Why Allan Gray is still bullish energy and cautious on darlings like CSL

Imagine for a moment that you had a clean sheet of paper from which to build your investment portfolio from the ground up. Would that rebuilt portfolio look the same as what you own today? I’m going to guess that for many people the answer is no, and that if given the chance to start from scratch their portfolios would look quite different.

I put this question to Simon Mawhinney, the Managing Director and Chief Investment Officer of Allan Gray, a contrarian investor responsible for oversight of the firm's Australian equity strategies.

Mawhinney was unequivocal in his response, which speaks to the firm’s high-conviction investment philosophy.

“There's not one company in our portfolio today that with a clean sheet of paper, I wouldn't want to buy today.”

On this basis, Mawhinney would be allocating ~43% of the fund into stocks in the energy and materials sectors, including a 10% holding in Woodside Energy (ASX:WDS). Allan Gray’s investment in Woodside is the largest holding of any active fund manager and is the third largest behind two large index funds, according to Morningstar. ((VIEW LINK))

When I sat down with Simon to discuss the thesis behind the firm's largest allocations along with healthcare stock that looks attractive, we also touched on what it means to be a contrarian investor and where contrarian opportunities exist right now.

Topics discussed

• 0.43 - Why trending share prices are cause for concern
• 4.50 - The outlook for high PE stocks in Australia
• 6:30 - One healthcare stock that looks attractively priced
• 9:09 - The thesis behind Allan Gray’s big position in energy and materials stocks
• 17:24 - An introduction to contrarian investing
• 20:00 - Is CSL cheap enough to attract Allan Gray?
• 22:55 - Allan Gray’s top contrarian ideas right now

To access the interview please click on the player or read an edited transcript below.

Edited transcript

James Marlay:

Hello, and welcome to this in-depth interview brought to you by Livewire Markets. My name's James Marlay. My guest today is Simon Mawhinney, the managing director, and chief investment officer of Allan Gray. 

Allan Gray apply a contrarian approach to investing and in our discussion today, we're going to talk about what it means to be a contrarian investor. 

I'll be asking Simon about Allan Gray's big investment in the energy sector and the implications of that investment for ESG-sensitive investors. And finally, we'll touch on where Simon thinks the next contrarian ideas may come from. So Simon, welcome. Great to see you. Thanks for your time.

Simon Mawhinney:

Thanks for having me, James.

Now, before we get into contrarian investing and your positions in energy, you published an article on Livewire at the start of the year called "Picking Winners That the Crowd is Ignoring". It was published in January 2022. 

What you did is you shared some research that you'd done into trending share prices. And one of the conclusions you made is that trending share prices were cause for concern for investors. I was hoping for people watching this video, you could explain a bit about the research, what it showed and how you came to that conclusion.

We basically took rolling three-year price performances of companies and looked at how the winners of the previous rolling three years compared to the winners of the rolling three-year period immediately prior to that. So consecutive three-year rolling periods. 

When there's a lot of trending in the market, those winners of today were also the winners of yesterday or yesteryear and the year before that. You have several consecutive years in a row where the same companies or types of companies go on to perform very strongly, that's a good example of trending. It's a rank correlation, and it really shows that the market is becoming more and more dislocated from a price perspective.

"I guess the takeaways from it are some of those sayings that you've heard; trees don't grow to the heavens. It's not possible. You can't have a small segment of the stock market become massive in the stock market at the expense of everything else."

Maybe an easier way to think about it is to, and I don't want to pick on Tesla, but Tesla makes these cars, which are all the rage and have done very well. And electric vehicles are a big growth area, but they can't exist without a lot of the other things that feed them like aluminium. 

You had things like Tesla do very well and aluminium producers end up being loss-making, and the ecosystem has to coexist, otherwise, Tesla can't do what it does, and the aluminium companies can't do what it does. 

When the market trends in one or other direction, typically it means that those two things are dislocated, and that ecosystem is not functional from a price perspective. There are a lot of opportunities then to obviously position the portfolio towards what have been the losers and away from the winners.

Now I'm looking at a chart, I'll bring it up for people that are watching the video, but you go back and have a look at other periods of price trend. 

Could you maybe just touch on where you've seen it before? Because this is something that you've been interested in looking at over a period of time, rather than just the three years prior to now.

The clearest area of trending was in the lead up to the tech boom and then bust as the trend completely reversed, but there have been others and they were different types of trends. That trending chart that it sounds like your viewers will be able to look at now, is not a price chart. All it does show is where various segments of the stock market have done very well at the expense of others. It's possible that when the chart is trending upwards that the stock market's going down in price or vice versa.

