Stock-picking secrets from the market masters

High stock prices aren’t necessarily expensive, embrace a buy-and-hold mentality, and don’t spread your net too wide: these are core principles for Hyperion’s CIO and portfolio manager Mark Arnold and Jason Orthman.

In the quarter-century since launching, Arnold and his team have turned some $1.4 billion of client capital into around $10 billion in funds under management – and almost half of this AUM has resulted purely from beating the benchmark.

With a style-agnostic strategy spanning both Australian-listed and global companies, and with active funds and an exchange-traded fund launching on 22 March (ASX:HYGG), Hyperion adopts a high-conviction approach. Finding a handful of structural “winners” and sticking to them like glue has reaped rewards for the funds and its investors.

In the following Q&A, the duo discusses their balance of macro research, company fundamentals and forward-looking analysis; favourite Aussie stock picks; and the buzz around Tesla. They also reveal one of their lesser-known holdings.

Mark, you were with Hyperion when the firm started back in 1996. How has your investment process evolved over the past 25 years?

In 1996 we were only investing on behalf of individuals. This meant we were seated across the table from the people whose lives our investment decisions were impacting. It was very personal – a bad investment decision on our behalf could mean the difference to our clients’ retirement plans, and that feedback was immediate.

We have never forgotten the responsibility we carry for managing other people’s money.

With that as our touchstone, the investment process we developed initially has been incrementally improved over time. Our values include making evidence-based decisions and being focused on generating alpha (returns that beat the benchmark). We have used our experiences over the past 25 years in various economic and market conditions to help improve the investment process. In simple terms, we construct portfolios for clients using long-term risk-adjusted return forecasts. The process for estimating those long-term forecast returns and the associated fundamental risks has been gradually improved over time.

You’ve written in the past about the role of “macro” in Hyperion portfolios. Why is an understanding of the macro-environment important for equity investors?

Macro-economic factors are important inputs to our view on the types of businesses that are likely to grow. We believe the economic tailwinds that helped the Value style perform are now economic headwinds.

Japan is an excellent example of a developed country that has failed to grow. It has not, in fact, produced sustained economic growth since the mid-1990s, and the economy hasn’t grown at all post-GFC. It’s important to understand what happened to Japan because other countries are now finding themselves in the same place. Some will probably need to employ similar strategies to address low growth.

These structural headwinds include:

• An ageing population and declining population growth;
• High debt levels;
  
• Constraints on natural resources and disruption including climate change;
  
• Technological innovation, which is deflationary and disruptive; and
  
• A hollowing out of the middle class.
  

If investors understand the macro factors at play, they will be better placed to assess whether their investment is positioned to deliver returns above the market.

How does this philosophy translate into the views you have on the current investment backdrop?

Over the past decade-and-a-half, we have moved to a globalised, internet and smartphone-enabled, world. The power law distributions that have historically described regional industry structures and competitive landscapes have now become global. Power law probability distributions describe the situation where only a small percentage of a certain population produce most of the value. This type of probability distribution is also known as a Pareto Distribution. A common example is the “80-20” rule where 80% of the value is produced by 20% of the population.

Stock market returns over the long term are not driven by the majority but rather by a small number of structural growth businesses.

The extraordinary returns from this small number of structural growth businesses result in the market’s return distribution having a positive skew rather than a normal bell curve shape. It is the compounding impact of high return structural growth businesses (“the winners”) that drive most stock market returns over the long term.

Unless a long-term “buy and hold” investor can successfully select future structural growth companies, that is, the structural winners, and give them sufficient weight in their portfolio they will not produce excess returns.

What are some examples of how these top-down views feed into your portfolio construction and stock selection?

At Hyperion, we believe a transition to sustainable energy and transport is one of the most important structural themes of the next decade. The removal of combustion engines off the roads, for example, is a relatively easy win for society in that it reduces air pollution and helps reduce carbon dioxide emissions that contribute to climate change. Solar, battery storage and electric vehicles now have the ability to disrupt the use of combustion engine vehicles and the traditional fossil fuel-based electricity grids. Clearly Tesla is well position to ride this wave over the next 10 years and beyond.

Looking more broadly, we are screening for companies with the following attributes:

• Structural tailwinds
• Large addressable markets
  
• Sustainable competitive advantages
  
• Capital light, proven business models
  
• Low debt levels
  
• Management with a long-term focus
  

Examples of Australia-listed companies that meet this screen include Afterpay (ASX: APT), Dominos (ASX: DMP), Fisher & Paykel (ASX: FPH), WiseTech (ASX: WTC) and Xero (ASX: XRO), while overseas we hold Amazon, Tesla, Square, ServiceNow and PayPal.

