7 questions with Roger Montgomery

For two years now, Roger Montgomery has been warning investors of a pending housing crash. While these claims were initially met with scepticism, as the data has deteriorated significantly in Sydney and Melbourne, more investors are coming to accept this thesis. According to CoreLogic’s Home Property Value Index, prices for detached houses in Sydney fell 1.66% in November, implying an annualised rate of -18.2%.

Given we now appear to be seeing his thesis play out in live action, we got in touch to get his current take on several key issues in the market. We hear where he’s putting cash to work in the market after the recent sell off, which sectors and stocks are likely to be worst affected by the housing correction, and why he’s changed his view on Telstra.

“When reputable and smart people collectively start doing dumb things, the party is almost always close to over.”

- Roger Montgomery, Chief Investment Officer, Montgomery Investment Management

1. For a while now, you’ve been publicly lamenting the lack of value on offer and have carried higher-than-usual cash levels. Where are you finding value opportunities following the recent sell-off?

It’s worth noting that the banks look like good value provided there’s not a recession.  If there is a recession, all bets are off!

I was frustrated back in September when profitless companies were surging.  I wrote for Livewire that a portfolio made up of high-flying stocks like Wisetech, Xero, Appen, Altium and Afterpay was trading at more than 15 times revenue and more than 480 times earnings. 

The performance of some stocks – knowing their underlying business model and prospects – was inconceivable so I called a peer in funds management whom I know had purchased some of these stocks.  I couldn’t understand how he was holding them even after they had doubled or tripled for him.  I couldn’t get a valuation even at the price he’d bought them for. 

He confirmed what I suspected; He had suspended any requirement to invest in quality, or at value, and was quite deliberately chasing growth and momentum.  So, I pressed him by asking; “if you didn’t buy with any reference to value, and the stocks have more than doubled now, how do you know when to exit?”  His reply: “You will see them rolling over.”

At that point I knew we wouldn’t have to wait very long for some sort of correction.  When reputable and smart people collectively start doing dumb things, the party is almost always close to over.

It’s fascinating that when we look at the broader index – the All Ords for example, we find it’s down 8% from a year ago and 12% from its peak.  But looking under the hood reveals a much less sanguine picture. More than half of the All Ords constituents are in correction territory (down >10% or more) with a median return since of Oct -19.1%.  Meanwhile, in the US, more than three quarters of US Small Caps are in correction territory with a median return since of Oct -25.7% and almost three quarters of the US Mid Caps are in correction territory with a median return since of Oct -21.9%.

We were holding about 20% cash in the both the Montgomery Fund and the Montgomery Global Fund ahead of the sell-off.  In our domestic fund we have since employed about half of that across our existing holdings.  We are cognisant though that we will receive cash if we sell into takeover interest and that we have two of our larger holdings benefitting from that interest.  So, should we sell, it will raise our cash levels again.

We are valuation driven so it’s important to know that we don’t stick a wetted finger in the air and decide ‘now is a good time’ to be invested or to be in cash.  Rather, we are driven by the opportunity set presented to us and our portfolio management process produces the appropriate cash balance.

2. As both a global and an Australian investor, which looks more attractive to you currently? What should potential offshore investors be considering?

Because we are bottom up, we simply look for individual businesses that we believe are high quality, have bright prospects and are available for a rational price.  To help us determine whether a company is cheap we consider the expectations implied by the price.

I have invested both domestically and globally and I don’t believe trying to pick one off against the other can really result in a successful outcome.  When quality businesses are cheap, you should be buying them wherever they are.

For what it’s worth, I think that the switch by the Fed, the European Central Bank and the Bank of Japan from Quantitative Easing to Quantitative Tapering is structural rather than cyclical. 

And the extent of the effect on bonds will overwhelm the normal interest rate cycle.  I also think the effect on Treasury bond rates will render BBB and CCC rated corporate bonds much less attractive.  Consequently, the cost of financing will go up materially for corporates.  There will be downgrades to BBB-rated bonds in 2019 and more volatility thanks to the fact that 1) more than 45% of all corporate bonds are now rated the lowest investment grade of BBB, and 2) a record value of CCC-rated bonds are due for refinancing in 2019 and 2020.

This will have a large negative impact on equity holders in those US companies and how that translates to the Australian market is really revealed in historical experiences; when US markets take big falls, the variance between markets narrows, meaning they all go down together and to a similar extent.