In the tech boom you had the technology, media, and telecommunication stocks do incredibly well in the late nineties, very early 2000s. In 2015, the cyclical stocks did particularly poorly. More recently, there's been a lot of growth and momentum stocks have done very well. 

Stable earners in this search for yield as interest rates have been very low, and people have wanted a reliable dividend yield. They've done incredibly well at the expense of anything that has had a volatile earning stream. That's where today's trending or the recent trending has manifested itself.

What does a complete unwind of this trend look like? And you've named a few examples of the types of companies there, is that where the pain continues to be felt?

I think the unwind looks beautiful actually, from our perspective. It is something that's been going on for a while. Overseas it's the tech unwind and that's mostly manifested itself. Certainly, if we're not well into it, we're into the first innings of that. We don't have a really robust or large tech sector in Australia, so it's less relevant here. 

It would be these very large or high multiple companies. The Wesfarmers, Woolworths, Coles, Dominoes, IDP Education, Seek, REA, and the few tech stocks we've got, it would be multiple contractions in almost all of those. Some of the more cyclical companies that traded very low multiples of current earnings will start to do very well. We are beginning to see a bit of that. I think some of the low multiple cyclical companies have begun to do better, but it's not at the expense of the others for the most part.

So it would be quite a big unwind in these. We have a lot of companies that have price-earnings ratios well into the thirties and forties in Australia. It's quite a significantly more expensive multiple than the likes of Apple and Alphabet Overseas, which are global franchises traded much lower multiples and are growing at similar rates. So it would be an unwind of those very high multiple stocks, I suspect.

I had to look over your portfolio and if we talk about sectors where we see high multiples in Australia, healthcare is one where there are a lot of companies, dominated by CSL, but there are a lot of other emerging healthcare companies that trade on quite high multiples. 

One healthcare company that has made it into the portfolio is Ansell. So what's different about Ansell compared to others in the industry and how did it make it into your portfolio?

Ansell's quite a boring company. It makes what you and I know as rubber gloves, but I think they're mostly nitrile gloves or latex-free gloves used for protection in various applications. And not all of the gloves are rubber, of course, there are some fabric gloves. 

All companies make it into our portfolio because we feel, or expect, and our research indicates that they are attractively priced relative to their future earnings or cash flow stream. At the end of the day, all companies are worth the present value of the future cash flows that that company will deliver. It doesn't matter what company it is. 

"And in our view, Ansell, because of its exposure to mainly developed markets, is probably a low growth company, 3% to 5% per annum, but guess what? That is the same, more or less, as the broader stock market. And we think it trades at slightly less than 15 times earnings in a market that probably trades at 18 or 19 times earnings."

So for a reasonably stable earnings company growing more or less in line with the broader system, we think that it's an attractive entry point. It's not going to make anyone rich quickly. And it's also very unlikely to make you poor fast. It seems attractive. There are some issues with it and I think it's one of the reasons why I think you can buy it cheaply. It hasn't benefited from COVID, it has been wrong-footed by an inventory cycle and the price of these gloves. 

I think, and hope, that in the fullness of time for those investors who are happy to wait, it'll be a reasonably solid contributor to our portfolio. Again, however, it's not one of those companies where there's 100% upside. There's probably a little bit of downside because there are risks with every single company and modest upside, but it's not the type of thing that anyone likes to talk about at a dinner table, and I find it somewhat awkward trying to explain it here now. But it's a reasonably stable earning company that trades at an attractive price.

Let's get into where you've got a lot of conviction and we have a big position as a firm across the energy sector. I did rough numbers, which is a fair description of just about all the numbers I do, and I came to around about 43%, including positions in Sims and origin. The largest position is Woodside, which I understand is around 10%. 

That's a position that Allan Gray initiated back in 2014, which is way, way back. So my first question is why do you think there is such a big opportunity in the energy sector?

I think one of the big drivers of these companies' profits is the underlying oil and gas price. And I think it's likely that oil and gas prices are going to be at levels significantly above where they have been over the most recent five years. 

There are a plethora of reasons for that, but the most important of which I think is there's been severe underinvestment in new supply. I think supply is likely to fall much faster than demand even in a net-zero, 2050 world. The balancing item then becomes price, so that would be the first thing, I think the backdrop, the underlying commodity price that will drive earnings. I suspect it will be a lot higher than it has been in recent years.

With that backdrop, if you can find companies with very long reserve lives that have reasonably low-cost production and strong balance sheets, they are the type of company that would flourish in that environment. In Woodside, which as you mentioned is about 10% of our portfolio, ticks all of those boxes, and the price is incredibly attractive relative to what we think these long-term earnings are likely to be. 

