You can now watch our latest investment webinar on demand, where our Chief Investment Officer, Simon Mawhinney, and National Key Account Manager, Julian Morrison, discuss fund performance, as well as delve deeper into stocks we hold such as AMP, Newcrest, Sigma, QBE and Nufarm. The webinar lasts just 30 minutes and CPD points are available for advisers who watch the webinar. Watch now.
Alternatively, the transcript is available below if you would prefer to read it. Please note that CPD points will only be given to those advisers who have watched the webinar.
Webinar Transcript
Julian Morrison:
Hello and welcome to the Allan Gray live investment update, the first for 2020. I’m Julian Morrison and I’m joined today by Simon Mawhinney, our chief investment officer. Simon, thanks for joining us.
Simon Mawhinney:
Thank you.
Julian Morrison:
Today we’ll run through our funds, performance, positioning and outlook, and from there Simon will delve into more detail on a few of the stocks we own. And we’ll finish up by taking some questions from the audience. If you do have a question today, please hit the raised hand icon on the top right of your screen and you can ask the question there. And as always, the information shared today is of a general nature only and not intended as specific investment advice. So with that we’ll get started.
The Australian market has been very strong of late as we all know. This chart shows over a 40 year period, but we’ve highlighted on the right the last year. For 2019 the return was about 24% for the broad market, which is way above the average annual return. So Simon, upfront for you is a question that’s probably on the forefront of many investors’ minds. As contrarian investors, we’d often be wary of a strong rise in prices. At the same time we’re mindful that the market is not necessarily wrong. So here is the rise justified? Do you think investors should be cautious at the moment? Is it the tale of different parts of the market doing different things? I know that’s a lot of questions but maybe you can offer some concise clarity of thought on that.
Simon Mawhinney:
Yeah I think there’s a lot of things going on. But you’re right, when markets are this strong and have increased as much as they have over the past year and in January this year, we’ve already seen a 6% increase in addition to that 23.8% you see on your screen. I think there is reason to be more concerned, especially when the fundamentals of the underlying market haven’t changed and I guess if earnings have increased 23.8% as the stock market did, there’s no multiple expansion.
Last year, earnings didn’t increase anywhere near as much of that. So price/earnings ratio multiples have increased in many respects. The stock market has brought forward future returns. We always say it’s the bus you don’t see that kills you, and with stock markets as strong as they have been over the last 13/14 months, we feel that there’s far more buses on the road than normal.
Julian Morrison:
Thanks, Simon. So at least there’s some cause for wariness at these all-time highs in the market.
Simon Mawhinney:
Absolutely. But I think that’s true always for us with respect to markets.
Julian Morrison:
Sure. So if we take that last 10 years, we could see as a very strong period since the financial crisis then we break it down by sector within the Australian share markets. We can see here the relative returns by sector over the last 10 years annualized. On the left for example, we can see healthcare has been the strongest and utilities has been strong. And on the right hand side we can see materials and energy have been the relative underperformance over the last 10 years, to take a couple of examples. And it has been this general theme over the last few years of those sectors perceived, or areas perceived, as more defensive, typically be more preferred and outperforming those perceived as cyclical.
As contrarian investors, obviously we prefer to look for opportunities in those unloved areas and that’s shown here with the red bars. That’s our relative positioning and the Aussie equity fund versus the broad market. We’re overweight in materials and energy and we’re underweight in, for example, healthcare and utilities. If we drill down within that and look at the performance of our funds over the last 12 months, so a shorter period, we can see that the stable fund on the left there, our most conservative fund, has outperformed its cash rate benchmark. But the other funds which are much more significantly weighted toward equities, have struggled to keep pace with their broader benchmarks in a strongly rising market. So absolute returns have not been terrible, but underperformance is there nonetheless and is never a welcome thing.
That defensive versus cyclical theme, at least to some degree, has played a role in this. If we cut further into this and focus on the Aussie equity fund, and we look at the 10 largest holdings in that fund over the last year, we can see here the names of the stocks in the fund and we can see in the middle of the red and the green bars show the relative contribution to performance over the last year. And the change in trading weight, the change of the position size on the right. We can see a few red bars there in the middle. And it seems to be consistent generally speaking with that theme of materials and energy having underperformed at least for calendar year 19.
We can see Woodside, we can see Illumina, Sims, Oil Search have detracted from performance. And over the course of 2019, we slightly increased those weights, which is what we tend to do on weakness. One notable exception, the materials, Simon, perhaps I can bring this up because we’ve had a question on that already from one of the audience is Newcrest mining. We can see there, it’s strongly contributed over 2019 in terms of relative performance and we have, as the blue bar shows, reduced the size of the position quite meaningfully, but it’s still big in the funds. The question that came through was, it’s still a big position but you’ve reduced it a lot so do you still like it, is it still appealing to you and if so, why have you reduced it so much?
Simon Mawhinney:
Yeah, so we tend not to like many things, but we knew Newcrest at one stage was a lot cheaper than it is today and we bought quite a sizeable position in the portfolio and had we left it untouched, it would be too large an exposure considering its price increase. And so this was just a conservative or pragmatic approach to portfolio management where we took some money off the table on the back of a very significant increase in price for Newcrest. It’s since fallen quite a lot in price. And so the weight in the portfolio has been increased and we’re comfortable with where the weight is currently. We think it represents reasonably good value relative to a broader stock market.
