During January 2019 the Ethical Partners Australian Share Fund returned 1.46% versus the S&P/ASX 300 Accumulation Index of 3.87%, an underperformance of -2.41% (after fees). Since inception on 9 August 2018 the Fund has returned -7.45% versus the S&P/ASX 300 Accumulation Index of -4.48%, an underperformance of -2.97% (after fees). During January the Fund benefitted from overweight positions in Telstra, TPG Telecom and Mondelphous but had no stand-out performers during the strong market rally. Key detractors for the month included Kathmandu, Nick Scali and AUB Group and having no position in mining giants BHP Billiton, Rio Tinto and Fortescue detracted from the Fund’s relative performance as a number of supply side shocks boosted commodity prices. Stocks that the Fund did not own that outperformed the Index detracted -2.1% from the relative performance during the month.
When placing capital for the medium term in solid, resilient businesses sometimes it may take time for performance to be realised. If equity investing were simple you would wait for good business conditions, identify companies that were doing well, forecast for those conditions to continue and buy those same stocks then make money. Right? The only problem with this approach is that you can lose money following it as all the good news is often priced in when it is obvious business conditions are strong.
Despite market participants’ attempts to forecast earnings, markets often end up pricing stocks for what is already known ie: the current conditions. It is difficult however (us included) to stand apart from the present conditions and/or sentiment on a stock. Below we demonstrate how the collective thinking can sometimes be caught up in the present, by way of analyst examples. This is not as a criticism of analysts or consensus but we find it useful to try to look at the bigger picture above the noise.
Back in 2015 analysts were calling for investors to buy Westpac. At the time loan growth was around 7%, ROE was 15.8%, Tier 1 Capital was 9.5%, the dividend yield 5.5% and the PE 13.7x. The market liked the stock at $34 and target prices were around $37. Fast forward to late 2018 and at a share price that is around 25% lower (at $26) analysts were urging a sell on the stock amidst loan growth at 4% (worse), ROE 13.0% (worse), Tier 1 Capital 10.6% (better), a dividend yield of 6.8% (better) and a PE of 11.0x (better). Target prices are now at $25. This highlights that when business conditions are good analysts are more prone to put a higher rating and target price on a stock and then reverse this as conditions deteriorate. This potentially misses the longer term resilience of a business franchise or its ability to recover from tough times. It also leads to potentially buying high and selling low. So today business conditions, regulations and the political environment are all tougher but buying the stock when times were good would not have worked.
Graincorp is another example. In 2012 when the crop conditions were excellent the stock, at the time, was trading at above $9.50 at a 60% premium to Net Tangible Asset backing, largely reflecting the good conditions. Today during a harsh drought, only 2 out of 9 analysts rate the stock a Buy and the company recently (pre the approach from Long Term Asset Partners) traded below $7.50, just 13% above Net Tangible Asset backing. Again, buying when the going was good would have resulted in losses.
So when conditions are poor and the outlook for a company is poor, analysts’ ratings can turn negative and target prices are generally lowered. Share prices usually follow. But this can be the time when there is the most upside if you are careful about what you buy and have done your homework. This can create opportunities but can also come at a short term cost to the holders of those equities that are under pressure, as the Fund experienced in the month of January 2019. What we constantly observe is that market participants generally become more confident with higher share prices and less confident at lower share prices. Our thinking about why this tends to recur in equity markets includes the following:
1. Emotion: fear of the share price continuing to go lower.
2. Opportunity Cost: of investing in a losing (for now) proposition.
3. Appearing Foolish to others.
4. Valuation Uncertainty: the outlook for the business is actually uncertain and thus, determining a sensible valuation appears more difficult.
We recently read in some market commentary that buying a stock like CSR at present is "like putting your hand in the alligator's mouth". We did. But the company has an enterprise value of approximately $1.3bn, land holdings estimated to be worth over $500m and group EBIT of over $200m (at the bottom of the cycle). The company has net cash on the balance sheet and even if the land is worth half of this estimate then we are still buying the rest of the business at an attractive valuation. But only 2 out of 10 analysts covering the stock today have it rated as a Buy. We also put our hand in the alligator's mouth buying Telstra back in August 2018 (3 out of 13 analysts had Buy ratings) following a halving of the share price from its prior peak and amidst headlines in the press such as this from the SMH: “$38bn bonfire: How Telstra's value has sunk under CEO Andy Penn.” And the headlines by the way, looking backward were all true. Since then however the share price has outperformed the S&P/ASX 300 Accumulation Index by over 12% and has been one of the best contributors in the Fund so far.
There is no doubt that buying with the crowd can show fabulous results for a time. But we feel that this also carries substantial risk. We are not contrarian for the sake of it but the idea in the book A Zebra in Lion Country by Ralph Wanger, 1997, puts it nicely: in a pack of zebras (or fund managers) those at the centre of the pack (with everyone else) take less risk but eat poorly and those on the outside of the pack are at perceived higher risk but eat better grass. On behalf of our clients, Ethical Partners will always try to be on the outside of the pack - where risk and return warrant being there. Not all of our large positions are disliked by the market but many are out of favour. To own them we have overcome the four reasons above, as follows:
1.Emotion: fear of the share price continuing to go lower. By the time we start buying we have assessed the balance sheet, cash flow and met with management. We may have visited the company's factories, shops or branches. Having established our estimate of value in the company we tend to buy more as the share price goes lower.
2.Opportunity Cost: of investing in a losing (for now) proposition. To us there is little opportunity cost as we believe the best opportunities are where you can buy well and at the lowest possible price.
3.Appearing Foolish to others. The team definitely feels this when our stocks and / or the Fund underperforms the market. But our belief is that we will outperform over the medium to long term as the value of what we hold is recognised by the market, but patience is required.
4.Valuation Uncertainty: When we look ahead we do not necessarily base our view on the one month or even the twelve months immediately ahead.
We recognise the uncertainty has resulted in the share price being where it is now. Warren Buffett summarises this phenomenon as follows: “The future is never clear and you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long term values”: We base our view on the quality and longevity of assets and their medium term productive use. On a recent visit to a milk processing facility we were reminded of the longevity of assets upon seeing that part of the plant had been operating successfully since the 1960's, which is a lot longer than most investors' time horizon. Assets are also generally more resilient through cycles than most investors believe. Valuing a business on the medium term using conditions that are not necessarily occurring right now is more difficult but when you don’t need to make heroic future assumptions, and the investment still stacks up, it does take some of the uncertainty away.
If stock picking were scientific what would work best over the long term would be what was described in the early part of this newsletter and merely following the current set of circumstances would yield impressive results. Stocks are indeed forward looking but forecasts, while purporting to be forward looking, are too often just a reflection of what is happening today or what is already known. This sets up the situation that the market ends up pricing individual stocks off the current conditions. Should things turn out differently then there is a wide gap with respect to both the positive and the negative that can be captured, or avoided, by the investor willing to take a different view. We are finding an abundance of these types of opportunities in the current market.
Nathan Parkin Matt Nacard
Investment Director Chief Executive Officer
