When valuations depart from reality, be sure to stay disciplined

Note: This interview was recorded on Friday 15 November 2024

With markets at all-time highs, it's more important than ever to remember that valuations can run away from reality at times. 

This is not lost on Glenmore Asset Management Chief Investment Officer, Robert Gregory. 

"We live in an environment where companies that perform really well, their valuations can move very quickly and to quite expensive metrics", highlights Gregory. 

To safeguard against this reality, Gregory encourages valuation discipline and keeping a decent cash holding "because, invariably, we will have corrections along the way", says Gregory. 

"And those corrections can be really good opportunities to buy companies that you want to own at attractive prices."

Gregory's focus on discipline has served him well - he's been one of the best-performing Australian equity fund managers in the country in recent years, delivering a +19.3% p.a. return since his Fund's inception in 2017 (as at October 30, 2024).

In the following episode of The Pitch, Gregory discusses the current market conditions but also why he prefers bottom-up stock picking. He also shares the company he would want to hold if markets closed for the next five years and the company in his portfolio that he regards as highly innovative. 

Edited Transcript

Chris: Rob, how much do you focus on macro, if at all, and how do you see things unfolding over the next, let's call it 12 to 24 months?

Rob: Macro is not a big part of the companies that fall into the portfolio. Most of it is just bottom-up, finding great businesses that stack up from a quality, earnings growth, and valuation perspective.

But look, I'm always monitoring the macro situation. Obviously, we are moving to a period where inflation is a little bit higher, but largely under control, rate cuts are playing out in the US, which has been very beneficial at the moment.

It appears that rate cuts in Australia keep getting pushed out, which is unfortunate for the small to mid-cap part of the market.

One point I would call out for the macro piece that I do use is almost more of a contrarian point of view. So as an example, a few years ago when bond rates were moving up quite aggressively because of inflation being too high, that resulted in a few sectors really facing some challenging near-term trading conditions.

So the consumer discretionary companies were struggling with the cost of living pressures and interest rates going up. The REITs were struggling because, as we know, REITs tend to underperform when bond rates are going up, and even some of the market-linked earners, like the fund managers and the platform businesses, were being sold off just with falling equity markets.

So where I do use the macro piece, from time to time, is when a certain set of macro conditions are making trading conditions quite tough for a sector in the near term. So the next six to 12 months can actually be a trigger to start doing the work on those companies in those sectors because you often have a situation where the earnings outlook for the next 12 months is tough, but it hasn't really impacted the medium-term outlook even though the stock prices might've been sold off quite a bit.

Rob, what are the biggest risks to the outlook and what are one or two factors that you think could change your mind?

Perhaps inflation. The central banks have done a lot of heavy lifting, getting it down from those 6-8% levels down to 2.5-3.5%.

I think with Trump getting into power, some of these policies potentially look like they could be inflationary, so I think that's something we've all got to monitor. So that's probably a bit of something that you've got to keep an eye on.

Certainly, if we saw a return to an environment where inflation started picking up and perhaps central banks had to start lifting rates again, that would be a trigger to re-evaluate certain holdings in the portfolio.

If that case were to eventuate, inflation goes up, we don't get any rate cuts in Australia, and we get rate hikes that change the earnings outlook for some of the positions in your portfolio. Are you looking to exit and keep powder dry? How does it play out in the portfolio?

It would be a trigger to further look at the valuations of certain stocks in the portfolio. At the moment, the Fund's got quite a decent cash holding, as it typically just does, on the basis that invariably we have corrections along the way. But I think it would be a modest shift - you wouldn't see a radical change in the companies in the portfolio.

Rob, enough about the negative, let's focus on the positive now. If the stock market were to close for the next five years, what's one stock in your portfolio that you'd be happy to hold?

Yeah, it's a great question. The company I would nominate would be Arena REIT (ASX: ARF) which is a REIT that basically acts as a landlord.

The vast majority of the tenants are childcare centres. It does have a small number of healthcare tenants. The positive attributes of the leases in the childcare sector, particularly for Arena, are very well documented.

So very long leases - the average WALE (weighted average lease expiry) for Arena’s leases is around 18 to 19 years. It has a very positive lease structure, so every year the rent will increase by the higher CPI or a fixed set percentage.

The leases are typically triple net leases, which essentially means the tenant is responsible for all of the maintenance and upkeep of the property.

The last point is that the occupancy is very high, so 99.7% occupancy of the portfolio, so high-quality characteristics in terms of the valuations. It’s probably not as cheap as some of the lower-quality REITs, however, I think if we're turning off the market for five years, I'm going to put a bit more weight on the quality of the company and probably a little bit less on a cheap valuation.

It's also a company with a long history of producing very consistent growth in earnings per share and dividend per share, so it's a company I feel very confident in.

You've mentioned a couple of times that at the core of a great investment is a company delivering a great product or service. Oftentimes they're doing something innovative, they're disrupting their space to deliver that great product or service. What is one company that you hold that you think is doing that well?

The company is Hub24 (ASX: HUB). It's really had a long history of being very innovative as a platform business. It's essentially a software provider to the financial advisor and financial community, and I wouldn't say there's been any one or two big bang pieces of innovation, but rather just a long number of iterative improvements to their platform.

Jason Entwistle, who's the head of product strategy at the company, has been there since the start, and the company's innovation effort is very well organised. They've got a Hub innovation lab and that's a group of people who are purely there to constantly look at how they can improve the product, how they can make life better for the advisor, how they can allow financial advisors to service more customers - which ultimately makes their business a lot more scalable. 

One thing Hub24 did was back in 2018, six years ago now. They identified machine learning and AI as critical features, critical things to implement into their products.

They've done some things like using AI to scrape data off forms that previously weren't being scraped off, and then using that data to streamline operating processes. The other thing I think I'd call out is they're very customer-obsessed.

A lot of the innovation comes about from HUB being very close to the advisors and their customer base listening to where they think it can get better. And as Hub24 often say, sometimes to be innovative you need to admit you're wrong and you need to go back and wipe something that you've done two years ago and improve it. It's a really high-quality, innovative process that they're running.

One of the knocks on Netwealth and Hub at one point was the race to the bottom in terms of margins, in order to attract fund flow. It sounds like from what you're saying that they're using the innovation angle to add features, add benefits, to overcome that issue.

I think the margin pressure was very heavily picked over by the market a few years ago for Hub and Netwealth, particularly when BT Panorama came in with some new pricing. The fee pressure will always be there, to some extent, but it has moderated in recent periods just because, I think, the larger incumbents realise they still have to be making a profit.

The industry, as a general comment, knows that there are a lot of investment needs that need to be made. So I think the pricing has become more rational in recent times.

What's one piece of advice that you think is important for investors to remember over the next couple of years?

Be really disciplined on the valuations of the stocks in your portfolio. We live in an environment where companies that perform really well, and their valuations can move very quickly and to quite expensive metrics. So I'd say be really disciplined, and keep a decent cash holding because, invariably, we will have corrections along the way.

And those corrections can be really good opportunities to buy companies that you want to own at attractive prices.

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