We often get questions about to what extent the Ukraine crisis has impacted the Woodside thesis. And it most likely has improved it somewhat, but the Woodside share price hasn't moved sufficiently to even need to recut the thesis on the back of the Ukraine crisis.

Say oil is $75, which is a good $30 to $40 a barrel lower than today's prices, then Woodside's a very attractive investment. And for that reason, we're very happy just to own it and hope that in the fullness of time; and I hope we don't have to wait another seven years to get our money; but it does seem far, far cheaper than most of the things that we do see in the stock market. And it's the reason it's our biggest company.

We'll chat more about Woodside in a second, but just on the view around oil prices, I know you're probably not in the forecasting game. Could you talk me through some of the bear and base and the assumptions that you use and have thought about? What could make them fall and how could you be wrong on that front?

Yeah. So you can afford to be quite wrong or have oil prices for quite significantly before the underlying value of many of these energy stocks are impaired. That would be the first thing I say. What would cause oil prices to fall? I guess a lot of things that we don't expect to happen and that is a very, very significant move away from hydrocarbons, far faster than some of the most bearish assessments of the energy transition. That would be one. 

New technology could be another. These things don't end up getting deployed overnight though, you generally can see these things coming. 

Another variant of COVID that is far more severe than the most recent one we've had, and causes governments and countries to lockdown again. I think that would be another negative.

A big hit on the demand side is what you're looking at.

I think so. It mostly would be demand-driven, because the supply doesn't change very much from time to time and mostly it's downward sloping from here.

If you were to look at Woodside today and imagine it wasn't at 10%, imagine it had a zero position if you were just to come to the market today, would you want to buy it?

"Yes. There's not one company in our portfolio that is in our portfolio today that with a clean sheet of paper, I wouldn't want to buy today. I think the past is irrelevant other than to the extent that it infers something that may be true in the future."

I think it's very important to look at one's portfolio and one's investments with fresh eyes on any given day, forget the baggage that's happened recently or over the last, six or seven years with Woodside, and say, what do the next six or seven years look like? In Woodside's case, and in all of these companies’ cases, we think they are very compelling reasons to own the company.

ESG is a topic that's not just bubbling away in the background, it's front and centre right now. And I understand you have a view that divesting from these companies is not the best approach. Could you tell me just what you think about the ESG component of the investment landscape today?

Yeah. So I'm going to assume like everyone else when you make reference to ESG, you really mean ‘E’ right?

Yep.

Okay.

In the case of Woodside.

In the case of Woodside and its environmental credentials, I think it's a fact that the world cannot go to, and neither is the world talking about net-zero 2022, it's net-zero 2050. There is a transition, and an important one, that we recognise between where we are today, and this decarbonized future that everyone wants to get to. 

We can't get there tomorrow, and we need transition fuels to help us get there, and we think a company like Woodside plays a very important role in that journey; predominantly because they are good corporate citizens and produce gas mainly, which is less emitting than other fuels. 

We do think owning Woodside and being able to engage with the company is more likely to result in some level of assurance that the company will do the right thing. Not owning a company or being forced to divest a company makes engagement impossible. Take AGL for example. 

We're not a shareholder in AGL for a number of reasons, but there would be no ability to engage with the board of management on AGL and the current corporate activity surrounding the company. It just is not possible.

To anyone that says a solution for the ‘E’ and the journey is divestment I think I would say that perhaps a bit short-sighted because you end up selling it to someone who most often cares less than you care about that company's sustainability. 

"I come back to the ‘what is the company worth?’ The company is worth the present value of its future cash flows. And therefore, the sustainability of the future cash flows is paramount. And so why would we own a company if we were not worried about the sustainability of their earnings stream?"

Yeah.

I think I do sense that the conversation is evolving a little bit on the environmental side of things, that engagement and ownership platforms are more accepted than perhaps they were 12 or so months ago or before the Ukraine invasion.

Yeah.

Of course, there are an ‘S’ and a ‘G’ in ESG that are also important and there are social implications of this decarbonization that we can't ignore, it's multi-layered and it's going to be difficult.

So let's talk about contrarian investing. What sits behind the word contrarian for Allan Gray and what do you think it means to be contrarian and what are some of the elements of it?

"At the heart of it is our belief that you can't buy a company cheaply unless there's some bad news associated with that company."

Again, flipping it on its head, companies that have very bright futures and are very well-liked, are generally priced accordingly. Then the converse, obviously if a company is not liked there are some structural concerns, it's going through a deep cycle or there's some company-specific news, which is not good. Those are the companies where there could be mispricings on the downside. And 

It's looking at those companies and trying to separate companies where we think that the market has got a particularly short-term lens on them where you can pick them up quite cheaply for those who are happy to be patient and hold them for a longer period of time. That is the ‘contrarian’ part of contrarian investing for us.

