How to invest for an inevitable consumer slowdown

To hear more of our discussion, check out the video below.

Podcast:

Transcript

Disclaimer:

Just a quick reminder, this podcast may contain general advice, but it doesn’t take into account your personal circumstances, needs, or objectives. The scenarios and stocks mentioned in this podcast are for illustrative purposes only, and do not constitute a recommendation to buy, hold, or sell any financial products. Read the relevant PDS, assess whether that information is appropriate for you, and consider speaking to a financial advisor before making investment decisions. Past performance is no indicator of future performance.

Steve Johnson:

Hello, and welcome to Stocks Neat episode number 10. I’m Steve Johnson, Chief Investment Officer here at Forager Funds. And I’m joined by a special guest for today’s podcast. I’ve got Alex Shevelev, who’s a Senior Analyst on our Australian Fund. I’m sure a familiar name and face to many of you, but I thought I’d drag him into the podcast today to substitute for Gareth.

We’ve just had the end of reporting season here in Australia so lots of interesting stuff to chat about. Once again, for all the whiskey aficionados, we’re not drinking whiskey today. We’ve brought along a bottle of wine. Alex is not a big whiskey drinker and I’m still peak marathon training so trying to keep the alcohol consumption to a minimum. But we’ve been very kindly sent a bottle of wine from a client so we’ll give that a little test run later in the podcast. Alex, welcome. Thanks for coming along.

Alex Shevelev:

Thanks for having me, Steve, and hello, everybody. I hear from our marketing team that this is a very popular podcast. I’m expecting Joe Rogan like numbers from the downloads.

Steve Johnson:

You might need to be more controversial than I would typically be to get Joe Rogan style numbers, but let’s see how we go. Alex, most people, as I said, would be familiar with you that are already clients of ours. But for those who aren’t, maybe just a little bit of an investing background from you. How would you describe yourself as an investor? How did you get into the investing game to start with and maybe how has that changed over time?

Alex Shevelev:

I’ve spent the vast majority of my time in the industry, going on 20 years now, looking at small and microcap stocks, and that’s where I really love to forage around. Now, these businesses they’re often, they’re quite young. They’re interesting. Sometimes they’re growing quickly. Sometimes they’re at valuations that are very extreme.

Alex Shevelev:

But the one really interesting, consistent point has been that these businesses often attract much less attention than the larger ones.

Steve Johnson:

I guess a broad question before we get into some specifics, it’s been a horrible seven months, really 31 December was the peak. But small cap, particularly industrial stocks in Australia, anything that’s not in the mining space, it’s been a horrendous seven month period. How are you feeling about market levels at the moment and prospective returns?

Alex Shevelev:

It has been a very difficult period for equities. And especially smaller companies and especially smaller industrial companies. One of the factors that I like to look at just with regards to your potential forward returns from here is really what’s happened the last couple of years. And I think most preferred metric for me is how has the market actually done over the past three years relative to what you could have gotten in the bank or holding bonds? And if you were invested in the All Ords over the last three odd years, you’ve made about 3.7% odd above what you would’ve made buying bonds back then.

That’s a reasonable number. It’s not too far away from the average that you would’ve expected over a very long period of time. However, if you were holding small cap industrial companies, you’ve actually lost 2.2% per annum relative to that bond yield at the time. You’ve actually had a really difficult period.

Now, the interesting thing here, and a lot of it has come about because of a pain of the last six or seven months. The interesting point here is that that does actually help you with your future returns because you have earnings that are marching up. You have dividends that continue to get paid. Overall, it actually is a pretty good setup for future returns and especially so in the small industrial companies.

Steve Johnson:

We might come to some specifics a bit later in the podcast. It’s pretty obvious what investors are worried about. And particularly in that space, you got interest rates rising quite rapidly. A lot of people on very cheap fixed rate mortgages that are rolling over at higher rates, that likely to have a big impact on the consumer, which is particularly relevant for that industrial space. I mean, how are those risks influencing your thoughts on some of these industrial businesses?

