Where these fundies still see value

With vaccines on the way, a settled election and the index returning to its February 2020 highs there has been a lot of good news for markets recently. However, making a return on this good news is easier said than done.

I've had people ring me up in the past week saying "I've seen this vaccine news, must be a great time to invest. I want to put some money in." That's like calling a bookmaker after the Melbourne Cup and saying, "Makybe Diva's won, I want to put some money on it." says Steve Johnson of Forager Funds.

In this thematic, Matthew Kidman leads the panel with Steve and Ben Rundle of NAOS Asset Management as the trio share their insights for 2021, the current opportunity set in the market and which sectors present valuable opportunities right now.

Notes: Watch, read or listen to the discussion below. This episode was filmed on 2 December 2020.

Edited transcript

Matthew Kidman: Welcome to the thematic discussion brought to you by Livewire Markets. I'm Matthew Kidman, and today we're going to talk about what's happened over the year. It is December, we're all exhausted, and what a year it's been. We've been up, down, up again, and guess what? The Index is the same as it was on January 1, but it doesn't feel that way. It has been an enormous change that we've all lived through, and all good stock pickers change their portfolio and their portfolio speaks to them, it talks to them and tells them what's happening out in the market.

To discuss the situation, we've got Ben Rundle from NAOS Asset Management and Steve Johnson from Forager Funds. Steve, start with you. What is your portfolio whispering to you? Sweet nothings at the moment? Is it a good environment? And have you turned it over a lot since that way back on January 1 when the Index was about the same as it is now?

Steve Johnson: Maybe I'll start with the second question, Matthew. The answer is yes, quite a bit of change. For us, the biggest difference has been out of some things that hadn't been working for us for years and into some businesses that are performing very, very well, so the quality of the portfolio has improved quite a bit. That's a lot easier to do when you've got lots of opportunities in front of you. We probably should have done it earlier, but easy to do when there's lots of opportunities in front of you.

I'd describe the overall opportunity set as probably a six out of ten. It's a little bit better than average.

Matthew Kidman: What was it in March?

Steve Johnson: A 10 out of 10. Yeah, and it's hard to convince investors. I've had people ring me up in the past week, "I've seen this vaccine news, must be a great time to invest. I want to put some money in." That's like calling a bookmaker after the Melbourne Cup and saying, "Makybe Diva's won, I want to put some money on it." It just doesn't work like that, right? We've seen the market move a lot, and I think the opportunity set is worse today than it was even a month ago or two months ago, but it's still good.

I still think you'll own equities for the next 10 years here and you're going to do fine, and I still think there's a lot of diversity out there in terms of pricing of individual businesses. For us as stock pickers, that's a healthy environment for adding a bit of value over and above what markets do.

Matthew Kidman: Jeez, we're talking 10 years, Ben, I'm trying to get through this year. I'll put the same question to you. A lot has changed. The Index might be flat and that's just the way it's panned out over 12 months, but has the opportunity changed? We are in a recovery, we have got lower interest rates. How does that affect your portfolio?

Ben Rundle: Look, I think from a general investor standpoint, the opportunity has changed, because what's happened is there's been a huge amount of stimulus come into the market, and all of a sudden we're seeing a lot of economic indicators really improving from where they were. I think you're going to continue to see that drive the overall economy. So from where we sit at the moment, there seems to be a lot of opportunities and a lot of rocks to look under.

To Steve's point about portfolio turnover, I was having a look before this about what our portfolio looks like now verse 12 months ago, because I think that's an interesting exercise to go through, particularly given what the market's done. I was quite surprised, there was only two changes to our portfolio and that's a little bit due to our investment process. So we are super concentrated investors, we've only got about 10 to 12 holdings in each fund. The very nature of liquidity means if there's a huge selloff, we're not selling out of our position the following day. Steve makes that point too.

You get calls from investors saying, "Well, move into this part of the market, move into that part of the market." I think action for the sake of action doesn't generate investment returns, you always find yourself chasing your tail. So fortunately that strategy for us this year has worked out quite well, and you end up being in stocks that eventually start to do well, and you've got a position in your set and you can ride that wave.

Matthew Kidman: So those two new positions that you've taken, was that towards the bottom? Was there value created? Where did you move into?

Ben Rundle: Well, we got lucky with one, we got to takeover bid in January or February for one of our stocks and sold into that prior to the pandemic. There was only one new position, we topped up an existing position. But the way that we look at new positions in the portfolio, typically it'll be a company that we've been looking at for a long time. In a market where you do get a selloff, then that's your opportunity to buy something that you've maybe liked for a long period of time and the valuation just didn't make sense. That was the case with this particular stock.

