A postcard from Paradice

One of Australia’s most iconic funds management firms will celebrate its 20th anniversary this year. From humble beginnings with just $30 million of assets under management Paradice Investment Management today manages ~$16 billion across five strategies invested in Australian and Global Equities.

The culture at Paradice is performance focused, which means considerable time and energy is spent outside of the office conducting research and uncovering new ideas. I recently sat down with Troy Angus and Matthew Riordan, who oversee Paradice’s Australian large and mid-cap strategies respectively, to get their views on the current investment landscape.

Fresh off the back of research trips, Troy and Matthew deliver their assessment on the strength of both the US and Chinese economies. They also explain how they are navigating a patchy domestic outlook and share a few of the companies that pass their stock selection process.

Topics discussed

• How is the US economy tracking and what are the flow on effects for global growth.  
• Troy shares some of the observations from his recent trip to China and explains why he believes sentiment is slowly improving.
• Matt talks through some of his observations on domestic economic data and why that is feeding into a cautious view on the domestic economy.
• Taking stock on highly rated companies and the need to stay focused on valuations.
• Stronger for longer – why Troy believes supply disruptions will continue to support iron ore prices.
• Infrastructure – a bright spot in the domestic economy.
• Will a change in government impact equities? 

About Paradice Investment Management

Since beginning in 1999, Paradice Investment Management has a proud record of delivering superior risk-adjusted returns and capital protection for our investors.

Visit the Paradice website: (VIEW LINK)

Transcript:

James Marlay: The catalyst for a chat was 20 years of Paradice Investment Management. You both run your own strategies and had investment careers prior to Paradice. How did you meet?

Matthew Riordan: I used to work in small caps and everybody knows David. It was 2004, he'd had some staff changes and he needed another senior portfolio manager. So, he wanted to catch up with me and he had a great reputation, so I was keen to catch up with him.

It was quite funny. At the time, he used to leave these messages on my phone. It's like, "Hi Matt, it's David here" and then he'd leave these long messages and get to the end and he goes, "That's David, David Paradice." He left messages like that for a year after I started working with him.

He wanted to actually get my wife on side, so he took us down to just around the corner here where there's a Chinese restaurant called Nobel House, also known as "Chernobyl," and shortly after that I signed up.

James Marlay: Was it similar for you, Troy?

Troy Angus: It was around February of 2007, and it was really post-discussions I'd had with both Matt and John Lake, who had also joined Paradice. Matt and I used to work together at a larger competitor, and we worked together at a prior competitor as well. We've been working together for almost 20 years now.

I had some discussions with Matt and John about the opportunities at Paradice and I had a desire to have a stake in a business, and Paradice just seemed like the perfect place. So we kicked it off in the beginning of 2007.

James Marlay: It feels like the macro is a really powerful force that you guys are feeling as bottom up stock pickers at the moment. What's your view on what's happening at the fundamental level in the US and China?

Troy Angus: The Fed pivot was a pretty significant event and has obviously led to a significant rally in risk assets since the beginning of the year. The reason for the rally is a result of easing financial conditions, in relation to both the cost of credit and availability of credit. Once the Fed decides they're no longer raising rates, a lot of liquidity frees up and I think we've seen that reflected in risk assets more broadly.

But the Fed eased up, principally as a result of the US economy peaking and perhaps there's now an expectation that will slow throughout the course of 2019, which is broadly our expectation, as well. You see a deceleration in US GDP growth as we go through 2019.

James Marlay: So, people often think of these things as one end of the scale to the other. Is it a bit more of a middle of the road path forward for the US economy?

Troy Angus: We're certainly not in the recession camp for the US, and you're decelerating from what was above sustainable levels of growth, so above three and a half percent GDP type numbers, back to what we perceive to be more sustainable levels at around that two, two and a half percent over the medium term for the US.

James Marlay: Smalls and mids are much more esoteric I imagine in what drives them, but we've heard a lot of people wanting to seek that offshore exposure, even in that small space, and get away from the domestic economy.

Matthew Riordan: If you look at our space, we look at companies outside the top 50, so companies with basically about $10 billion market cap down. A lot of those companies have actually got into a scale where they've been able to invest offshore, so a lot of the companies we look at have operations in the US, Europe, and Asia.

There's a lot of building materials companies that we look at that are exposed over there. That was quite a weak period, but it is fair to say you had a situation where you mortgage rates had jumped up, and it combined with some particularly bad weather.

There was record rainfall in different parts of the US, and the feedback coming into spring over there is things are actually looking a bit better, and we've actually seen a 100 basis point decline in mortgage rates over there, which is helpful as well. There's a feeling that we've gone back to gradual improvement again.

