Making money in 2017

Key points:

• Chris Stott: The Australian economy generally looks OK, the housing doomsayers will be wrong. Elevated PEs make for a ‘stock picker’s market.’
• Ben Rundle: Gold can act as a hedge against Trump-related uncertainty. USD earners could struggle due to high AUD, but Australian economy is holding up well overall. Large increases in commodity prices have driven upgrades for resources stocks.
• Chris Stott: Easy money has been made in resources, they’re avoiding the sector for now.
• Chris Stott: The rotation from small-caps to large-caps should continue, some small-cap growth companies like WiseTech, Domino’s, and Technology One look expensive.
• Ben Rundle: Some small caps are on ‘huge multiples’ as they were the only place to find growth last year. Any disappointment could see sell-offs up to 40%. Large-caps to outperform, led by the banks, who’ve shown pricing power and should benefit from higher rates.
• Chris Stott: Struggling to see value among ‘bond proxies’ such as Transurban and Sydney Airport. As interest rates start to move higher, some investors may dump stocks in favour of term deposits.
• Chris Stott: Nick Scali (ASX:NCK) is under-owned and relatively undiscovered. Trading on a PE of 13, and growing at 20 to 25 percent over the next one to two years. The macro backdrop is ‘perfect’ for NCK. The company has an under-geared balance sheet and net cash.
• Ben Rundle: MNF Group (ASX:MNF) is his favourite stock. It trades at a relatively high multiple, but I achieving 25% p.a. organic growth, plus acquisitions. It’s under-geared, and he says it’s “incredibly well run.”

The current investing backdrop

Marlay: The backdrop in 2017 is dominated by discussion of the US and its new president; he’s had a busy first week. Domestically, here in Australia, we’re gearing up for reporting season. A few downgrades coming through, particularity in small caps. Regarding the investment backdrop, how are you spending your time thinking about this big picture backdrop versus what's happening locally, and how you separating the two issues, or are they related?

Stott: They're definitely related. We are typically just fundamental, bottom-up stock pickers. You no doubt have to factor in the macro as a large cap investor, but to a lesser extent as a small cap investor.

The macro is grabbing a lot of the headlines at the moment and will continue to do so for Trump's general controversial nature. That won't stop as we go forward, but the picture looks okay for the Australian market. Interest rates are on the move up, we expect a hike later this calendar year or early 2018 in response to stronger inflation, and stronger GDP growth, particularly from resources. The economy and housing markets remain quite strong, so I think the doomsayers will be wrong on housing. We’ve got low interest rates, low unemployment, the petrol price is low. The consumer feels okay at the moment, so discretionary retailers look okay.

PEs are certainly elevated in the industrial side of the market. So, the old cliché is ‘the stock picker's market.’

Do fundamentals support the recent rally?

Marlay: We've seen the Trump rally has some traction, it's had a strong three-month period. Do you think the traction it has is justified? Is there enough data and momentum in the economy to suggest things have turned a corner?

Rundle: To some extent, I think it's justified. Chris hit the nail on the head; it's very much a stock picker's market, and it's hard to try and trade the macro situation, given we just don't know what he (Trump) is going to do. If you take that view then maybe you've got some gold in your portfolio, as a hedge against any fear or any erratic moves that take place.

If you look back here to Australia, things look okay; the economic numbers are alright. There are some parts of the economy that will struggle; the Aussie dollar has held up well, for example; that will hurt some industries. We have sensed inflation easing a little bit, so I don't think the consumer is hugely strong, but there are some sectors that are doing well. If you look to resources, for example, we've had such a strong move in the underlying commodity prices, and it's taken a while for the analysts to upgrade those stocks.

We're seeing a huge EPS revision upwards for the whole market coming into reporting season. I think a lot of that is the resources businesses, and I think it’s justified. In that environment, if you're a commodity company trying to push out as much volume as you can at a high price, that will pay off. Even companies that have a huge amount of debt will be able to create enough cash flow to pay it down quite quickly.

Are resources still attractive?

Marlay: The story of the resources companies has captured investor’s attention. The question is; is it long term change? How do you think about that when you see stock prices that have rallied dramatically, commodity prices are dramatically higher than where they were? Do you want to step into that space or are you now cautious on the resources due to the price increases we've seen?

