You can now watch our latest webcast on demand, where our Chief Investment Officer Simon Mawhinney and Investment Specialist Julian Morrison discuss fund performance, as well as delve deeper into stocks we hold such as AMP and Nufarm. The webcast lasts just 30 minutes and CPD points are available for advisers who watch the webcast. Or, if you prefer, you can read a transcript of the webcast below:
Allan Gray Live webcast transcript – July 2019
Hello and welcome to the Allan Gray Live Quarterly Investment Update. My name’s Julian Morrison, National Key Account Manager for Allan Gray. I’m joined today by our Chief Investment Officer, Simon Mawhinney. Simon, thanks for joining us.
In a moment, Simon will be taking us through one of our more recent additions to the portfolio to give you some greater detail on how we’re applying our contrarian investment approach in the current market. Just before that, I’m going to run through some perspectives, performance and positioning of our funds for the last quarter, and then we’ll get onto Simon’s stock update.
Now, this is a forum for your questions, so if you have any questions, please click on the blue raised hand icon at the top right of your screen. Submit your question and we’ll get to that in the Q&A session toward the end of the webinar. A last point to note that there are CPD points awarded for this seminar. Also, you can collect them from the online site at the top right of your screen. The light blue button downloads those points.
And lastly, I must add that all the information we provide today is of a general nature only, so none of this is to be taken as specific investment or product advice. So with that, let’s get started. So where are we today? Well, the broad Australian market has risen strongly over the last 10 years. And depending on how you define a bull market, it starts from probably the depths of the financial crisis.
Over about 10 and a half years, the market has risen by about 12% compounded per annum, which is stronger than the long-term average. And in just the last six months alone to the end of June, the market has risen 20% in total return terms. Now, for most investors, this probably feels quite good to have a strongly rising market. But if you’re in the business of looking for the cheapest, most underpriced, unloved stocks, this can present a bit of a challenge. Perhaps even more challenging and somewhat concerning is that the areas that have driven the strongly rising market are some of those areas where we at least feel prices were already distinctly overvalued for some time. And so the risk of overpaying is significant, we believe, in those areas of the market. But the consensus seems to be riding strongly upward.
If we need a reminder that consensus can be wrong at times, just look to the federal election that was held in Australia during the last quarter. This chart here shows the betting odds for a coalition victory in the months leading up to the election, and we can see that whilst the coalition was an outsider even to begin with, a total around four or five to start with, odds rose as high as 14 which suggested they were extremely unlikely win. Of course we know that they did. Now, this tells us a few things as an analogy for investing. Firstly, the consensus can be distinctly wrong. Secondly, when the outcome differs from a strongly held consensus view, prices can move very, very violently. And lastly, even if you are right about your opinion, you may have to wait patiently and look wrong for a while before you’re rewarded.
Moving on to our funds, looking at the last quarter, we can see that we and our investors have had to wait patiently over the last quarter and indeed the last year whilst we’ve suffered some underperformance. While our most conservative fund, the stable fund has underperformed, sorry, outperformed its cash benchmark, those of our funds with a greater exposure to shares, in particular our Australia Equity Fund and our Global Equity Fund run by Orbis, have underperformed meaningfully versus their benchmarks. And that underperformance has fed through to the Allan Gray Australia Balanced Fund, which has investments in similar shares to those funds.
We’ll touch now on some of the attribution for the underperformance. So one way to look at this is to look at the ASX 300, the broad Australian sharemarket, total relative returns by sector for the second quarter. So, these grey bars simply show the performance of these sectors versus the broad market over the last three months. We can see on the left, telecoms has outperformed most strongly, followed by healthcare. And on the right, the energy sector underperformed most meaningfully, followed by the utilities.
So considering that this is the order of performance of the sectors versus the market, we can now overlay with these red bars the exposure that we have had in the Australia Equity Fund to those sectors. So, on the left we can see that we’ve had an overweight position in telecoms, while we’ve had an underweight position in healthcare, financials and industrials moving to the right. So in a general sense, we’d like to see lots of red exposure above the zero line on the left, and underweight positions represented by red bars below the line on the right. And that’s not been the case.
Looking at some of the detractors to begin with, in particular, we’ve had a significant underweight to financials, which has been an outperforming sector for the quarter, which has contributed to our underperformance. But as our longstanding investors know, we are stock-specific individual company based investors based on fundamental valuation. And if we look at the individual stocks within those sectors, QBE has been a large holding for us in the financial sector, and that has driven some underperformance during the last quarter. Notwithstanding that QBE has outperformed over the last 12 months.
