Volatility is the mother of opportunity

It was a somewhat unique situation to be interviewing a former colleague when I sat down with Marcus Bogdan, CIO at Blackmore Capital recently. So, I have been across his investing style for a while and have always liked his conservative and understated approach underpinning his long-term outperformance. 

The timing of our chat was auspicious as well, with the market having just hit new highs, yet (as we soon found out) being on the cusp of a sharp pullback. Volatility is the mother of all opportunity though, and as we hear below, Marcus had spent the previous few weeks trimming, with the fund's cash position close to maximum, ready to deploy once valuations looked better. 

Challenging markets like these are Marcus' bread and butter, having learned the ropes during the dramatic events of Australia's last recession which he recounted when we caught up. 

You may have seen a few snippets from our discussion in recent weeks. Now you can read the entire discussion below. 

Full transcript

Dan: And recording. Thanks, guys.

Alex: Okay. Great to have you here, Marcus. Thanks for coming along. So just to get the ball rolling, could you tell us how you got started in the markets? What were the market conditions at the time, and how did this shape your investment philosophy and your process. 

Marcus: Sure. Well, I started my investment career in Australia's last recession. It was the early 1990s. In the year I started, interest rates were 17%, unemployment was over 10%, and we saw a number of financial crises. We saw two state banks foreclose, that was the State Bank of Victoria and South Australia. We had the Pyramid Building collapse, and we also had deep operational losses in Westpac and ANZ. And it was, in fact, the worst banking crisis for 100 years in Australia's history. So it was quite significant. 

And so starting as a young analyst, the impact of that on the importance of balance sheet conservatism, on the quality of earnings and the resilience of earnings, really lodged very deeply in me as an analyst, and in helping me prepare for things like the global financial crisis where, again, we saw incredible duress on businesses and balance sheets. But we'd seen a lot of that already in Australia's last recession.

This certainly made us focus on earnings through the cycle, earnings quality, balance sheet conservatism, whether it's hard assets on the balance sheet or the level of leveraging in balance sheets, they are critical elements in the way that we shape portfolios. 

We also like to know where companies are in their earning cycle and the sorts of returns that they have achieved historically. But what was very clear from that recession was that you could have very good, sound businesses, but if they're in the wrong financial structure, it was devastating. And we saw that again repeated in the global financial crisis.

Alex: What are the chances of another Australian banking crisis? 

Marcus: Well, we always have economic cycles, and a lot of the time, there are different drivers. I think what's happened since the global financial crisis is that the banking sector, through Basel and capital support, has been significant in underpinning the banking system, which is a critical foundational point in any economy. 

And Australian corporates, in particular, if you look at net debt to EBITDA for industrial companies, is around one times. And so we don't have the extent of leverage in the system that we did, nor do I think we have the complexity around financial structures. So both of those things are quite different.

Alex: You travel a lot to speak with company management and other industry participants to help you deeply understand industry trends. So how much of a part of your process is this? And how much edge do you think it delivers?

Marcus: Travel is a critical component, and it's also the most interesting part of our role, is going out in the field and doing primary research. Not only interviewing the companies that we're invested in or particularly new companies, but looking at the competitors, looking at industry structures, interviewing industry consultants, interviewing regulators, and having that broad spectrum of different views. Bringing all of those together helps us generate our ideas and our thinking about companies that we have in the portfolio.

Alex: You recently returned from a trip to the UK. Can you share three of the key findings from this trip that are relevant to the Australian market?

Marcus: Sure. The first one was Brambles (ASX:BXB), which is an Australian listed company, but primarily has the bulk of their earnings both in North America and in the UK and Europe. And they're a very interesting case study because they are critical in supply chains, and so they give you a very good litmus test of what's happening in underlying economies. And it was very clear from our discussions with them that economic activity had slowed, particularly in Europe, where they are very much more sensitive to exports. Economic growth in the US had also slowed but from above-trend levels back to more normalised levels. And the way that they were approaching difficulties in cost, in both labour, transport, and energy, and their ability to be able to pass those on through to their customer base. That was the first company.

The second company was CSL (ASX:CSL), and particularly Seqirus, which is the influenza business. CSL has got a long heritage in influenza vaccines, but they made a significant acquisition at the end of 2014, where they bought a business from Novartis. And at that time, that business was loss-making, but it had world-class research, particularly around cell-based influenza vaccines. And through CSL's industrial focus and efficiency of capital, they have instigated a remarkable turnaround in their earnings profile. So where it was losing circa $245 million USD back in FY'16, it is now expected to be earning around $200 million in FY 20, or an EBITDA margin of 20%.

And the third company that we saw was Ocado. Now, Ocado are an online grocery deliverer of products. And the relevance of Ocado to Australia is that they formed a joint venture with Coles (ASX:COL) to build the first online distribution centres for them, one in Melbourne and one in Sydney, using robotic technology. And what we were trying to distill was whether you could actually generate sufficient returns and earnings and actual earnings growth from online grocery compared to the physical store. Because at the moment, online is, at best, breakeven compared to 3% or 4% EBIT margin that they are achieving in the physical store network. And so insights on how they were approaching their market and their confidence around it, of being able to lift returns in online, was particularly interesting.