3. Sydney house prices appear to be in freefall (-1.66% MoM at time of writing), which is something you’ve warned about for some time. Based on the current available information, does this look to be the start of a major crash, or is it just a benign correction?

For anyone who borrows 80% or 90% to fund the acquisition of an asset, a benign correction is never benign!  We did predict this sell off and warned investors almost two years out when record high prices were being achieved and were accompanied by record levels of debt.

With some properties already falling by as much as 30%, the question now is to what extent the marginal seller is forced to sell at even lower prices.  We had been very worried that APRA’s 30% cap on the proportion of all mortgages that could be written on interest-only terms would mean a very large number of 2014 and 2015 borrowers would be forced onto unaffordable Principal & Interest loan terms in 2019 and 2020.  APRA has lifted that cap meaning a lot of mortgage holders won’t be forced on to the more onerous P&I mortgages.  The problem that remains is that many of these borrowers lied about their expenses and so will be captured under the more rigorous checks following the Royal Commission.

My best guess is that within the next 18 months there will be a time where a buyer will be able to approach an agent or a developer, and provided they aren’t picky, be able to offer 20% or 30% below the advertised price (which is already down materially) on a bunch of properties and probably have their bid hit by one or two vendors.  They’ll get a very good deal.

A supply shortage will emerge again in the next few years which will support valuations, but a price recovery is likely to be limited by the fact so many people have so much debt on properties on which they have lost money.  The ‘once bitten twice shy’ effect will limit a recovery for a while.

4. Which sectors and/or stocks will be worst affected?

In the second half of 2018, there was a substantial drop in both the number of property transactions and in the number of loan applications for renovations.  These are reliable leading indicators, with a 10-month lag, for the consumption of renovation-related products; everything from plasterboard to new sofas.  That means that demand for related goods will be hit hard when year-on-year comparisons are requested in June/July.  So I expect companies from CSR and Boral to Nick Scali, Beacon Lighting and JB Hi-Fi’s Good Guys to downgrade, even after possible downgrades in the first half.

We know that new car sales have fallen off a cliff and I am aware of several dealer principals that have let staff go.  A lot of investors wait for the data to confirm that conditions are tough but by then it’s often way too late.  You build up a reasonably reliable picture from enough anecdotes and the picture I have is that a negative feedback loop is already underway.  Record debt, slumping big-ticket purchases, layoffs and falling house prices will probably usher in a period of deleveraging which will have a negative impact on the retail sector particularly.

5. Are there any sectors and/or stocks that have been unfairly sold-off on housing fears, and actually appear to be offering value now?

If there are, we haven’t spotted them yet.

6. The Royal Commissions into Misconduct in the Banking, Superannuation, and Financial Services Industry has recently wrapped up, with AMP and IOOF being the biggest victims so far. Who are some of the beneficiaries and how do they benefit?

With a long-enough investment horizon, the decline in bank shares represents an opportunity.  I don’t think anyone will be talking about the Royal Commission in five years from now, and provided there isn’t a recession, their current prices represent reasonable value.  Even if a raft of lawsuits and class actions follow, all of them are trading at a discount to our current estimate of intrinsic value and with the population heading towards doubling by 2050, you can be reasonably confident the banks will be writing a lot more business then.  Some investors demand a catalyst before investing, to try and get the timing right but I think the catalyst might be the absence of a recession.

If, however, a recession does transpire, bank share prices will de-rate.  With the above long-term perspective in mind, lower prices will be a good thing for a net buyer. 

I have seen a few broker notes touting the idea of investing in Fintech, Media and class action funders and lawyers but I do believe an investor should look at each company on a stand-alone basis and review its prospects from the ground up. 

Changes to class action conditions, for example the proposal to allow solicitors acting for plaintiffs in class actions to charge contingency fees, and the proposal to prevent competing class actions by consolidating claims into a single class action will change the landscape for individual companies and should be examined closely before buying stocks based on a theme.

7. You’ve publicly been quite bearish about Telstra for several years, why the change of view?

I wrote a very bearish article about Telstra for the Australian in February 2015 when the price was above $6.60.  But since then the share price came back to $2.70 or thereabouts at which point, we believe the bad news was all well-known and factored into the price.  What the market hadn’t appeared to have thought about was the good news including both sides of politics’ stated desire to offload the NBN before the end of the next term and Telstra’s progress on its cost-out strategy, which would help fill the hole left by an end to the NBN one-off payments to Telstra.