James Marlay: What about China? It's obviously closer to home. It seems to be a really powerful driver, particularly for the domestic economy.

Troy Angus: The Chinese economy seems to be picking up at the moment. It's a very seasonally based economy, and typically from after the Chinese New Year, you start to see a re-acceleration in growth. That's basically what we saw.

Principally, it's in areas related to fixed asset investment, so that might include subways, roads, rail, electricity, transmission lines, et cetera. All of those types of projects have started to accelerate in the beginning of 2019, and that's supporting demand for steel and iron ore, and other commodities.

James Marlay: Do you feel like the Chinese government have got it under control?

Troy Angus: They've been pretty instrumental in implementing stimulus, as in when it's been required to keep the economy on track, and it looks like from what we saw, they've done it well, again. Certainly to date, in any case.

Matthew Riordan: I was there in November and you could feel things were definitely starting to weaken. The trade war was starting to bite, and they've clearly reacted to that weakness as they have time and time before. Obviously, what happens with the trade war will be another big swing factor going forward.

James Marlay: Has there been any evidence of what some of the flow-on effects might be of the trade tensions, particularly in the second half of year?

Troy Angus: That trade war really impacted the Chinese psyche from what we can gather, and they changed the way in which they went about business on the expectation that the trade war tensions would persist.

Obviously, we still don't know whether or not they will, but it's obvious post the stimulus that confidence has started to return to those Chinese manufacturers and other companies, and that's really supporting growth at the moment.

James Marlay: How would you characterise the opportunity set that's available to you at the moment, and where are you finding opportunities or what are you steering well clear of in that mids and smalls space?

Matthew Riordan: We're very much style neutral, so we look at all of the different companies in the space. The housing market is the thing on everyone's lips at the moment, and for the last 12 months you've seen house prices down on average 7 percent. In Sydney it's down double digits, Melbourne's close to down double digits.

That's then started to flow through to approvals and it's also gone into housing sales, which are down almost 20 percent. Big ticket items have really been impacted, so car sales have come off dramatically, but if you look at things like retail sales, they've held up better than we would have anticipated.

Likewise, employment has held up better than we would have anticipated, but I think the risk from here is that as construction itself starts to roll off, we'll see that then flow through to the employment market.

We've already seen some of the leading indices, like the job indices, start to tail off. We're cautious in terms of the domestic economy, and throw a Federal election on top of that, and that creates uncertainty.

Domestically, we are quite cautious and we're actually underweight domestic cyclicals, and the market obviously anticipates these things. So, building materials have underperformed, regional banks have underperformed, retailers have underperformed.

In terms of the high PE stocks, we look at all of these. There are actually some really interesting business models out there. Afterpay is a very unique stock. It's actually a really brilliant idea and it's been well embraced by consumers. Xero by far has the best cloud product out there.

James Marlay: It's interesting. We use it as a business, the person that services my swimming pool uses Xero, and the electrician who lives next door sent me a Xero invoice last night. It's not just for the mainstream. Everyone can use it.

Matthew Riordan: I'm an accountant by background, and the old systems were just really hard to use. That's the attraction of it. But the big thing for us is ultimately valuation, and what we're seeing today is really reminiscent of what we saw in the late '90s.

You've got a lot of stocks on huge PEs or the stocks that are actually not making any money that have large market caps. Some of the guys in the market say to you, "Valuations don't matter so much". But ultimately, a share price basically reflects the net present value of future cash flows.

Valuation always matters. We are concerned and these things can continue for a while, but at some stage, it becomes unsustainable if the share price doesn't justify the valuation.

James Marlay: We talked last time about the miners changing their spots and capital discipline. Do you see that trend continuing?

Troy Angus: It's likely to persist, definitely, pretty much across all of the major miners that we look at, so the likes of BHP, Rio Tinto, Fortescue, even the smaller guys, South32, Iluka, et cetera. They've all embraced capital discipline and the need for good cash flow returns to investors, and equally, not to invest capital at sub cost to capital rates of returns.

They've been, all of them collectively, have been actually very disciplined to date. But cycles, they start like this and they're like this through the middle, and they end when that discipline goes out the window. We're not there yet, but it's something that clearly we're watching.

James Marlay: I think 2018 was the first time that more capital was returned to shareholders by large caps than was actually invested into new business development. Is that just a lack of opportunities?

Troy Angus: I think as it relates to the miners, it's perhaps the capital discipline we've spoken about, as opposed to a lack of investment opportunities necessarily. Because as a miner, growing volumes does not always equate to growing value and these guys have now recognised that.

And the fact the miners have distributed more cash than they've spent is probably more a reflection on the fact that commodity prices have been at elevated levels and managed to stay there. They're sharing those windfall gains with investors, which is great news.

