Two different approaches to navigating 2019

If you found that last few months of 2018 a bit testing on your nerves, I can assure you that you’re not alone. It seems to have taken equity investors a few extra weeks to get their feet back under the desks after a bruising few months.  

So, for our first thematic discussion of 2019 we have tried to keep it simple by asking “Is it safe to wade back into equities?”  

We're joined by James Gerrish from Shaw and Partners and Joe Magyer from Lakehouse Capital. The investors present two distinct approaches with James seeking to be more active, whilst Joe adopts a very long investing horizon against which to assess his positions.  

One thing that you will note is that both of our guests are opting to hold higher levels of cash leading into reporting season as they await company results. Tune in to the full discussion where we cover the points below.

Topics for the panel 

• What is your view on the opportunity set and outlook available on the ASX? 
• Which indicators do you place weight on, why do you value them and what are they telling you right now? 
• Examples of where you feel selling has been overdone or alternatively where you feel risks are still elevated? 
• Is there a strategy or approach that you are adopting for the current environment? What is it and why do you have this approach? 
• How do you want your portfolio to look for 2019? 

Transcript

James Marlay: Welcome to the first thematic discussion of 2019 here at Livewire. My name's James Marlay and I'm joined today by James Gerrish from Shaw and Partners and Joe Magyer from Lakehouse Capital. It's been a tough old time in equities, particularly Q4 2018. A few people licking wounds. 

The question today is, is it time to weigh back in to equities? We're going to ask these two gentlemen how they're seeing the playing field for 2019. 

James, I'll start with you. We've all had a bit of a break after a really difficult end to 2018, quite a bit of clean air to think about the year ahead. How are you feeling about the opportunity set that sits in front of you on the ASX at the moment, what are some of the clear observations you could make? 

James Gerrish: I think it was a good break first of all, and I think reflecting back on 2018 there were some key take outs. You know, we've had 10 years of a really bullish phase in the markets and twice in 2018 we had interest rate infused slowdowns, so the market pulled back in Q1 of 2018 on the back of higher bond yields. And in Q4, it pulled back on the back of lower bond yields. So, I think that twitchiness in the market will continue. I think that'll play out in 2019. So there are more difficult markets to come I'd say James. 

James Marlay: For a while everyone was complaining about the lack of volatility- 

Joe Magyer: And then they got what they asked for. 

James Marlay: They got some volatility and they complained about it again. You can't win being an investor Joe. 

Joe Magyer: Yeah that's true. 

James Marlay: But you have to go and pick stocks and that's what you guys are paid to do. How would you sum up your assessment of the opportunity set from an equities' perspective on the ASX? 

Joe Magyer: We're selectively enthused. I think that there are some sectors particularly around housing that I think look really vulnerable and there's a lot of downside potential and we're steering clear of a lot of those, but for investors who are very growth focused, as we are, a lot of growth names just got absolutely kicked to the curb in the last quarter and a lot of them are a lot cheaper today. I'm looking forward to reporting season and the opportunity to see fresh sets of numbers, companies that are sold off in a big way.  

James Marlay: That's a good point. We've been chatting before about expectations going into reporting season and that's really going to be where the rubber hits the road, so to speak. What are you expecting from a numbers perspective? And how do you think that lines up against the market's expectations when it comes to pricing your stocks? What are you expecting in February with reports? 

Joe Magyer: Broadly, I think if you are very Australia centric, you're purely a domestic business, and you've got heavy exposure to the consumer, you've got a lot of operating leverage in your business, I'd be worried about that. I'd be worried about what guidance looks like. Those are things that I'd be particularly worried about. I think companies with global exposure are probably going to be a lot more defensive this go around. 

James Marlay: James, anything to add to that in terms of reporting season, what the market expectations are and what you're going to be looking at? 

James Gerrish: I think you need to be wary of the consensus trade. I take Joe's point on board around the Australian consumer. It's the consensus trade, the research that I read over the break is very negative on the Australian consumer, you know, high debt levels and low-income growth, etcetera, that all plays into being negative on the Australian consumer. Weak housing et cetera, but the overseas thematic investing for overseas growth, that's a well-known theme. Expectations are high so if I look at a stock like Macquarie Group (ASX:MQG), they've got high expectations built into their share price. Some of the companies that are exposed in the retail space have got low expectations built in. I'm not saying go out there and buy retail as discretionary retailers. But it's all around expectations. So, in overall, expectations are low. So I think the area of most pain might be up during these reporting season, given the market's pretty bearish going into it. 

James Marlay: Okay. Let's just bring it back up just a touch, coming back to this concept of having a bit of a clear head and a fresh start, to look out on the year ahead. What are some of the data points and the indicators that you turn to to start getting a temperature check on how things are tracking? 

James Gerrish: When you look at what's driven this market over the last number of years, it's been cheap liquidity, it's been low interest rates, it's been the availability of capital into the market. And I think in Q4 of calendar 18, I think we saw one thing over in the U.S. corporate bond markets, spreads started to widen and that make the cost of capital go up for U.S. corporates. You know buy backs over in the U.S. have been a really important thing that's driven equity markets over in the U.S. And I think that's probably one indicator I'll be looking for this year. We've seen it in the Aussie housing market. If regulators tighten up credit, the availability of capital dries up, less buyers means lower prices. So to me, that availability of capital, the liquidity in the market, the cheap rates is really a key for this year and beyond. 