Alex Shevelev:

I think they’re very prevalent at the moment and I think you’ll hear a lot of people describing that it’s a very macro driven market. And unsurprisingly so. I mean the rate of interest rate increases has been very dramatic. And we’re sort of in the midst of it now. Not just in the midst of the increasing rate cycle, but actually people are just now starting to feel it because you’ve had a two to three month flag between the increase in interest rates and people actually feeling that in higher repayments.

You’ve seen it in house prices that are off, call it 8% in Sydney and maybe 5% or 6% around the country. And you are really heading into a period where people are probably going to have much more restrained spending because they will need to service their debt and to the extent that they haven’t had to, for quite a number of years.

Steve Johnson:

Yeah. There were people taking some comfort out of the reporting season. A. Generally very healthy results. But B, companies saying that consumer demand is remaining elevated and healthy at the moment. But it does feel like you’d be pretty foolish to assume that that is going to remain the case for the coming 12 to 24 months.

Alex Shevelev:

It does seem that come December and potentially the first and second quarters of next calendar year, we’ll really start to see the vast majority of the interest rate rises come through of again, the continual inflation of items of a non-discretionary nature, like food and fuel really start to bite.

I mean, people have argued about this for a while. And professional economists really have been quite a fairway behind the curb on this, but the market pricing has been quite strong over a long period of time. The current expected cash rate by December is about 3.3%. And by June next year, 3.9%.

We can argue that that’s a function of the market itself, some technical factor. And we don’t actually get there because let’s say they move too fast and have to backtrack. But it will have a reasonably significant impact, especially on companies that face the consumer.

Steve Johnson:

Okay, so how do you factor that into the types of businesses that you want to own, how you value those businesses, if you are anticipating a more difficult environment out there?

Alex Shevelev:

Well, I think a good example of that is actually companies that will not be relying on those consumers in the first place. We own ReadyTech. That’s a company that provides software to various segments, including education. They do payroll and software for councils. That business, it will not be facing a consumer who was seeing less money in their pocket. It will be facing an organization that has reasonably steady revenues, that has a focus on keeping its systems up to date because those systems often help them to save money and be more efficient with their internal processes.

And in fact, companies like that are now taking advantage and actually increasing their product pricing to their customers because they are seeing some inflationary pressure and they’re actually able to pass that through to their customers.

Steve Johnson:

Yeah. And then even on the consumer demand side of things, it is I think directly pointed at home owners and mortgage holders in terms of where most of the pain is coming here. And I saw an interesting broker chart this morning, just splitting out all of the retailers by exposure to mortgage holders rather than just consumers.

Alex Shevelev:

I guess no surprise that the Lovisa shoppers are towards the lower side of that with many fewer mortgage holders in the shoppers at Lovisa.

Steve Johnson:

Yeah. Lovisa at one end of that spectrum and then Nick Scali at the other, where you’re doing house furniture, you’re going to be far, far more exposed to that. And then, there’s a lot of different cycles at play at the moment as well. And you can talk to this better than me, but we’ve got some stocks in the portfolio that they’re definitely consumer exposed, but where they’re recovering from a prior crisis. And it’s two offsetting factors here that might help you, I think in terms of your near term profitability for some of those businesses.

Alex Shevelev:

Well, I think that’s very true. I mean, on the travel side, the percentage of disposable income spent on travel fell dramatically. And unsurprisingly, because we weren’t able to spend the money on travel. That is now bouncing back. And other businesses that suffered through a lockdown environment. Gyms being one, that are now at full run rate or recovering to full run rate relative to their pre-COVID numbers, that potentially still have some ways to go as they’ve improved their business during this period.

Steve Johnson:

I might get some critical feedback from the mortgage holders out there, but I do feel as well, that that gym paying membership crowd’s probably less correlated with the home ownership crowd than a younger renting crowd, potentially. Not sure. I might get in trouble for saying that…

Alex Shevelev:

And you are paying, I mean, in some of these businesses, reasonably low monthly fees for using them gyms in this case, towards the ones we own, for Viva Group towards the lower end of the weekly and monthly charges that you’re likely to see. So you could well get some movement from the very expensive. I think someone was telling me this morning, the Barry’s Bootcamps in inner city Sydney are $60 a week. I mean, there is that. And then there is a cheaper $14 alternative at your Lion Fitness.

