So is every investment opportunity.

Fundamental analysis is the best way to capture all the different opportunities available in the market through time. To find out more about what's on Firetrail's radar, click the 'contact' button below.



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