So yeah, they do provide opportunities, depending on how much cash you're sitting on, depends on how much you can take advantage of them. But yeah, I think that just creating portfolio turnover for the sake of it doesn't generate a healthy return.

Matthew Kidman: Now, we'll leave that cash for a second and we'll come back to it. Steve, where is the opportunity? If you think you're going to be in the equity market for 10 years, you're a value investor. Where is the value sector-wise at the moment?

Steve Johnson: I would say it's more individual stocks across the market, but if I had to pick one when I look at our portfolio at the moment, I would say really well-run discretionary retailers. There are plenty of opportunities in that space that we are looking at the moment and own at the moment. So we own MotorCycle Holdings (ASX: MTO), we've recently added a bit of Michael Hill (ASX: MHJ) and Shaver Shop (ASX: SSG). Three examples, I think, of businesses where people have forgotten that the consumer was really struggling leading into COVID. We had two and three years of a consumer that was battling and lots of these businesses were doing it tough with pretty low same-store sales rates.

I think what Ben's touched on there, this stimulus rolling into 2021, I honestly think this is a bit of a World War II moment. You had the depression in 1929, you had 10 years of economies really struggling to get started, and then a war and everyone said this is going to be a disaster. All these governments are taking on debt and it's terrible. It turned out to be the massive stimulus that the economy needed.

I think we're going to sit here at the end of 2021 into 2022 and say we actually needed that addition of fiscal stimulus. Monetary stimulus is not working, and has not been working for years, you finally got the fiscal stimulus behind it. I think some of these businesses have been working really, really hard through difficult times to improve their businesses, to get more productive.

In the case of MotorCycle Holdings, it's bought a bunch of businesses that were struggling at the time, it's got the rights to sell Indian here in Australia. It's not the same business that it was in 2019. I think although the share prices are up, everyone is just looking at it saying it's going to go back to 2019 profitability. I think it'll do much better than that over time.

Matthew Kidman: Okay, Ben, let's get back to your scenario, cash. How much do you hold at the moment compared to what you would have done 12 months ago? Because that's a pretty good sign of actually how you're feeling.

Ben Rundle: Yeah, it is. So, cash for us is a direct reflection of the opportunity that we're seeing in the market. So at the moment, we sit on about 5% cash, I think pre the pandemic, we had about 10% cash. So, typically very low. Actually, I was going back through fund manager monthlies the other day and looking at what everyone was holding at the bottom of the pandemic, and there was a long list of financial holding, 40% and 50% cash at the absolute bottom, which tendency leans you towards that way to be cautious.

But typically for us, we sit on very low cash levels, purely because we are concentrated. If we can find an opportunity, we aren't trying to time the market, we'll invest if we think the company we're investing in is at the right valuation, regardless of what we think the market's going to do.

Matthew Kidman: But you have got less cash, which is a good sign. That must mean you're generally positive. I'll put to you the same thing, you're looking at stocks all the time. Sector-wise, what looks attractive now? What would you be focusing your attention on?

Ben Rundle: So I think Steve makes a good point, is there's certain stocks and there's certain parts of sectors that I think look interesting at the moment. So, I'll give you an example. If you look at the tech sector, I don't think there's anyone out there who doesn't agree that the tech theme or tailwind will continue for quite a few years time. Now most of the sector looks screamingly expensive, but there are certain pockets of the sector which don't.

Superloop (ASX: SLC) is an example of a business that you can buy it at below replacement cost. Their assets are relatively new, and so because of that, I think the most utilised part of their network is only about 30% at the moment. They've gone through this investment phase and now going through the earnings growth phase where you're getting a huge tailwind of people requiring more data, faster internet. That fibre network will really become an infrastructure-like asset that's going to have a significant amount of earnings growth over the next four or five years.

Matthew Kidman: So, Steve I'll put the same question to you. Cash, it's an insight. Are you holding more or less than say 12 months ago?

Steve Johnson: Less. So, five to fifteen for us is normal. We are currently at five, we were running on fumes up until a few months ago, we literally had every cent that we could scrape up invested. I still think it's reasonably perspective out there, but again, it's changed a lot, even in the past month. Portfolio's up 13%, 14%, both of our international and Aussie fund just in the last month, and that's on the back of a pretty strong period prior to that. I still think it's a good opportunity set, it's just not what it was a few months ago.