Steve Johnson:

Which is owned by Viva Leisure for people listening in out there. Yeah. And look, our whole investment process is to buy things when they’re deeply unloved. So I think you can even, you can buy a good discretionary retail business that is heavily exposed to the cycle here and still do well if you buy it at the right price. So far, we’ve been pretty conservative around the more heavily exposed stocks to the part of the sector. Their prices have come off a long way, but we could well be wrong about this.

But general feeling, being that as things actually get worse and the numbers start turning up in the results, we might get better opportunities there than we’re seeing in the market today. It can be a dangerous way to think, but our philosophy is generally to buy when there’s extreme panic out there. And there’s certainly been some pessimism, but we’re probably not at the extreme pessimism end yet for some of those more exposed discretionary retailers I’d say.

Okay, let’s open this bottle of wine very kindly sent to us by a client of ours. It’s actually called Shut the Gate 2019, the Forager. It’s a Clare Valley Shiraz. So this one’s going to have a fair bit of heaviness to it. Are you a wine drinker, Alex? Do you like drinking your vinos?

Alex Shevelev:

I can’t really comment on the wine today, Steve, because I’m not particularly a wine drinker, but I’ll leave most of a commentary to you on that one.

Steve Johnson:

Well, it’s the blind leading the blind, I hate to tell everyone out there. You should hear some of Gareth and I’s commentary around the whiskey. It’s not particularly sophisticated. This is a 2019 Shiraz. I looked it up on the internet before I opened the bottle today. What you’d expect from a Shiraz, but this 2019 vintage of this particular wine is one of the better regarded ones. I’ll take a quick taste. Alex, first impressions? You’re allowed to scream like Chloe did when she had a whiskey. Or it was more a blah than a scream.

Alex Shevelev:

Right. No, look, it’s quite nice. But beyond that, I’m not sure if I can provide any expert commentary on that one. Circle of competence and all that, Steve.

Steve Johnson:

Yeah. I mean, definitely. I think there’s, this one’s quite noticeable. I’m not normally great at picking up the taste, but you can definitely taste that oak cherry taste that’s pretty common in a heavy Shiraz. And this very, very drinkable wine, but I’d be drinking it with food alongside a nice steak or something like that would go down very well.

Okay. Let’s move on to any wider thematics or implications out of reporting season. We’ve just wrapped up here, full year results for most companies, half year results for some others. But most reporting their full year results and starting to talk about 2023. What did you take out of all of that?

Alex Shevelev:

I think the first point that’s particularly interesting is around inflation. We had heard a lot from companies around labour inflation and that component continues. The likes of software companies will be saying that their employees, when they change jobs, are often changing jobs for 15 to 20% higher salaries than they had before. And it’s actually difficult to attract those people in any case.

The labor difficulties and the increases continue. The part that was interesting out of that reporting season is generally commentary around physical supply chain issues that have been abating somewhat over the last couple of months. And sounds like that sort of continues to abate.

Steve Johnson:

Yeah, Harvey’s just come back from a conference in the U.S. And a lot of people still complaining about it. It was described as a game of Whac-A-Moles. As soon as one problem goes away, like chips, for example, something else crops up and there’s a part missing. Or those supply chains are a lot more complicated typically than what we face here in Australia. But some really clear big picture things as well with shipping costs have fallen 70, 7-0% from their peak. That is very clearly opening up.

You’ve got lumber prices in the US, which translates to a global price down 60% from their peak. The oil price back below 90 more recently. Some of those rampant cost issues are abating and it feels like supply chain issues are starting to mitigate as well. I saw we had new car sales in August in Australia, the highest they’ve been in quite some time. Things are starting to turn up and they’re also turning up into a weaker consumer environment as well. A lot of companies in the US in particular, but did you see any of this in Australia where they’d been overstocking? And people had been so worried about supply chain that they bought a whole heap of excess and now there’s extra sitting on shelves.