Stott: Typically, at WAM we invest in industrial companies, and to a lesser extent resources companies. We and a lot of other investors over the last twelve months missed the rally in resources, and that has hurt a lot of domestic fund managers’ performance. But as you look forward from here, I think the easy money's been made in resources (BHP $26). People will be looking for capital management, which is typically an early to mid-cycle phenomenon. I expect to see more secondary capital raisings from resources companies that have had good runs over the last three to six months. We’re staying away from resources at the moment; we think the easy money's been made. If commodity prices hold up, as Ben said, resources could be one of the strongest sectors this reporting season with earnings per share growth starting to come through in a large way for some of these companies.

Small-cap pain – more to come?

Marlay: Moving from the strong to weak; we've seen the small cap, and mid cap growth centre has been littered with quite painful downgrades. Should we stay away from this sector? Are these companies particularly susceptible to downgrades at this part of the cycle?

Stott: We still think that the rotation that commenced around five or six months ago, out of small caps into large caps, will continue and we think that the large caps could potentially lead the market over the rest of 2017. The PE contraction will continue with bond yields backing and interest rates, globally going up over the next decade. A lot of these high PE names like WiseTech, Domino’s, and Technology One are great companies, but everything's got a price. Those three, in particular, look quite expensive, so it will be interesting to see how the market will treat these companies on lofty multiples this reporting season, given they may put good results.

Reporting season expectations

Marlay: Often in reporting season the reports are judged on expectations and how they deliver against those expectations. What's your sense of how the market is priced, and what the expectations are going into reporting season?

Rundle: Small caps were the only place in the market where you could find growth last year. Because of that, they became a very popular trade, and they trade on huge multiples. Any hint of disappointment and we're seeing catastrophic sell offs in the order of 20, 30, even 40 percent. But if you look ahead this year at what will drive the market, I think that large caps will continue to outperform. Look at the biggest companies on the market, the banks; they are showing pricing power by adjusting rates higher out of cycle. I think we’ll move into an interest rate upgrade cycle throughout the course of this year, which will be positive for banks. You’ll start to see that affect returns and drive their share prices, which will help drive the wider market.

The end of the Yield Trade

Marlay: Chris, early this week said you felt the yield trade had run its course and would continue to unwind. Which stocks do you put into that basket and how long is it going to take for these things to roll off?

Stott: It could take a while, but Transurban and Sydney Airport are two that really stand out to us in that bucket. This chase for yield that we've seen - we've seen with our business with the rise of the self-managed super fund and chasing that fully franked yield - we think that will continue. But with interest rates starting to move higher over the next three to five years, the interesting thing will be these retail shareholders that have been looking to the banks and some of these bond proxies for yield in the last four or five years. When they start seeing they're being offered term deposit rates close to three, four, or even five percent over the next three to five years, that marginal investor may switch out of equities and go back into cash. That's something we'll be watching very closely. We think that a lot of those ‘bond proxies’ look expensive on a fundamental basis and we really struggle to see value in that space currently.

Nick Scali (ASX:NCK)

Marlay: We've talked about a few areas to avoid, have you got a few areas where you're doing some ‘happy hunting’ that you can share with us?

Stott: One stock that we think will report quite well next month is Nick Scali. Nick Scali is a furniture retailer, it’s still under-owned, and we think it’s relatively undiscovered by fund managers. It’s on a PE of 13, and we expect growth of 20 to 25 percent over the next one to two years. The macro backdrop for Nick Scali is perfect at the moment; you've got low interest rates, low unemployment, and Sydney and Melbourne are really firing on all cylinders. We think that will really drive Nick Scali's earnings per share growth over the next one to two years - with an undergeared balance sheet and net cash.

Marlay: And the property cycle's strong enough to support that?

Stott: We think so. We think that residential property still has many more years to run. Interest rates are generally going to remain quite low for a long time, even though they will be moving up. You won’t see 10 to 15 percent returns in residential property over the next three to four years, but it'll more move back to the mean – two to three percent returns. We don't think that we're going to see a correction in house prices, particularly in the urban CBD type areas, unless there's a large change in how the banks lend.

MNF Group (ASX:MNF)

Marlay: Ben, have you got something for the shopping list for reporting season?

Rundle: My favourite stock is a small cap called MNF Group. The multiple is quite elevated when you compare it to the rest of the market, but they're achieving 25 percent organic growth at the moment, and they're tacking on a few small acquisitions. It's incredibly well run, it's undergeared, and even though it’s in that small-cap space where it's susceptible to some large volatility day to day, a stock like that can report very well and continue to do well throughout the course of this year.

Marlay: Well there you have it. There's a bit of a backdrop for the investing year. It's not plain sailing and everything that worked last year might not work again this year.

Filmed on 31^st January 2017, with Ben Rundle from NAOS Asset Management and Chris Stott from