James Marlay: Joe do you have anything to add to that? Is there anything from a big picture perspective that you draw on. 

Joe Magyer: Yeah, so we tend to be bottom up but you know I think you'd have to have your head in the sand to not notice that Sydney housing prices are almost down 10% over the past year. And you know for a long time, we're at the barbecue and everyone talks about how prices can't fall because of all these different structural reasons that make this market unique. And yet they're falling. And there's no real catalyst for change with that. You know your marginal buyer out of China probably isn't coming back anytime soon because capital controls are still getting tighter in China. Lending standards, still getting tighter with the banks. You've also got fear in the market, at this point it starts to feed on itself so I'm not sitting here predicting a crash but I think if you told me that those dynamics were in place and their prices were down 10% year on year, I'm a little surprised that people aren't a little more conscious of the down, the tail risk around that with some companies. 

James Marlay: If we're talking about specifics around where opportunities lie, and opportunity to lose capital lies, can you single out any particular areas where you think the opportunity set is greater where stocks may have been thrown out with the, the baby's been thrown out with the bath water a little bit? Or conversely areas where you still feel like there's a significant risk to the downside where there's too much exuberance priced in? 

Joe Magyer: Yeah. I think if we're going to talk, I'd say on the housing side so there are a couple where you look at Commonwealth Bank (ASX:CBA), yes, it's come back quite a bit. Yes, it's gotten a lot cheaper, but it's still selling at 2.2 times tangible book value, which is a pretty rich valuation for a bank who's lending standards balance. You haven't really been stress tested in a quarter century. You've got higher capital requirements that are a structural thing. Soft housing market. It doesn't feel like a good range of outcomes for me. 

James Marlay: James anywhere you think investors have gotten too bearish on a particular part of the market or vice versa where there's too much exuberance? 

James Gerrish: You know I think the Aussie dollar's an interesting case in point. The other markets, they are bearish the Aussie dollar, I’ve seen a lot of expectations for sort of $0.60s. You know, if I rewind the tape back to the start of 2018, the market was more bullish the Aussie dollar and it's dropped from sort of 80 cent level down to 70 cents. It had a low of 67, so you know I think that bulk of the move on the Aussie dollar has been done on the down side. I think the next meaningful move on the Aussie dollar against consensus might be up, from an investment standpoint, that implies that we should be a little bit cautious those overseas earning stocks, those stocks that are exposed to overseas growth. So you know, I think we've got a bit on the other side of that trade this stage. 

James Marlay: Alright. Well let's put a bit of a framework around what you want to own, what you want your portfolio to look like for 2019. Can you talk me through how you want to have yourself positioned? 

James Gerrish: You know I think it's going to be a fluid year I think for the first and foremost. It's going to be a year where I think the market overall will be fairly range bound, and we've had, as I've said before, a really strong bull market over the last 10 years. We had a pretty big warning pull back correction in the December quarter, 15% in Australia, 20% in some other global markets. So I don't think a market that has rallied for so long on unwinds in such a short amount of time, so I think the market is going to be range bound with a downside bias overall this year. So our portfolio is going to go through periods of hard cash level, so I was speaking to you before coming on air, we've now gone to nearly 30% cash in the market. I know 5900's been a cap on the market at the moment. It'll obviously be driven by reporting season, and we want that cash in the portfolio for flexibility as opportunities arise. So I think we'll be a year where selling optimism makes sense, and stepping up and buying the periods of pessimism, which will ultimately play out.  

James Marlay: So you're taking a bit of a get the result first, buy later approach to reporting season rather than be holding stocks going into it? 

James Gerrish: You know I think we've seen over recent times you can miss the first tick up in a stock if it reports really well. I think the market does go and bid that stock up. Going forward, vice versa on the downside as well. I don't think you need to rush in and buy stocks after they have a meaningful downgrade or a miss. The market takes a while to play that out, so I think you've got to be a little bit patient. Having cash, as I said, improves flexibility. And there's going to be bargains coming out in reporting season. We've seen it already in the first couple of days of reporting. There's been some landmines. So I think avoiding those landmines in reporting, it's a hard thing to do but that's what you need to do this reporting season. 

James Marlay: Joe, what's your strategy for 2019 for smooth sailing? How do you want your portfolio to look for this year? 

Joe Magyer: So with the caveat that we're very long term investors and very consistent with our process, we're very quality driven looking for large tams that are growing, good balance sheets, good management teams, good valuation. So with the caveat that we're more or less looking for that all the time. I'd say we're a little more focused on financial leverage right now, on protection around down sides so just making sure we don't have direct exposure to continued pull back in housing, that financial leverage isn't going to eat you at lunch at the business level.  

James Marlay: So no debt? 

Joe Magyer: Well we can tolerate some debt, but not enough that a pullback is going to end you. You know, stuff happens. I don't want to pretend like it's impossible, but you know, I'd like to improve our odds by reducing the number of those in the portfolio. You know, highly visible earning streams where you've got loyal customers, recurring revenue streams. You're not selling $5000.00 Italian sofas. You're selling software that's mission critical to the business that relies on it. That's more my cup of tea. 

James Marlay: Alrighty. Well it sounds like the boys are still feeling a little bruised from a tough 2018, and it's going to be a gently as she goes approach to 2019.  

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