Alex Shevelev:

There have been a few cases where inventories are quite a bit higher than what was expected. And I think the threat to that is that it actually soaks up quite a lot of capital. It just sits there as inventory. And these businesses may have been reasonably clean, had good cash conversion historically. But through these supply disruptions to put their foot on inventory that they need for their customers, they’ve had to hopefully a one-off and hopefully a one-off and a subsequent clearing of that inventory. But they have had to put capital to work in a space that doesn’t usually yield you very high returns on that capital, which is just holding inventory.

Steve Johnson:

Where especially if you’ve got a discount it to clear it, to turn around and say, the demand’s not there that we thought was going to there be there. And now we’re selling things at lower prices. I felt that was more common overseas than here in Australia. But an issue with some of the retailers like Ascent talking about inventory builds. City Chic, massive problem there in their business that they’ve bought. I mean, they’re saying they’re going to sell it all. But they’re pretty, I think they were fairly significant negative free cash flow for the year, despite making a big profit just because they’d bought a whole heap of inventory to sell.

Alex Shevelev:

And it also reduces your ability to use that capital for other more productive purposes in the shorter or medium term, to use that to invest in new facilities, organic expansion, or to use that in an inorganic fashion to buy other businesses. It becomes a capital sync.

Steve Johnson:

Okay. And across the retail sector. I mean, we already touched on it, but it felt reasonably healthy out there in terms of actual results and even trading updates into July and August. What were some specifics from you?

Alex Shevelev:

Look, and it might be this idea of the lag before people start to really feel the mortgage strains. But the likes of a Super Cheap, for example, the business is actually doing quite well relative to last year. We are going through a period here where the last year’s comparative for the first couple of weeks of this new financial year is actually locked down.

And so, some businesses will be stating a number that seems quite healthy. But as we know, throughout the FY22 year, those restrictions loosened. If you were a physical retailer, this is probably your best year on year comparison period, and it’ll improve. It won’t be quite as good as we move through the year, but relative to a 2019 pre-COVID level, the likes of a Super Cheap are still talking about like for like sales that are in the order of 30% above.

Now, that is somewhat of a conundrum. Because we have had yes, nominal increases in wages. We have had inflation of those underlying products, but we are still quite a dramatic way above in terms of household spending the prior trends that were in place for years and years before COVID. I think there is still quite a bit of threat to that, partially from the macro environment. Also partially from a normalisation of peoples spend, away from physical goods, for example, and towards travel and experiences.

Steve Johnson:

Yeah. I mean that increased spend that we are seeing all over the place in services driven businesses, it just has to come from somewhere. It’s not simple mathematics to say that spend has to come out of a different category. I think you’re absolutely right. It’s a very rear-view mirror way of looking at things to say, “Oh, it’s still great because like for like was 29% higher than 2019 last year.”

Steve Johnson:

We’ve seen so much evidence. I think almost every business and stock you look at draw the trend up to 2019, keep that line going straight to now. And whatever adjustment you need. We’ve seen it with the online retailers. I’ve actually been surprised how much reversion there has been in some spaces where I thought that pull forward of demand might have created some permanent changes of behavior, like online shopping at an Adore Beauty or a Kogan or someone like that.

Largely it has gone back to the same patterns that it was in 2019 and a little bit more online penetration like you would’ve expected. Okay. And what else from your hundreds of meetings or however many you had it through reporting season? Much talk about the housing market out there? I mean it’s front page of the press and the papers every day in terms of prices potentially coming down. The RBA governor talking about the same. What are the CEOs and company leaders saying about that particular issue?

Alex Shevelev:

I think for those that are directly exposed, that is those, for example, that sell plots of land or sell plots in a retirement community, for example, they are talking about that as being a mild negative in the areas where they’re involved. They’re not talking about it necessarily inner city Sydney, where prices are falling a fair bit more. They’re talking about the other outer suburbs and outer areas where that’s not quite as extreme.