When you initiate a position, do you have a timeframe in mind?

Our investment horizon is at least 10 years. We think like business owners, not short-term traders. When we buy a stock, we are not looking for a short-term exit strategy. If the company performs well and the long-term outlook remains attractive, we will continue to hold that company. The weight in the portfolio of each stock will vary over time based on the attractiveness of its long-term forecast risk adjusted returns relative to the other stocks we have in the portfolio and on the bench.

The most recent monthly fund update shows that five stocks make up more than 40% of the portfolio. What is your philosophy on portfolio concentration and how do you determine position sizes?

By investing in a relatively concentrated number of high-quality businesses, being patient and holding these businesses over the long term, investors can focus on their best investment ideas and benefit from the compounding growth in their value. This is an extremely powerful and effective approach to wealth creation. At Hyperion, we believe that in a permanently low growth world, an effective way to achieve attractive returns in equities is to be selective and combine a smaller number of stocks that have the potential to compound returns at high rates over the long-term, into a concentrated portfolio.

The historical tailwinds of high GDP growth, falling interest rates and stable industry structures that have aided short term investors in the past are unlikely to persist in the future.

We determine position sizes in the portfolio based on the expected long-term risk adjusted return profile of each stock relative to the other stocks in the portfolio.

Backing “structural winners” has been the right strategy over the past decade. Does the recent rotation towards cyclical stocks present a window of opportunity to invest in some of these growth names?

The rotation back to traditional value stocks does represent an opportunity to increase exposure to high-quality growth stocks at more attractive prices. We believe that any rotation away from structural growth stocks will be temporary.

Selling the future to buy the past is not a sustainable investment strategy in the long-term. Most traditional value stocks are “old world” businesses that are mature and are likely to be disrupted in the future.

Buying these types of stocks is unlikely to produce attractive long-term returns because in a structurally low growth and disrupted world, the revenues and profits of these companies will struggle to grow. In addition, many of these companies will suffer permanent declines in their profits over the long-term.

Can you share a stock that currently holds a smaller position in your portfolio, but which you believe has exciting growth ahead?

We recently bought Spotify which we see as a very exciting company. The streaming industry is a large addressable market worth approximately $200 billion annually, giving Spotify significant earnings growth potential. The company is also a market leader in terms of its reach with users.

Its commitment to also becoming a major podcast platform, the uptake of Car Play by car owners, and Spotify’s discovery algorithm – which learns and serves content the user will enjoy – is already positively driving the company’s revenue. Consumers’ appetite for on-demand, streaming entertainment is disrupting “old world” media such as free-to-air TV and radio, with Spotify well positioned to grow revenue.

Some of these high-profile growth names have generated exceptional returns, but many investors struggle with their high valuations. What’s your insight on this?

Tesla is certainly one stock that has been much discussed publicly. Media coverage refers to Tesla as a car company, but we see it with potential to disrupt in more than the automotive industry. What we see, but perhaps others don’t, is that Tesla is a software and technology company that happens to make cars and energy products.

Firstly, consider the power industry. As electricity production and distribution moves from centralised, carbon-intensive sources to renewable generation and storage dispersed throughout suburbs and unused land, we will see the creation of new products and services. Tesla is well-positioned to capitalise on this structural change thanks to its electricity management software. Its software enables users to generate and store electricity and move electricity between households and businesses.

In the transport industry, Tesla enjoys a wide moat between it and its competitors. It is a clear global leader in the manufacturing and distribution of software and battery based EVs. It has significant and increasing cost advantages in the manufacturing of EVs. It is now a clear leader in the race to full autonomy solutions in vehicles. It first started designing its own autonomous driving chips a few years ago, and it is making rapid progress towards full autonomy. Its vision based generalised approach to solving full autonomy is radically different to most of its competitors. It has amassed more than 3 Billion miles of data, again well ahead of anyone else. It will be difficult for others to catch up.

It’s easy to underestimate the scale of the innovation being driven in “new world” companies like Tesla and therefore to misjudge where they sit on the exponential growth curve.

Access Australia's Fund Manager of the Year 2021

The Hyperion Global Growth Companies Fund seeks to achieve medium to long-term capital growth and income by investing in high calibre companies primarily listed on a recognised global exchange, at the time of investment. The active ETF (ASX:HYGG) will launch on 22nd March 2021. Find out more here