A baptism of fire: How chaos can help forge clear vision

It was English writer Rudyard Kipling who famously wrote in his poem "If" of the value of "keeping your head when all about you are losing theirs". In a similar vein, the previous year has proved to be a rite of passage for investors, both young and old, professional and pupil alike, just as the GFC was over 10 years ago. 

Having worked for two decades with hedge funds, in private wealth and investment management, Elston Asset Management's Leon de Wet has developed a strong appreciation of risk, an aptitude for clear communication, and a clear and level head during times of crisis. 

In this wire, de Wet shares the values he and his team have learnt from both the GFC and the COVID-19 financial crisis, as well as the opportunities that he sees in large-cap Aussie stocks for the year ahead. 

You’ve been described as “quiet and calm". How did these attributes aid your investment strategy during the highs and lows of 2020?

When the pandemic hit, it was definitely a jolt, but I didn’t let the market volatility rattle me. Of course, I can’t take credit for being the only cool head in a crisis. Everyone in the Elston team handled 2020 well. Naturally, in hindsight, there are things we might have done better. However, overall, our rational assessment of options and decisive actions stood us in good stead.

We stayed calm and moved swiftly to participate in discounted capital raisings, reduced cash to reposition for an expected recovery, and increased and hedged our US exposure.

For me, 2020 really reiterated that as investors we need to be prepared for the unexpected. It’s also important to stay positive. No matter how bleak things seem to be, there are always opportunities. You’ve just got to make sure you’re in a position to take advantage of them.

You’ve got to be calm. You’ve got to be rational. You’ve got to have your disciplined processes in place. And I think you’ve got to have realistic time horizons too. If you can do all that, then no matter how bleak things get, the sun will always rise for you.   

You’ve worked at Elston for more than 11 years, how does the firm differ from its peers?

The big difference for me is the team approach. The decision to manage portfolios as a team, rather than structure everything around a lead PM has really defined Elston. It’s meant that, right from the start, a variety of perspectives have been welcomed. And some of the discussions have been pretty energetic. I like that. 

It means that individual interpretations can be presented and argued. Behavioural biases can be countered by fresh analysis. As decision-makers, we challenge each other, and I think that’s a great dynamic because it ultimately leads to more considered decisions. 

I’d say the GFC shaped my thinking too. Working through that era strengthened my belief in following a disciplined process and a belief in the people around me at Elston. It was a baptism of fire that forged a terrific team with a clear vision. 

How would you describe Elston’s investment strategy?

Looking at Australian equities specifically, Elston is a true-to-label high-conviction large-cap offering with around 80% typically allocated to the top 50 stocks. That said, we are index unaware and comfortable not owning the biggest index constituents at all if we believe there are better opportunities for making money for clients over our 3-year investment horizon. Given the longer-term view and willingness to take contrarian positions, stock selection is predominantly driven by bottom-up research.

Fundamentally we are buying businesses, so most of our time is spent understanding the business, and deciding if we’re comfortable with the cashflows they’re expected to generate over our time horizon.

Now the reality is businesses don’t operate in isolation and some are more sensitive to the economic cycle than others. So we do take macro into account, but it is more of a consideration from a risk-management point of view. 

Obviously macro is a bigger factor for multi-asset portfolios as the economic outlook will inform which classes are expected to perform better and even our preferred positioning within an asset class, say duration versus credit for example within fixed income. These macro views are discussed quarterly with input from an external research provider. 

Some of Elston’s largest holdings are those that have been hardest hit by the pandemic – the likes of the banks, airport and energy stocks. Do you believe these sectors have the most room for upside in 2021? Which stocks, in particular, do you believe will be winners in the year ahead?

Even with the uncertainties that remain as we head into 2021, we do believe this year will deliver a rebound in global growth. That should provide a tailwind for those companies that are economically exposed. Obviously, travel and leisure services that have been hit hard by COVID-19 are now looking forward to increased mobility. That means that a transport infrastructure asset like Sydney Airport (ASX:SYD) can be a winner. As a natural hub, it should benefit from the tourism recovery as routes reopen.

If you’ll excuse the pun, the new vaccines really are a shot in the arm for lots of sectors.

Improving oil and gas demand is now on the horizon which should provide a more constructive backdrop for our positions in Beach Energy (ASX:BPT) and Origin (ASX:ORG). While we do think current prices are ultimately too low to incentivise new developments, this does however not drive the thesis. 

Beach is resilient against lower oil prices with its gas business covering all operational and stay-in-business costs, and the balance sheet provides the flexibility to fund its numerous growth options.

While Origin investors will be rewarded with increasing dividends as strong free cash flow generation from APLNG drives a much-improved balance sheet. And let’s not forget Beetaloo. It’s a potential world-class shale resource that can provide an inexpensive growth option for Origin. Lower wholesale electricity prices are a headwind but can to some extent be countered with further reductions in the cost to serve in the years ahead.