As we move to the right, we can see Metcash. Our exposure there has driven underperformance in the consumer staple sector and our significant overweight exposure to energy has also been a key detractor in energy as the weakest performing sector for the last quarter and indeed for the last year. Our exposures there are Oil Search, Origin, and Woodside. We’ve had some questions on our exposure to the resources sector, so I’ll ask Simon to address that maybe in a moment.
Firstly, looking at some of the positive contributors for the quarter, it’s not been all negative. Our significant exposure to Telstra and overweight to that sector has helped us offset some of the underperformance over the last three months and indeed the last year. Exposure to Austal and the industrial sector has been a very strong performing stock, and we’ve been trimming that in recent months. And also our exposure to Newcrest has been a very strong contributor to performance over the last three months and a much longer period as well. So, these have been some of the positive features, not quite enough to offset the underperformance previously discussed.
So how have we responded to that? Well, typically, you’d expect us to buy more of the things that were down and unloved and to sell, reduce some of those things that had been performing very well. So, here we show the top buys and sales over the last six months. Now, I might just ask Simon to touch on some of these. So, Simon what have you been reducing and trimming from the portfolio and what had been adding to?
Most of the reductions have come from as you can see, things like Newcrest Mining, which has been a trimming exercise for us on the back of some very strong performance. But then also some Telstra, as Julian mentioned, was a strong contributor to our performance or an offsetter to our underperformance. But the big theme, if I look over the last six to 12 months, has been that we’ve been selling a lot of the stable and defensive earners.
And on this table you can see AusNet and Chorus, and we’ve been using that money to buy companies which happen to be cyclically impacted or more cyclically impacted, but trade at very attractive prices. And so, we seem to have been, as these defensive companies have become very highly priced, we’ve moved out of those into the sold off cheap cyclicals, and NAB is an example. You can see some of the oil stocks, even some buildings stocks like Fletcher Building we’ve bought.
Great, thank you, Simon. I think some of the questions coming through as to where the money is deployed will be interesting to get onto as to where that money has been redeployed, and we’ll get to those in a moment. Just moving on quite briefly. So, given that’s the case and we’ve been reducing exposure to some of the better performing stocks and looking for new places to put that money to work for our clients. Now we look at a much longer term perspective. So, here we can see a 10 year relative performance chart for the sectors of the Australian sharemarket. And over 10 years, we can see healthcare has far and away been the strongest performing sector followed by the REITs, the property sector and utilities. On the right-hand side, we can see energy has been a perennial underperformer over the last 10 years.
So, how are we positioned with regard to those sectors? As one might expect, again, we have the most significant exposures as shown by these red bars here, overweight positions in energy, materials and telecoms, and in consumer staples. Those sectors that have underperformed the broader market over a long period of time where we think prices are depressed and valuations far, far cheaper, and there’s less valuation risk where we have big underweight positions are in those sectors that are performed more strongly. For example healthcare, where we feel valuations reflect very, very optimistic expectations.
Simon, at this point I might ask you just briefly to comment on firstly the energy sector. We have a strong overweight position there. We have several holdings in that sector and we do have a few questions from investors as to our conviction there given the underperformance over a long period of time. Can you maybe highlight some of the key points?
Yeah, so that’s been our biggest detractor some time actually. And our conviction remains strong. It’s our strong sense that world energy prices are low, well below prices necessary to incentivise new production. And as everyone will know, production from existing fields decay reasonably quickly. And the current excess supply that exists we think will run its course and the market should be a little bit more balanced.
We’re not quite sure when that will be, of course. And we wouldn’t have invested so heavily in the energy sector had we known how long it would take. But it is fair to say it’s very difficult to pick a catalyst when it comes to investing. And we tend not to focus on catalysts. What we do know or are reasonably confident about is that the companies we’ve chosen to invest in are very strongly capitalised balance sheets with little debt, very long-life assets, and for the most part are low on the industry cost curve. And so I think they’ll be able to, I guess suffer these low prices for as long as it takes until the industry rights itself.
And then just briefly, Simon, on the other side, taking healthcare as the best performing sector over the last 10 years. That’s been an extraordinary run. Can that continue? Do you have a view on the valuation of stocks in that sector? We don’t own any of those big popular healthcare stocks.