For other companies, they’re probably more concerned at the moment about the impact that has on consumer confidence, that the impact that has on the wealth effect. We’ve had quite a sharp increase in house prices, giving people the confidence to spend up on larger items. Winding that back somewhat, may be problematic. And we’ve already seen part of that in consumer confidence.

Steve Johnson:

Yeah. And again, I think the pain probably started in May or June. It takes a long time for that. Not a long time, but it certainly takes a number of months, even for people to start paying higher interest rates for that to translate to lower house prices. I don’t think people telling you that things were fine in 2022 is necessarily a huge amount of comfort about what the next year looks like.

I saw a quote from Stan Druckenmiller, a very famous U.S. based investor the other day, talking about how this environment, it’s never been more difficult for him in his 40 years of investing to forecast what profits the companies are going to make, of the companies that are in his portfolio. And he said, “They’re businesses that I know inside out. It’s just such a strange, difficult external environment, like nothing we’ve experienced before.”

And I feel a little bit like that here in Australia as well. There’s a wider range of potential paths that things can go down than we’ve seen before. And that’s been the case throughout this whole COVID experiment. We’ve had monetary policy experiments and fiscal policy experiments. And it’s been a number of years of surprises. And it feels like that is far from over in terms of what happens over the next 12 months or so.

Alex Shevelev:

Yeah. Look, I think that’s very fair. There will be surprises come up in the next 12 months. And a lot of them will be because of macro situations. I think there are certain businesses that are handling it better than others though. And we talked about the likes of ReadyTech.

RPM is another large investment in the portfolio, software for mining companies. And that has performed very well to date in terms of attracting new subscription revenue to the business. And it feels like that business is not going to stop because of all these macro factors. Yes, commodity prices being dramatically lower would be a hindrance, but the current levels or levels marginally below are sufficient to continue growing. There’s a lot more stock specific factors at play here rather than just the overall arching macro themes.

Steve Johnson:

We might just finish off with a couple of stocks that we probably haven’t talked about as much in our monthly and quarterly reports, but which I think are really interesting in the context of everything that we’ve talked about today.

Maybe start with what is a combined fairly significant investment for us, which is Apollo Tourism & Leisure and Tourism Holdings. They’ve proposed a merger. It’s potentially going to become one company. And in our portfolio that would be about six and a half or 7% of the portfolio. Combined, that’s one of our largest investments. Again, in the context of everything we’ve just talked about, maybe a really quick overview of that and what you like about that as an investment.

Alex Shevelev:

So both of these businesses, they operate in recreational vehicle. So they manufacture or purchase in. They operate and rent recreational vehicles, camper vans. And subsequently, they sell them. Now, the businesses have actually done a really good job through COVID not needing to raise money because a lot of a business was dependent on international tourism. That international tourism came way back.

But what really helped both businesses was that you had an increase in the price of those vehicles and large fleets that were not required to service the much lower demands of international and domestic tourism. These businesses sold off the fleets. Generated really substantial capital, paid off a lot of the debt. And are now in a position where they have seen, are seeing and they are seeing it currently. And they will continue to see a move back to some of the demand patterns that were prevalent before COVID struck.

Steve Johnson:

Yeah. And I think one thing that I really like about this thesis is that it’s easy for people to go back to 2019 and say they were making X amount of profit and they may make that again. I think this is a sector that’s been through a lot of change because of COVID. Both of these companies have become a lot more efficient and a lot leaner. And this is not necessary for us to do well. But I think there’s a decent chance here that you look back in a few years time and you go, not only are we back where we were in 2019 in terms of demand, but we’re significantly more profitable than we were then because they were forced to get a lot more efficient.

Alex Shevelev:

Yeah. I think that’s exactly right. They will be operating in a more efficient fashion now than they were before. We have had prices increase across a number of categories. And RVs have been no exception in Australia at the very least. You’re now getting higher yields on your fleet as well.

Steve Johnson:

Yeah. It’s going to be interesting. I mean, they’ve put out some pretty healthy guidance for next year. And Apollo, I think already back.

