Quickfire Q&A with Ben McGarry

As volatility has picked up in recent months, many investors who thought they were protected in a down-market have quickly discovered otherwise. Asset consultants have discussed the value of finding genuinely uncorrelated returns, while also acknowledging the difficulty of finding them.

One Livewire contributor who’s managed to put in solid performance through the choppiness is Ben McGarry from Totus Capital. His fund is still up 10.2% in the year to 30 November (benchmark: -1.0%), and has outperformed the ASX by ~4.6% over October and November. I took this opportunity to get in touch and hear a bit about the ‘special sauce’ that has helped him to this success. He shares his thoughts on the current volatility, how he’s playing the banking Royal Commission, and which major ASX stock he’d avoid if he were a long-only investor.

“The sector has been a graveyard for listed equity investors and we think its reputation as defensive is not borne out by the historical facts. We see increased risks to occupancy as the economy slows into 2019. The company has $300m of net debt and a cost base that is largely fixed in the form of rent and wages.”

- Ben McGarry, Portfolio Manager, Totus Capital

1. Markets have seesawed from week to week ever since the October correction, is this volatility here to stay?

Yes, we think volatility is here to stay. We have been in a low volatility world for several years and the trend appears to have changed now. Stocks are facing some well documented headwinds (housing downturn, consumer slowdown, shrinking central bank balance sheets, rising interest rates, trade wars, political uncertainty) which, in our view, is likely to continue to drive increased volatility going forward. While equity markets have pulled back considerably since the end of September, in general they haven't yet fallen enough to offer valuation support relative to where they have been historically. 

2. There's been a bit of discussion about achieving truly uncorrelated returns on Livewire in recent months, what do you think has allowed you to maintain such a low correlation? 

Low correlation with the Australian equity market is a function of the fact that we have maintained low net exposure in recent months. Gross and net exposure for the Alpha Fund at the end of November 2018 stood at 203% and -5% respectively. Effectively this means that for every $1 of capital in the fund we have $0.99 long equities and $1.04 short equities. This compares to an average net exposure since inception of the Alpha Fund of ~40%.

We are also index unaware in the construction of our long and short books. The Australian equity index is a market capitalisation weighted index with heavy exposure to financials and materials, two sectors which we have tended to be short.  

3. Given you can invest in Australia or overseas, where are you finding more opportunities today?

We tend to be long high-quality companies with tailwinds for earnings growth, clean accounting and reasonable valuations. Currently we are seeing more of these long opportunities in the US market (mainly at the mega cap end of town).

The problem with the Australian market on the long side is that there is a very narrow set of these high-quality businesses and as a result, they tend to get bid up to prices that are high in comparison to similar assets offshore. The second reason we are finding more attractive opportunities offshore is that we see material headwinds for the Australian market in falling house prices and leveraged consumers.

4. US tech stocks have corrected ~20% in the last couple of months but are still up a long way from a few years ago. Are they offering a good buying opportunity at current levels? 

Whilst we believe equity markets in general don't look cheap relative to history, at the very large end of the US tech sector we think Alphabet, Facebook and Microsoft all offer reasonable value at current levels. We are more cautious on the more expensive, second tier US tech names, where business models appear to be less sustainable and valuations stretched (>10x sales in many instances). In Australia we are short a couple of very expensive mid cap tech stocks that are using increasingly aggressive accounting practices to maintain reported earnings growth. Some of these companies have seen material insider selling in 2018.

5. I note you've recently moved net-short overall. Are you finding more opportunities on the long-side or the short-side following the recent correction?

Some of the obvious shorts in sectors like building materials stocks exposed to housing and financials hit by the Royal Commission have played out but we still think there is downside in selected discretionary retail and bank stocks into 2019.

On the long side there are some high-quality mid-caps companies that are now back to levels that look interesting to us.

In the USA we have been adding to holdings in Facebook and Amazon on this sell off while adding to shorts in companies like Tesla and Netflix, which are heavily reliant on access to debt and equity markets to fund their growth ambitions.

6. Could you share one of those opportunities with us?

One high quality small cap company that stands out to us is Objective Corporation (ASX:OCL). The business is building a very high-quality recurring revenue stream selling mission critical software into the public sector. Objective’s accounting is the cleanest in the ASX listed software space, expensing all research and development upfront. The founder CEO owns 67% of the company and is buying back stock at these levels. Margins are low and should expand as the business leverages off its heavy investment in R&D and adjacent businesses. These investments are compressing earnings and inflating the historical PE ratio. We expect the 1H19 result to be weak as a one-off services contract rolls off, but in the medium to long term we think Objective is an attractive investment at these levels.

7. It's been a wild ride for Tesla since you published about it on Livewire in August, could you provide us with an update on your view here?

Tesla has all the hallmarks of our most successful short calls in previous years (Blue Sky Alternative Investments and Quintus). It has a charismatic founding CEO, cult like investor following and a share price that has completely detached from fundamentals. The company has never posted an annual profit and the stock is trading within a whisker of all-time highs despite intensifying competition, the expiry of EV subsidies in the USA and a stretched balance sheet.  We can’t think of a mega cap company in our investible universe that is more reliant on access to capital markets than Tesla. We see the risks as asymmetric to the downside in 2019.

8. You list Financial Services Royal Commission as both a long and a short theme, could you explain your view and how you're navigating this theme and provide examples?

Early on it became evident that the Royal Commission was focused on conflicts of interest inherent in financial services companies that both manufacture investment products and provide advice to clients on where to invest. This has been a significant negative for companies like IOOF and AMP (two companies that we have been short). We believe the shortcomings of these business models will accelerate the shift towards independent advice and this should be a long-term tailwind for platform providers like Netwealth and Hub 24 which offer non-aligned fund offerings.

In addition, the Royal Commissions focus on lending practices within the Australian banks has led to a material pullback in credit availability. With lending volumes slowing, increased regulatory focus and bad debts at historically low levels, we consider the outlook for earnings growth within the major banks to be poor. The major banks have been a source of alpha for the Totus Alpha Fund on the short side in 2018.

9. If you were a long-only investor, what would be your top ASX-listed stock to avoid/underweight in 2019?

G8 Education (ASX:GEM) has rallied almost 50% since its October lows and we see material headwinds for the business in 2019 as they continue to roll out new childcare capacity into an already oversupplied market.  The childcare sector has been a graveyard for listed equity investors and we think its reputation as a defensive sector is not borne out by the historical facts. We see increased risks to occupancy as the economy slows into 2019. The company has $300m of net debt and a cost base that is largely fixed in the form of rent and wages. If the economy weakens as we expect the dual effects of operational and financial leverage could result in material downside for G8 shares.

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Totus is a long/short investment manager principally investing in listed equities and index futures in Australia and internationally. Find out more here.