Yeah. I mean, I guess it can definitely continue. We just find much better value elsewhere. Many of these healthcare companies, given their defensive earnings streams and therefore their ability to pay reasonably certain dividends have become go-to stocks for people in search of yield. And in the process, prices have been put up to levels which seem incredibly elevated from our perspective, but that is our perspective. In many cases, you’re paying low to mid-thirties in terms of multiple of earnings for companies that, for the most part, are growing at low single digit percentages. So, in our view, that sector is fair value at best and potentially quite expensive.
And therefore potentially quite risky.
From one point of view.
Thanks, Simon. Okay, so we’ll just finish up this part of the session by looking at our Balanced Fund and our Stable Fund and the positioning there. So looking at the Australia Balanced Fund, the exposures to Australian and international equities have remained fairly static over the last quarter, with around 60 to 65% of the fund invested in equities across international and Australian. We can see here that part of the international exposure is hedged using index futures which should be somewhat defensive in the event of a market downturn.
On the fixed income side, the most notable feature there is that our duration our interest rate sensitivity is significantly lower to the market. And whilst that’s detracted from performance, relative performance, over the last three months and the last year, as interest rates have fallen, in the event that that were to reverse we would be significantly more defensively positioned than the market.
On the Stable Fund, the red area here shows our exposure to equities over time. The black line shows the broad Australian sharemarket over time. And what you can see here is that we follow our contrarian approach both at the stock level and also in terms of how much exposure we take to shares versus cash given the valuation in the market. As the market has risen higher, you can see we’ve shied away and removed exposure from equities. And as the market has fallen, for example, in the middle of the chart, the black line falls, our exposure represented by the red area has risen significantly. So what has happened in the recent period, as the market has continued to rise very strongly, as I said, 20% in six months and reached all-time highs, currently, I think today it’s tracking around an all-time high the ASX, we’ve reduced our exposure to equities significantly in this fund to about the lowest in the history of the fund at around 20%.
So, this chart of the Aussie Equity Fund is really just to remind us and our investors that it’s a very long-term game. The last quarter, which we’re discussing here to provide an update is just the last blip on this chart. So, I think it’s very important for investors to remain focused on the longer term. And so to summarise this part of the session, we believe the Australian market has been near all-time highs. Certain areas of this market have driven the rise. Certain areas of the market may be distinctly overvalued and investors need to be wary of excessively positive sentiment.
With that in mind our approach, as always, is to focus on investing in areas of the market in stocks that we think are attractively priced, undervalued and typically unloved. And as I touched on at the beginning, following that approach, if you’re opposing the consensus can make you look wrong and feel awkward for a while, but when the rest of the market is being incredibly impatient, we believe patience can be a distinct advantage. And on that, we’re going to delve now into one of the more recent additions to the portfolio in a specific stock, that being Nufarm. So Simon, maybe you can take us through that.
Thanks, Julian. I’m going to make Nufarm’s discussion very quick or brief because most of the questions that I see coming through and some of the pre-received questions all revolve around AMP, and would have been a better company to discuss. And so we’ll cover that off in Q&A. In any event, Nufarm is a crop protection company. Essentially, it formulates manufactures and distributes herbicides predominantly as well as having a side seed business.
And as this chart shows, somewhere along the middle, around the middle of the chart, the enterprise value is around three and a half billion Australian dollars, which is relatively evenly split between debt and equity value. And the first point to probably notice, that’s the sign of an over-indebted company as a result of some of the acquisitions the company has done and some of its headwinds that it’s currently experiencing.
But the bottom of the chart tells us how much money the company should make, both in the free cashflow and almost an earnings sense. And it’s based on guidance that the company’s given, which was its earnings before interest, tax, depreciation and amortisation of 455 million. It’ll spend $200 million of capex this year as per guidance giving a free cashflow of a little over 250 million, which puts the company on a little under 14 times those that free cashflow.
And probably not a bargain, but cheaper than the broader stock market. And we don’t think that this company will grow any more slowly than the broader stock market. But there’s reason to think that this could be incredibly cheap versus the stock market. And I try and show this on the next slide where based on a number of headwinds that the company is experiencing, if many of those abate, the company should trade at less than 11 times its normal free cashflow. And we think that that’s exactly what you’re buying with a company like Nufarm. It’s had a number of either drought conditions or extreme weather events with flooding in North America that has reduced the demand for the products that it distributes, formulates and manufactures. It’s had some issues with some of its European assets from a logistical sense. And if those two things abate, we think earnings should increase by around 50 million. And that’s the top circle that I’m talking about.