Matthew Kidman: So if I went back 12 months, you were close to that 15% mark?

Steve Johnson: Would have been about 10 in both funds, that's right. Yeah, exactly. People pay me to invest their money in the stock market and I want to be mostly invested most of the time. So for us, that means in that five to 15 range, eight years out of 10, I would say. If we're above that, I'd take it as a signal, if we're in that range, it could change overnight. It could change with one idea, could be a restructuring or a cap raise or a takeover that changes that cash waiting for us fairly significantly, just from one week to the next. So, five to 15 is just normal operating levels of cash, I would say.

Matthew Kidman: So, it's been an unusual year. 20 odd years I've been around, I've never seen something drop 38% and then get it all back before the year was out. Lessons out of 2020. What have you learned as a portfolio manager? Because you can't sit here and tell me you've experienced this before, it's new.

Steve Johnson: It is new. Number one lesson for me, businesses are dynamic things, they're not spreadsheets. We all sat there in March and we said, "Well, this business' revenue is going to be down 30% and therefore it's going to be losing money and it's worth nothing." That was a massive, massive mistake from people, because when you've got a business with a good management team and someone with a whole heap of skin in the game, they can change what their business does, they can change its cost base. You've seen dozens and dozens and dozens of businesses turn around and say, "Okay, our revenue is down 30%, but our margins are actually up."

Ben and I are both big shareholders in a company called Enero (ASX: EGG), which has done an absolutely sensational job through this environment. It's in marketing services. Everyone looked at it and said this thing's going to get absolutely hammered, and they made more profit last financial year than they made the year before. That's been a really big thing for me. I think if you can find the right business, you just trust the management to get on with adapting to the environment and you don't need to worry about it anywhere near as much as an investor.

Matthew Kidman: So from that, don't be as scared as the real world feels, because businesses can evolve. Is that what you're saying?

Steve Johnson: They can evolve and they can adapt to the environment that they're in, yes. I think that's why it's important that they've got the balance sheet to manage that. You need to look at financial leverage and those types of things, but also look at the incentives for the management team to really do something about it. I made another mistake back in March of thinking, okay, there's going to be all these capital raising, I want a little shareholding in all these companies that are going to raise capital. So we went, where's all of the debt, let's go around and buy a little bit of shares in all these companies that have got debt.

You know all the companies that raised money were the ones where there was no skin in the game. The investment banker walks up to the board and says, "You guys need money." There's no risk, there's no downside for people that don't own shares. We should've thought about where are the incentives, not where's the balance sheet risk. Because MotorCycle Holdings had a lot of debt, we didn't buy anywhere near as much as we should have at the bottom. But the guy who owns it owns 30% and he's not diluting himself unless he absolutely needs to. So that was a second lesson for us, yeah.

Matthew Kidman: Ben, I'm sure back in March you thought, "Well, that goes an era, there goes our biggest investment." We all had those moments but what were your lessons? Because no one wrote the book for us going back to January when we were listening to some elevator music.

Ben Rundle: The best lessons you get in investing are when you lose a lot of money. Because if you make a lot of money, you think you're a genius, if you lose a lot of money, that's really where you get found out. So going through that huge selloff period, a lot of people remember it, we're at home, there was no one to talk to in the office and say, what's going on? What do you think? It was very much, you're on your own, looking at stocks fall very, very aggressively. So, what I did was actually create a daily diary and write down just some of the things that I was seeing, some of the things that were happening.

Since then, I've gone back and looked at that diary. I mean, granted we've come out of this selloff period a lot quicker than what we're seeing in the past, but going back and having a look at some of the things that were happening, it's an absolute 100% different story today. I think the lesson I learned out of that is that the good times don't last forever, but neither do the bad times.

As I said, it did recover probably a little bit more quickly than what we've seen from other crises. But it's still the same in terms of at the bottom, it seems like the world is ending, and then a couple of years or a couple of months later, things can really change. I think that's something to just keep in mind with investing, that the market hasn't gone to zero, It's grown over time.

Matthew Kidman: We all panic in that situation.

Ben Rundle: I think everyone panics in that situation. I think the best thing you can do is, Steve said it'll make you realise which companies are strong and which ones you want to own. I think coming out of it, if you tilt your portfolio in that direction, then you'll do extremely well, when and if the, more likely when, the recovery comes.

Matthew Kidman: You can write it down, the good times are going to keep rolling.

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