Alex: So what was the last stock you added to the fund, and can you outline its journey through your research process and the thesis for holding it today?

Marcus: Sure, sure. Well, at the onset, we're a low turnover portfolio, and so it's not regularly that we're bringing new stocks into the portfolio. So several months ago, we reinvested back into Ramsay Health Care (ASX:RHC). Historically, that is a company that we've held. But several years ago, it was very clear from the trajectory of earnings that they were pulling virtually every financial lever to lift up returns. And you saw a terrific escalation in earnings per share growth, up to 14% to 16%. 

Now, those earnings now have been re-based, and as we look back in history, we can see that they were over-earning at that period of time. And those earnings were re-based to around 2% to 3%, which we thought was a very interesting time to go back and look at the company. We like its geographic footprint in both Australia, in private hospitals, in the UK, in France, and now more recently with an acquisition called Capio, which is in Northern Europe. We liked the profile around healthcare and demographics, and also being part of a company which is a leader in certainly private healthcare, in those jurisdictions.

Alex: Great. So taking a wider lens, what is your current view of Australian equity market valuations?

Marcus: Well, we've had an extraordinary set of circumstances since December, and we've seen markets rise over 20% from their lows in December. And so we've seen the price-earnings ratio for the Australian market go from 14 times, which is the longterm average for our market, to over 16 times today. But it hasn't been driven by better earnings profile. In fact, we're seeing a number of downgrades and cuts by analysts. But it's been driven by unconventional means. And so given where earnings are where the price-earnings multiple is, we are cautious. And so we have stepped back in the last couple of weeks, where we've actually raised cash levels quite materially in the portfolios as we are struggling to find value at a reasonable price [Ed note: Filmed on 2nd August, the week before the market fell steeply].

Alex: Do you think, given that context, reporting season could see a few companies get smashed on results?

Marcus: Well, we've already seen a number of companies' pre-alert earnings stress, and we're seeing that in the industrial space, we're seeing in the consumer space. And that's very much been a daily and a weekly phenomenon. And so I think for the earnings results season, it will be very much around the outlook statements. And whether, since we've had the re-election of the coalition government, certainly around government there, we've had interest rate cuts, we've had tax cuts, whether any of that is starting to filter into a company's earnings profile. And so that's the emphasis that we'll have on reporting season.

Alex: Given a strong recovery over the last six months, how are you positioning Blackmore's portfolios today?

Marcus: Well, it is very much diversified across value, growth, and our key driver in our portfolios is quality at a reasonable price. We're finding it much harder to find quality at a reasonable price where the multiples are today. And so we have stepped back and we've raised cash levels up to 20%, we can go as high as 25%, but I think that's indicative of where we see the market now. And hopefully, we can use the cash to be able to invest counter-cyclically when markets do have some form of retracement. And so we're well placed to benefit from that.

Alex: Is there a consensus trade out there that you think the market has wrong today?

Marcus: Well, we're looking at Healius (ASX:HLS), which is formerly Primary Healthcare. I think the market really has built in very little expectation that this business can be turned around. But in the healthcare space, we actually like it. We like the fact that it's in general practice, pathology, and diagnostics. It has a very good position in each of those sectors. The federal government has been very supportive of a ten-year plan for general practice, particularly in treating chronic health conditions. The multiples compare to other healthcare stocks are at a substantial discount. It's on a EV/EBITDA of nine times or PE ratio of just over 15 times, which is at a substantial discount to other companies in the healthcare sector. Admittedly, earnings per share growth is less, but we think that they are at the nascent stages of turning around this business and we still remain very constructive around the healthcare sector and it's an overweight in our portfolios.

I think the market is waiting for evidence of some indication that they're actually turning around earnings and that they can generate earnings in a consistent manner. It has been bedeviled by a range of issues, which has led to significant write-downs and I think, given that you've had over a decade of disappointment with that company, the market is sceptical and hence, it is not placing any premium in its price today.

We like the space and general practice, pathology, and diagnostics. We like where they are positioned in the industry, and I think we're starting to see some signs of greater consistency and better execution at a corporate level.

Alex: Healthcare is something you've generally had quite a lot of exposure to, and something of an area of expertise that you leverage as a manager.

Marcus: Yes, I mean, we certainly try very much to stay within our areas of competency, and so, portfolios are overweight in the industrial sector and also in the healthcare sector. And historically, if you look it at our portfolio over a number of years, we've had our biggest positions, both the industrials and in healthcare space. But in particular in healthcare, we like the fact of ageing demographics, we like the fact that a lot of these companies are in multiple jurisdictions so they're reducing regulatory risk, we like the volume growth and we also like looking at companies that are either number one or two in the industry so that they can deliver volume at an efficient price.

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Blackmore Capital's long-term outperformance is a testament to their belief that better risk-adjusted returns can be achieved through an active process of company and industry visits. Find out more here.