The next, if you carry on going around clockwise, is an excessive working capital investment currently, given that they hadn’t anticipated the drought. And so they’ve manufactured a lot more than they need and therefore invested in unsold inventory. And as they have wound back their manufacturing and formulation activities so that they manufacture what they can sell, we think that there should be, and the company has guided to this as well, $400 million of cash generated as they wind down that inventory.
It’s being very weak partly as a result of these earnings headwinds from the droughts, their elevated balance sheet, but also the Bayer/Monsanto glyphosate litigation, which however significant to Bayer is unlikely to be significant for Nufarm. Nufarm is a distributor for the most part of glyphosate, which is Roundup as known to many. And it would be, to think that Nufarm would have a financial liability on the back of this would be akin to a pharmacist who distributes what is an approved medicine and later is found to be harmful being recalled and the pharmacist being sued as opposed to the manufacturer. So, we think that’s very unlikely.
They’ve got an attractive seed business, which is one of the consumers of the cash and has yet to contribute to earnings. And either it’ll be a viable business, in which case it’ll contribute to earnings or they’ll close it, in which case they’ll stop spending money on it. And that has elevated the capex profiles. So with all of those things, it doesn’t seem overly heroic to think that all of these things could happen, Nufarm trades at a very attractive multiple of its free cashflow.
We have only recently started to buy Nufarm, but the price really counts. This is the first time since we’ve been managing money in Australia that we’ve bought Nufarm and that’s because its price has fallen quite significantly, and this chart only covers off on the last year or so. But you can see how we’ve gone from having no holdings as represented by the shaded grey area to about one and a half percent of the portfolio invested in the company, which is not significant. It’s quite a modest weight. But given its elevated balance sheet, we’re conscious that the company may issue equity or do a rights issue, in which case we want to make sure we can follow our rights. But we think it’s very attractively priced relative to the stock market. And for us, price is very important and it’s the reason why we’ve bought a modest position at this stage in Nufarm.
And so I’ll just summarise on that brief bit, but price is important to us. It’s always the central tenet that we use to determine whether we’re going to invest in a company or not. And it’s the price relative to those earnings or the earnings that you will generate from that investment in future. Nufarm has a lot of challenges, but the attraction for us is its price and our assessments that even bad outcomes in future are reasonably priced at today’s share price.
And then touching on some of what Julian has spoken about, given how strong stock markets have been, we continue to focus on preservation of capital and are attracted to companies where we think there are asymmetric payoff profiles to the upside. Nufarm is an example of one of those, but despite our poor performance over the past year, we are tirelessly obsessed with focusing on finding these companies and investing in them and we remain quite optimistic as to the portfolio’s composition and likely future. Thanks.
All right, Simon, thanks very much for taking us through the thesis on Nufarm. So let’s go to some questions now for the Q&A. As we thought, as Simon you said, there’s been quite a few questions that have come through on AMP. Thanks to Vivian, Chris, Tony, Ian and Keiran for those. So, if I was to summarise the sentiment from these questions, one of the key things that’s come up is the sale of the life business and the likelihood that that will no longer go through. And given that’s the case, can you provide an update on your assessment evaluation, the position on the portfolio and whether you still have conviction in the stock and also whether there’s more pain to come before it gets better?
Okay, well, yeah. That’s quite a lot in one. But around 18 months ago, AMP agreed to sell its life business and we, the company’s actuaries and the stock market’s universally felt that it was a bad deal, not because it’s a bad thing to sell, it’s the price they managed to achieve. And the stock market promptly sold the company off by 25% which is or was around two and a half billion dollars in value.
Subsequent to that, there’s been a regulatory hurdle which has resulted in this sale unlikely to proceed. And the stock market has taken a particularly gloomy view on that as well. And the share price has fallen a further 15% and given, which is a bit strange considering that the initial 25% sell off was a reflection of how poor the deal was. And now that it’s not proceeding, there’s similar negativity. But there’s two reasons for that.
The one is that the business has actually deteriorated since they first agreed to sell it. And, according to the company release, by 700 million. And linked to that, there is a concern that AMP will just recut the selling price to reflect the 700 million. Or potentially worse, will keep the business, run it down as a legacy asset and raise up to a billion dollars in excess capital to help them through that process.
And so there’s a lot of people who think that AMP is going to raise a billion dollars of equity. And then there’s other people who think that AMP is going to recut the sale proceeds. From our perspective, yes the business has deteriorated a bit, but to sell something at two and a half billion dollars less than it was originally worth and then for that business to deteriorate by 700 million dollars, net-net puts us ahead relative to this deal proceeding.