Alex Shevelev:

Apollo is saying that in the 2023 year, they will be back to doing the profit levels of pre-COVID, which are already very healthy levels. And that is a base from which they’re likely to grow rather than some one-off effects. THL, given the greater focus on New Zealand is still somewhat behind, but gave reasonably healthy guidance and looks like it’s moving in the right direction as well.

Steve Johnson:

And news to come there. They’ve proposed this merger, some issues with the New Zealand Competition Commission and the Australian Competition Commission as well. They’ve proposed some remedies to that. We’re hoping that over the next few weeks even, we get some news on that front that they are allowed to proceed with this merger.

And it’s actually going to create a fairly meaningful global player. There’ll be some assets in the U.S. And some assets in Canada there. One that we’re quite excited about in terms of the portfolio. And we touched on this stock already, but Viva Leisure, a little founder-run gym operator that’s got big plans to roll them out. Can you maybe just touch on that one quickly as our last stock for today?

Alex Shevelev:

It’s a smaller position than the combined RV exposure that we have here, but it’s a good little business that is rolling out and acquiring clubs. I mean, they’re up to now about 150 clubs and servicing through their corporate owned locations, about 160,000 members. That number continues to grow every year as they invest in new locations. Either through a multibrand approach and also through acquisitions. They’re making all these acquisitions at quite cheap multiples, and they’re able to put some of the benefits of their scale into these smaller locations.

The business has had a really, really tough time as a listed entity the last couple of years. And by and large, that’s because they only had a six month period where they were reasonably clean of COVID after their IPO. That business at the time generated EBITDA margins in the mid 20% range. And with the added scale, they’re driving back to those same levels over the next couple of years here on a revenue line, that will be much higher.

Steve Johnson:

It’s a super competitive industry, or it certainly feels that way to me, that there’s a new gym opening up on every second corner. And you’re reading the UK high street woes. Their number one solution is to be putting gyms in over there as well. What is it about this business that makes you confident it can earn high returns on that significant amount of investment that they’re making?

Alex Shevelev:

Well, I think the businesses as they expand organically. There is a brand at play there. There is the benefit of locations around a central hub. That is helpful in terms of attracting only incrementally larger number of members. But that can actually drive a dramatic change to the economics of the situation.

There are also other things, for example, paying. Being able to have a payment system that they’ve developed internally that will save a couple of percentage points off the revenue for an independent gym. They have these systems to do that and will not have to pay that fee to the same extent. All of these little things over time will result in a business that can actually compete against some of the other operators and do it at quite high returns on that incremental capital.

Steve Johnson:

Yeah, I think the highest intensity of competition is actually at the sexier end of the industry, which is like you talked about a Barry’s Bootcamp, that’s substantial amounts of money per week or per class. And what’s interesting here is the founder, significant shareholder in this business is from a construction background, not a gym background.

And I think that’s actually important part of what’s happening here that he’s trying, or he is doing this more efficiently than other people. And has a very strong focus on minimising the amount of capital that you put in so that you can earn a decent return on that, even though you’re charging very, very low membership fees. And it’s different in terms of scale, but we’ve seen that Planet Fitness business in the U.S. be super, super successful at even lower prices than this.

As they’ve got scale, they’ve become even more vertically integrated that they actually manufacture their own gym equipment over there. And it would be interesting to see how this one unfolds. As you said, it’s a pretty small investment for us. It’s fairly newly listed and it’s not really had a clean track to run on ever since it’s IPO. We do need more evidence there to make that a bigger investment in the portfolio, but an interesting one to follow. And one that people out there can experience on a day-to-day basis as well if you want to go and check out their gyms.

Well, thanks for tuning in, everyone. We’ve almost finished our glasses of wine here, and I think worth a try for the Shiraz drinkers out there that have got a nice steak on the barbecue this coming weekend. You can go and get a bottle of the Forager Shiraz by Shut the Gate from the Clare Valley. Thank you for tuning in once again. We’ll be back in a month or so’s time. And jump on the website or send us an email if you have any questions. Thanks for your time, Alex. We’ll get you back on for sure. We really appreciate it.

Alex Shevelev:

Thank you, Steve. Thank you, everybody.