The sectors (and a stock) that passed Perpetual’s quality filter

Perpetual’s Vince Pezzullo sincerely hopes financial markets aren't heading for a repeat of the 1970s - or the 1990s - as he explained in the latest episode of Livewire’s Rules of Investing podcast. Midway through the podcast, Australian banks were discussed – specifically how they’re positioned within the current inflationary environment. 

That's where his point about a possible return to the 1970s - with its echoes of an energy crunch, rising inflation and a hot war (in the Middle East, on that occasion). 

Or perhaps the current period more closely resembles the 90s, when there was also a structural shift in inflation and offshoring was taking off in a big way. The difference matters, because one of these periods turned out to be far more harmful for markets than the other, as Pezzullo explains during the interview.

Other key topics canvassed during his chat with Livewire's David Thornton include:

• Are markets reliving the 90s or the 70s?
• Why inflation is patient zero
• Why he’s long Santos
• Is speccy tech ever cheap enough?
• Where Perpetual is hunting now

“It goes back to how quickly central banks will turn around and think they’ve done enough to get on top of inflation. Many of the things banks are trying to solve for are out of their control,” says Pezzullo, deputy head of investments in the Australian equities team (and other parts of the business) at Perpetual Asset Management.

For Australian banks especially, the labour market holds the key. And it’s here that Pezzullo references the 1970s and the 1990s – we’re headed for a repeat of one of these eras, economically speaking at least. (So please, leave those flared jeans and NKOTB CDs in your closet).

“I look back to either the 90s, where the setup was falling inflation and you had a structural shift, with Volcker crushing it and the WTO and everyone else offshoring,” he says.
“Or is it the 70s, which is way worse, because costs were persistent and (central banks) really had to crush the economy to try and build that slack, and that’s not great for markets, no matter where you sit?”

Pezzullo believes It’s too soon to say just yet whether inflation will be cyclical, as in the 1990s, or structural as it was in the 1970s. But either way, as a relative investor, Perpetual will remain fully invested (aside from the cash levels required for liquidity purposes such as redemptions).

We explain later which areas remain appealing as these “least worst” investment options during such a period. But next, we look at what Pezzullo says about the macro environment, where inflation remains top of the pops.

Energy holds the economy hostage

Podcast host Thornton framed a poignant question on whether the energy sector is effectively holding the global economy hostage. The context here is that rising energy prices kicked off the broader-based inflation rise and subsequent rate increases of the Fed, BoE and most other developed market central banks since early 2022.

The first-order effect of rising energy prices (you might also think of it as “patient zero”) is inflation.

“And the second and third-order effects of energy prices as they filter through the economy are quite material,” Pezzullo says.

He discusses a “perfect storm” for energy producers, with pressure from a greater focus on renewables at the same as Russia’s invasion of Ukraine – hot on the heels of the supply chain snarls of COVID – drove a change in the flow of energy around the world.

As an example, Pezzullo alludes to gas prices now sitting around 10 times higher than where they were a few years ago.

“With Europe trying to wean itself off Russian gas, that gas is now going somewhere else, so the supply flows are very different now to what they were a decade ago. It’s hard to reverse that once it goes,” he says.

Gas prices in North America are a fraction of those in Europe, where producers (and consumers, sadly) may simply have to accept a very high cost of energy.

“As a company, you’ve got to accept potentially lower growth. It’s usually the consumer that pays for that. It’s much harder for many of these companies to deal with, that’s why inflation is a little more embedded,” Pezzullo says.

A reaction to this is that we’re seeing buyers from Asian markets – both south-east Asia and the subcontinent – popping up to buy Russian gas.

There are other elements at play, too, including an explosion that shut down the Freeport LNG terminal, which reverberated around the world as the US’s biggest LNG was taken offline, potentially for months.

But there’s one Australian gas producer, Santos (ASX: STO) that Pezzullo and his team are still bullish on, partly because it’s positioned well thanks to its reliable, cheap gasfields located in Papua New Guinea.

STO is also well-placed on the net-zero push too, with a solid footing in carbon capture operations. “People are realising you need to have a spread of energy sources, and carbon capture becomes a more acceptable outcome. It’s an expensive technology but it’s going to be necessary,” Pezzullo says.

The Perpetual quality filter

He falls back on his team’s four quality filters. While conceding they’re basic points, they’re no less crucial in identifying companies that have a stronger chance of performing through rising inflation and other challenges. These are:

1. Good management – the LTIs and STIs
2. Great balance sheets
3. Attractive industries, and
4. Profitability.

On this last point, Pezzullo says many concept stocks have survived only because the market was willing to accept longer paths to profitability. But he sees good reasons to own Quality companies, which in many cases run more traditional businesses that are incumbent leaders in their field.

Why? Because capital is scarce, concepts are going to be harder to finance. “It’s hard to justify 50 times sales multiples, as we also we saw in the 90s,” he says.

At the same time, if newer types of companies are no longer challenging incumbents, such firms that were often facing direct threats previously will benefit. “Some of the more traditional businesses that own more real assets should do quite well,” Pezzullo says.

Equities

How Perpetual's Vince Pezzullo invests when multiples retreat

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