Finally, while we do count both ANZ (ASX:ANZ) and Westpac (ASX:WBC) amongst our largest holdings, we are underweight on the domestic banks with no allocation to either of the other Big 2. There is active discussion in the team around increasing our weighting, with mixed views on the potential for stronger credit growth to help offset net interest margin pressure. 

To us, it looks increasingly likely that the local banks are well provisioned, and that impairment charges could drop sharply leading to higher dividends and even buy-backs in early 2022. This may provide support for further share price gains as investors search for yield. 

Virgin Money (ASX:VUK) is a conviction pick amongst the banks. It’s trading at around 0.6x tangible NAV and has a decent balance sheet with credit loss provisions sufficient to withstand the write-offs likely to emerge next year. Ongoing cost cuts will support pre-provision profit growth. 

From what I can see, you are underweight in healthcare compared to the benchmark and don’t hold any technology stocks - do you think the momentum that we saw in these sectors in 2020 has run out of steam?

We do think there are still opportunities within healthcare, an example being Ramsay Health Care (ASX:RHC) which we added to portfolios this quarter.

With respect to technology stocks, it’s something that’s divided the market. Some portfolio managers are seeing the positives of tech adoption being accelerated by the structural shifts in a post-pandemic world. The other thing to consider is that with rates at pretty much zero at the moment, some investors are prepared to really pay-up for future growth.

The issue for us is simply around sky-high valuations. There are companies that we really like, but we’re just struggling with the valuations. When you see companies trading on triple-digit forward earnings you’ve got to balance up the uncertain earnings growth with the price paid for that forecast increase in profit – because the price paid in our view does ultimately matter.

We’re not anti-tech. It’s just that at the moment we don’t see the margin of safety. And history tells us that investors can get it very wrong.

An example of this is Microsoft during the dot-com bubble. This was, and still is, a fantastic business, but at one stage it was trading at a peak earnings multiple of around 85x. Unfortunately, sentiment shifted, and investors adjusted what they were prepared to pay for that uncertain growth - by 2011 it was less than 10x future earnings.   

Do you believe inflation is on the horizon? Any predictions for interest rates and bond yields in 2021?

As a team, we’re certainly not in the “inflation is dead forever” camp. But the pulse is definitely weak and it’s likely to stay that way in the year ahead.

I think it’s interesting to look at the central banks all around the world who’ve attempted to get inflation into their target ranges. Despite the fact that they’ve put in herculean efforts, they’ve clearly failed. And that was against a backdrop of labour markets that were significantly tighter than today.

In Australia, the official cash rate is on hold, as actual inflation is unlikely to remain sustainably within the 2-3% target band. At the same time, the RBA’s QE program should prevent longer-dated bond yields from rising too much further from current levels. However, real yields on cash and bonds are likely to head lower.

What do you see as the role for ETFs within your portfolios?

In the Australian equity component, we will go direct and buy underlying securities. Within the multi-sector portfolios, we invest in other asset classes where we don’t have the same level of expertise to make the underlying investment decisions, and so we use managed funds and/or ETFs to get that exposure.

I suppose for us, when we’re thinking about whether we go ETFs or managed funds, we think about a couple of things like what is the propensity for outperformance in that particular market versus the benchmark or what is the price that we have to pay? Ultimately, fees do matter for clients and we need to be sensitive to that.

So as an example, if we’re thinking about maybe allocating to emerging markets, there’s no doubt that active managers can and do deliver alpha. We probably want an active manager that understands the market and the nuances there, the rules and regulations. So that’s probably where we’d spend our fee budget. Whereas in a more established market like the US we might be inclined to be a bit more passive, especially if the market conditions are a rising tide that raises all boats.

Having said all that, 2021 is expected to present a more challenging environment, so we’re probably moving to a phase where it makes more sense to use active managers. Yes, we’ll pay slightly higher fees, but we’ll get managers who are able to adjust more quickly to changing market dynamics. 

As a managed account provider, what do you see as the role of SMAs in investor portfolios and do you believe they will continue to grow in popularity over the coming years? 

For some advice businesses, SMAs provide the core investment solution supplemented with non-managed account satellite investments to create portfolios more tailored to individual investor needs.

For other advice businesses we’ve worked with, SMAs are used only for the Australian equities component to enable a more efficient and professionally managed investment solution compared to legacy stockbroking models.

While obviously biased given that Elston is a managed account provider, I do think that given industry pressure to deliver improved client outcomes and the win-win nature of SMAs, they will continue to grow in popularity.

I can’t see why there won’t be ongoing uptake of a product that probably represents only around 10% of the wrap platform market currently. SMAs offer financial advisers the benefit of reduced administrative and compliance workloads, which in turn, allows them more time to spend with their clients. At the same time, clients get access to transparent, professionally managed portfolios that are tax-efficient given individual cost bases.  

The Elston vision

Elston is one of Australia's largest privately owned and operated financial services companies, tailoring investment solutions to fit your goals. For more of Leon's insights, make sure to follow him here.