So, we are quite optimistic about AMP, or certainly incrementally more optimistic given that this deal isn’t likely to go ahead. But we can’t comment on the likelihood or otherwise of the board re-cutting the selling price or raising equity. We hope they don’t recut the selling price. We’d like them to keep the business, and we don’t think it’s necessary for them to raise equity. At the time of that announcement, AMP was a 3% position in the portfolio. The share price has fallen about 10 to 15%, and we’ve essentially used that weakness to increase our weight in the portfolio to around 3.2%, which is around half a percent of additional buying. Of course because the weight is a bit above where it used to be, but the share price is a lot lower.
So, there’s still a lot of risk attached to AMP. It has a lot of challenges ahead of itself. We’re not naive about the challenges ahead. It’s not that long ago that people were saying similar things, though slightly differently about Newcrest, and it’s gone on to be a very good performer for the fund.
Maybe, Simon, that’s a good segue into the next question, which has come from Andrew on resources and Mark specifically on Newcrest. We still have a significant position in Newcrest. It’s done very well. It’s a large position in the fund. What’s your view there? Does it warrant retaining that position in the fund going forwards? Has it reached your assessment of value? Where does it sit in that spectrum?
I think it’s a very, very good company and it’s not unreasonably priced in the context of the broader stock market. So we have, as you would have seen from one of the slides that Julian put up earlier, significantly reduced our holdings in Newcrest, but it still remains a core part of our portfolio. And until such time as we can find a better stock to replace that, it’s likely we’ll hold some Newcrest in the portfolio. I think gold prices are low relative to the cost of extracting the metal from the ground and still probably don’t afford miners an economic return on their invested capital, which is usually a good time to invest in these commodity companies. But the rest of the Australian listed gold space is not overly appealing. Short mine lives, high costs. And so we’ve been trying to avoid that.
Sure, sure. So, not as cheap as it once was, but it’s still much more attractive than the market in general.
I think so.
We’ve had a couple of questions on interest rates and these pertain to two of our funds. So one question specifically has asked, given the recent changes in the RBA cash rate and the falling interest rates, has that changed your approach with the Stable Fund?
Not really. Other than falling interest rates tend to result in asset inflation, in this case the equity market. And so we’ve used those increases in equity prices to reduce our weight in the equities in the Stable Fund. But yeah, it’s not necessarily the case that interest rates will remain close to zero forever, but it’s also not clear what the paths to higher interest rates are. But we’re not changing what we’re doing in the stable fund. We haven’t changed how we manage money for many, many years, and the Stable Fund will continue to do what it does. And I think that’s the fund that has the least appetite for risk in our stable of funds and we remain conscious of that.
And so another way to look at it, what you’re saying is the usage of cash in that fund is first and foremost about managing risk rather than about earning an interest rate return, per se?
Yes, though that cash will always earn an interest rate return, not dissimilar to the prevailing cash rate.
Sure. We’ve got time probably for one more question. We had a couple come through from Chris and Peter, who have both asked about your view on the overall market outlook and then one or the other of these would be more specifically about the banks. So over time, we’ve been quite bearish on banks or we’ve had significantly less exposure than the market to banks, and at different times we’ve stepped that up. So, now we’ve been at least in the last six months adding a bit to NAB. What is your view currently on the banking sector, the big banks?
I don’t think they’re tremendously cheap. We’ve had 30 years of high single digit credit growth. And the next 30 years, whilst it could be like that, it would create some serious excesses in our economy if credit growth continued as it has for the last 30. And it is credit growth that fuels the earnings of these banks, and so I think they’ll grow a lot more slowly than they have. They’ve obviously got some cost base issues too with respect to regulatory pressures and the Royal Commission outcomes, but they did sell off quite significantly. And we did take the opportunity to increase our bank exposure from around four, five percent to around 10%. But from here, I think we should be able to do a lot better than the banks themselves and I’d be happy to be assessed relative to them if that’s the way it is.
Sure. Okay. Well, it looks like we’ve hit our marker of 30 minutes. We’d like to thank all of those people who’ve sent in their questions during the process. There were quite a lot that came through and we had limited time. So, if we didn’t get to yours today, please don’t worry, we will get back to you via your relationship manager to address your question specifically. Simon, thanks very much for joining us today.
Thank you, Julian.
And to everyone who dialled in and registered for the call, thank you very much for your time and for your patience. We look forward to hearing from you and with any further questions you have.