"It's not buying things just because they're contrarian. I think being contrarian for the sake of being contrarian is probably foolish. If it looks and smells like a turd, some things are just that."

A good example of that in my mind would be some cryptocurrencies and NFTs at the moment. They're not particularly well-liked at the moment. They've gone through some price weakness-

Bad news, bad headlines.

Yes, exactly. But does that mean they are great things to include in a portfolio? I mean, I don't think so. It's hard to actually assess something you think is worth zero, so that's some of the types of things. There are other companies that are simply disliked because they've gone through a deep cycle. 

People try and invest with a catalyst in mind and there's one thing, picking a catalyst. The other thing is making sure you get the timing right. Both of those are very difficult. Getting both of those things right is near impossible. Contrarian investing is putting the cycle to one side, putting the catalyst to one side, putting the timing to one side, and saying, "It's broken. This company's needed. It's good. It's cheap. Let's buy it and put it in the back bottom draw and hope in five years, or before, it rerates and the value is crystallised."

You've talked about seeking out the bad news as one filter. I know there are many and it comes down to that intrinsic value. You've also published some articles about companies where you think the valuations are completely nuts. 

There was one on CSL. You published a really timely article called "Buy Now, Pain Later". Looking at the value of Afterpay, CSL is off 20%, and Afterpay 40% since you published those articles. They're now some of the bad news stories. Is there a time when they start to look attractive to a contrarian investor like yourself?

Yeah, I hope so. I don't think it's now. I think we've seen the hors d’oeuvre. I think a lot of the buy now pay later sector is just worthless. It's not clear to me that Afterpay or that part of the block will ever make a return. They're the types of companies that have sprung up in very low-interest environments. None of them have been through a retail cycle yet because we haven't had one, so, it's very hard to know whether these companies have a right to exist or will exist. It is typically not the type of company we are attracted to. 

Of course, there are some tech companies out there that probably are great contrarian ideas. Some of them will be amazing and your money will go up tenfold, but the probability that you can pick the one or two that do that is very low.

And then on the healthcare, that company you mentioned, CSL is a very good company, it's done very well. But it trades at a very high multiple of this year's earnings, and the stock market forecast those earnings are going to continue to grow at around 11% per annum until 2025. You're still paying mid 20's multiples for CSL in 2025, after having five-plus years of 10% growth. 

It strikes me that that's quite expensive. There are companies that have international franchises overseas, like Apple and Alphabet, Google that you can buy at very, very significantly lower multiples of earnings. And those earnings are equally forecast to grow at similar rates.

Our investing is predominantly Australian-focused. But when I look at CSL and I compare it to very different but perceived high-quality companies overseas, it looks extraordinarily expensive. I wasn't aware of the specifics, but it doesn't look cheap to us today and it's not in our portfolio. I hope one day it will be, but it would have to fall quite a bit.

If the high-growth companies have still got more to fall and aren't attractive, the commodities aren't as depressed as they were, and you don't want to own NFTs and Bitcoin. Is there anything that looks deeply contrarian in the market today?

I think so. I think gold, it's not well-liked. 

"I never thought I would say this, but gold is not a liked commodity and therefore I suspect there's some opportunity in the gold space." 

We own Newcrest. I think energy, if it's not contrarian, I do think the energy sector's very cheap in aggregate, and it's a combination of this buyer strike and some of the selling pressure.

It's divisive.

It is divisive, of course. You know, if you're me and you work somewhere where you don't have energy in the portfolio, and you've got a client base that says, "Oh, we don't like energy." You're probably going to seek greener pastures elsewhere. It's quite an awkward thing to own. I think it's very cheap. I'm not sure if it fits the contrarian mould, specifically. I'm now mixing up what is contrarian with what is cheap, and it's a slippery slope, but I think some of these things are very cheap. They may not necessarily be contrarian, but it is a fact there are fewer contrarian things today than there were say, 12 months ago, almost by definition. Many of these despised sectors have rerated and turns out that their future wasn't in fact woeful, it was just bad. In the process, the share price has risen quite a lot.

Which is probably why they're less contrarian

Exactly. Yeah.

Well, Simon, thank you so much for coming in today. I always enjoy it when we get the opportunity to have a chat and it was a bit of a surprise for me today. Thank you very much for your time.

As for me.

For all you viewers out there, I hope you enjoyed that discussion with Simon. As I mentioned, Allan Gray, contrarian investors and a great exploration of some of their big positions in their portfolio at the moment. Remember if you're a Livewire viewer, give us a like on the wire. If you're watching this via YouTube, keep an eye out for new content, we're bringing it to you every week.