James Marlay: Last time we spoke, your portfolio tilt was towards the mining companies. What does your portfolio currently tell us about your views?

Troy Angus: We're still long the iron ore names, which include the likes of BHP and more recently Fortescue. The reason that we've stayed long is because we think iron ore prices are probably going to be stronger for longer.

What gives us the conviction there is that supply disruptions in iron ore to date have been quite large, and we think they're going to be protracted. The steel mills over there are remarkably complacent about the prospect of that supply returning, i.e. they think it's going to return quickly. In our view, that's not going to happen.

They're running down inventories and as we've seen in recent weeks, with another 10 percent on the iron ore price, those steel mills are going to need to get back into the market and start buying more product to support inventories and steel production.

What we don't own include some of the defensive stocks. We think the market's overpaying for some of the defensive names which have rallied very significantly post the collapse in long bond yields.

These include some of the infrastructure names. Also some of the more expensive property trusts, which include the likes of Goodman Group and Dexus. That's not a reflection on the quality of the businesses, it's just that the valuations are unsupportable.

Some of the stocks in Matt's sector have absolutely benefited from those collapsing long bond yields as well, because those ultra long duration high growth names can be quite sensitive to moves in long bonds and much lower discount rates. The market said basically, "If you've got free money, we'll give it to the companies growing the fastest."

Matthew Riordan: It reminds a lot of when you started over here in 2007 and all of the property trusts were trading significant premiums to NTA and as a result, they're out just raising money and why wouldn't they? They'd be crazy not to. We're starting to see elements of that creep back into the market as well.

James Marlay: We've just come out of the Royal Commission for the banks. Do they have a little bit of clean air ahead of them now?

Troy Angus: From a regulatory sense, there's perhaps more certainty, so that's a tick. But from a business perspective, and an economic sense, obviously the major banks are very housing related, so we still see margin pressure. We don't see credit growth accelerating.

In fact, it's likely to continue to decelerate, but very modestly, and then cost growth as a result of regulatory impost is likely to continue to bite. What that means for the major banks is you're probably not going to see any earnings growth in the foreseeable future.

James Marlay: Matt, I know you can't talk so broadly in sectors when you talk about the smaller end of town, but what are some of the things when you look at what you hold, what you own? What does it say about your view on the opportunities set in front of you?

Matthew Riordan: We're always out there turning over stones, and I mean from a sector point of view, we're underweight domestic cyclicals. We're actually underweight regional banks that are even more exposed. But in terms of some of the stocks in the sector, one of the big thematics that we are seeing in the market at the moment is on the infrastructure side.

Obviously, it's been stronger for a long period of time. You'll see a lot of charts in terms of what is intended to be built, but the reality is the capacity doesn't actually exist to build that at the moment. So, what we've constantly seen is that that cycle has just been elongated.

Things like CIMIC and Downer, are exposed to that area. Take Downer for example, that's a really well managed company. If they hit their earnings this year, that'll be the eighth time in a row, yet the stock's trading at a 30 percent discount. To us, something like that looks very cheap and we're just finding just different stocks out there.

What we typically look for are stocks that for whatever reason are a bit unloved, but where we can see a catalyst for those stocks to get re-rated. What you tend to find over time is that if the company does keep delivering, then over time the market will embrace it and re-rate it, and that becomes a powerful factor.

Another good example is Chorus. I know a lot of people who hear about broadband fibre rollouts go, "Oh," given the experience they've had. But it's actually a great product. It's early days yet 50 percent of people who can access the fibre have taken it up. It's basically a stock that's going through a transition from being a development company to an infrastructure company.

In the next three to four years, you'll basically see the capex of that company go down by 75 percent and we'll start to see it go double-digit free cash flow. So to us, things like that look really attractive and we expect that to get re-rated over time.

James Marlay: If there is a change of government, do you see it as something that investors really need to have their finger on the pulse for?

Troy Angus: Yeah, I don't see it impacting markets that significantly. Because I think, certainly from our perspective, there's a broader expectation that Labor are a shoe-in. So, to the extent they are, it's probably priced in the market.

In a lot of the names, perhaps there's some idiosyncratic things that they're going to do, which we haven't yet worked out, but in the main, I think that's a broader expectation for the market and ourselves.

Matthew Riordan: I mean, there are some policy specifics around franking and there's a lot of debate about negative gearing, what that might mean, the changes there if they are introduced. I think the proof will be in the eating for that, so we'll see.

James Marlay: We've done a little bit of a whirlwind around the grounds, but thanks very much for taking the time to sit down and have a chat with us.

Troy Angus: Pleasure, thanks for your time.

Matthew Riordan: Thank you.

Troy Angus: Cheers, thanks.