How the pros invest in a slowing economy

The Australian economy is undoubtedly slowing, which was evident given the number of earnings downgrades and soft results witnessed in the most recent earnings season. And while bottom-up stock pickers try to identify those growth companies poised to rerate based on a catalyst, paying close attention to what is happening in the domestic economy is still an important part of the investment process.

And with the effect from falling house prices starting to take its toll, particularly on the Australian consumer, there needs to be a strong reason to own certain businesses tied to this area of the economy.

Listen to how Martin Hickson from Wilson Asset Management and Ellerston Capital’s David Keelan navigate stock selection against a deteriorating economic backdrop.

Ben Clark: I'm Ben Clark, and today we're going to be talking about how the professionals are investing in what looks like a continual deteriorating economic backdrop. It's pretty challenging out there, but there are ways to combat it, and we've got David Keelan from Ellerston, and Martin Hickson from WAM. Martin, I might start with you. I've seen a couple of the big off-shore professional investors coming out here, doing the rounds and seemingly, in some cases scratching their heads thinking the pessimism is a bit unusual given our economy is performing a lot better than most. Is there cause for concern out there?

Martin Hickson: I mean, the economy has been performing well, but it definitely is slow. We've seen that through the recent reporting season. We saw a number of companies that are exposed to the consumer issue earnings downgrades, or softer first-half results. The economy definitely is slowing, and we're very wary of that at WAM.

Ben Clark: How much of that do you take into account when you're constructing your portfolios, when you're looking at investing?

Martin Hickson: At the end of the day, we're bottom-up stock pickers. We're trying to identify growth companies with a catalyst or rerate it. However, we definitely take into account what is happening in the domestic economy. We've seen significant slowdown which is affecting retail stocks, housing stocks. The wealth effect from falling house prices is definitely starting to bite, so it is a part of our investment process, but the key part is looking for those undervalued growth companies that we will rewrite based on a catalyst.

Ben Clark: David, if I could turn to you, I saw the 10-year bond yield went under 2% today, which is almost the lowest it's been in this cycle. The bond market is saying there is cause for concern. Are you concerned?

David Keelan: We think we're close to the top of the cycle than close to the bottom. But picking absolute tops and bottoms is a dangerous thing for a bottom-up stock picker. We tend to try set up a portfolio so that overall the portfolio is net cash, not only comes with debt. Less than three of our stocks are not able to fund themselves via free cash flow. We just take a more pragmatic approach to the companies that we select at the moment.

Ben Clark: We've been through February, we've all heard from a lot of different businesses. Is there any areas of the market that you would call out, that you're seeing the economy is really starting to impact on the business?

David Keelan: I think Martin was correct. Consumer is extremely patchy and to own anything in that environment, there needs to be a strong reason.

Ben Clark: Martin, we know that area of the economy is weak, is it more about what's happening now? Is it more of a concern about the outlook for where we head from here? Do you feel like it's actually having much of an impact now?

Martin Hickson: A lot of it's about the outlook. We saw in-line results from JB Hi-Fi and Super Retail, however both share prices fell over 3% in February, versus the market up 6%. Their outlook statements were a little bit softer. We saw a large downgrade from Bingo, they were guiding to 15 to 20% growth, downgraded to flat growth, which saw the share price fall 50%. They are being impacted by weaker residential construction volumes and less waste.

Martin Hickson: Stockland, Lend Lease, Mirvac also pointed to slowing residential house sales in the first half. They are talking about a pickup in the second half, which we think is unlikely given house prices are continuing to fall.

Ben Clark: It sounds like there is cause for concern there. But there are businesses that can do well despite all that. When you've got them coming in, post their presentation, what are the traits that you're looking for in a company that you think can steer you through this environment?

Martin Hickson: A lot of what we're looking for at the moment is stocks with an offshore growth angle, or a structural growth angle where they can grow irrespective of what the domestic economy is doing. One such example is Infomedia (ASX:IFM), they've got a large technology business focusing on electronic catalogues for car dealerships and OEMs. 80% of their revenue comes from offshore, 95% of their revenues recurring. We think that they can grow despite what's happening here in the domestic economy in Australia.

Ben Clark: David, anything you can add in terms of traits? Looking at companies with off-shore exposure seems to be a pretty common theme now. Domestically, is there anything that you'd be looking for that you think can continue to grow and have you got an example for us?

David Keelan: Yes, one of the businesses that have reasons to grow and have some structural force behind it other than the normal level of cyclicality, one company that we like and has done pretty well this reporting season is Megaport (ASX:MP1). Megaport is solving the problem for data centres, a capital-light business solving a problem for a capital-heavy business.

The valuation is high, and it's one of our companies that isn't free cash flow profitable at the moment. But given the growth rates and the management, the board, we’re to believe they can go on to capture a lot more of the market.

Ben Clark: Okay. It looks like a pretty tough economic environment, might get worse from here but there's always some things you can have a look at that can make you some money.