Julian Morrison:
Sure. Okay. Thanks Simon for that. So that sort of behaviour you see shouldn’t be a big surprise for a longstanding investor in terms of we tend to add the positions on weakness, relative weakness, and then trim those positions on strength, and that’s certainly consistent there. That type of behaviour obviously existed in the Aussie equity fund there for Orbis on the international side. It’s the same type of approach we take and that feeds through to our other funds like the Australia balanced fund that we have here. Here we’ve shown the asset class exposures for this fund that you can see the Australian equities in red, the global equities in blue.
What I’d like to draw your attention to though, and maybe focus on just for this moment, is the fixed income exposure, which is Australian in grey and international fixed income in black. So that area represents a reasonable part of the fund. And within that exposure to fixed income, our duration is significantly shorter than the benchmark. And duration is a concept that reflects a couple of things. Firstly, it’s the average expectation for receipt of cash flows from your investment in those fixed income securities. And it also represents a measure of interest rate sensitivity, so how sensitive are your holdings to movements in interest rates.
Simon, I just wanted to touch on that with you. Our duration in the fund is two years as the measurement goes versus seven for the benchmark. So we’re significantly underweight duration, we’re less sensitive to interest rates. Can you maybe talk a bit about why that’s the case? And to put that in context, I’ve put here long term interest rates, 10 year government bond yields for the US and Australia, and we all know that at record lows, so why are we positioned short duration? Is it a conservative thing? And what maybe, is the implication for the fund should interest rates fall further or indeed if they rise?
Simon Mawhinney:
Okay. So I just assume that it’s a given in terms of understanding that as interest rates fall, fixed income securities go up because of the inverse relationship between interest rates and price. And so on that chart from 1980 to today, bond securities have risen very significantly in value to the point where we are today, where interest rates are low and admittedly can go lower, but not a lot more. And there does seem to be some sentiment from central banks, like Sweden’s, that the limits of monetary policy have essentially been tested already. So I don’t think we have a competitive edge in assessing what next year’s interest rate will be for various terms or even the year after.
I think in the context of the next 10 years, I think we’re comfortable with our assumption that interest rates are likely to be higher or at best, the same as they are today. And on that basis, having very long duration bonds in a balanced portfolio is unlikely to yield great returns from levels where we’re at today. And so that’s the reason we’ve tried to reduce the duration of the fixed income portfolio. It also is potentially a lot less risky. Fixed income is considered a very low risk investment, but with interest rates as low as they are today, were interest rates to double say to levels as existed in 2010, the impact on a fixed income portfolio with long duration would be quite significant. And it’s that risk that we don’t feel inclined to take on behalf of our clients.
Julian Morrison:
Sure. So we are somewhat defensively positioned in that fund. Thanks, Simon. Moving on to the Stable Fund, our most conservative fund. We saw the performance of that fund earlier on, it’s been exactly as its name suggests, relatively stable over time. Here we’re showing the exposure in the Fund to Aussie equities versus Aussie cash. The red area shows how much we have in Aussie equities over time. And the black line shows the broad Australian share market, the ASX 300, so that you can see that as the market rises and becomes more expensive, we tend to shy away. And as the market falls, we tend to step in and take advantage.
Simon, maybe just a very brief comment on the right-hand side we can see the fund is as low as it’s been in equities over its history. Can you just maybe briefly comment on that? What’s the size of the exposure to equities and how do you balance conservatism with taking advantage of opportunities?
Simon Mawhinney:
Yeah, so I think the equity weight in the Stable Fund is 17% currently and it is the lowest it’s been and it is on the back of a very strong market. And there are parts of our stock market which we think are extraordinarily expensive and it’s those parts that the Stable Fund has chosen not to have any exposure to and indeed other funds as well. But there are other parts which seem reasonably attractively priced to us. And so the reduced weight in the Stable Fund as the market has risen, has really been taking equity exposure of these very expensive, in our view, companies out of the Stable Fund by selling them and either maintaining or slightly increasing the exposure to the companies that we think present even more compelling investment propositions than they did say a year ago.
Generally speaking, as I said before, I think there’s a lot of buses on the road. I think there’s the propensity or ability to end up buying something that looks reasonably attractively priced today on the basis of blue sky, which seems to be the expectation, but a bit like Treasury Wine Estates today releasing some unexpected news, that is likely where it happened to some of these other companies with very significant multiples to be very savagely dealt with by the stock market. And this Stable Fund is a very defensive fund and not one that we want to have exposure to those very expensive ends of the market.
Julian Morrison:
All right. Thanks Simon for that. Well that leads nicely into the summary to this first part of the presentation. So we summarise by saying markets have been very strong, certainly the Australian market. That generally feels good to lots of investors, but at the same time it increases the risks that some areas of the market may be high and expensive. We’ve talked about the theme of defensive generally being preferred over cyclical exposures, but we are mindful that even the most defensive company in terms of its business structure or business model may not be defensive for an investor if it’s bought at too high a price.
We’re very mindful of that and that’s why we remain focused on fundamental valuation. We always try our best to buy cheaply, looking at the out of favour areas of the market. And with that it probably leads nicely onto the next section, Simon, if you want to maybe cover a few of the individual stocks we’ve held over time and how they fed and what are our current views.
Simon Mawhinney:
Okay, thanks Julian. Yeah, so there’s a number of requests that we’ve had over the almost years to talk about or to give almost a postmortem of some of the companies that we’ve written up in our previous quarterly reports, because often what happens is we write about these companies and then seldom readdress them for our clients. And so what we’ve done in our recent quarterly report and what I’ll touch on here, is just talk about four companies that we’ve recently written up sort of in the last two and a half years, and track their performance relative to the stock market since we wrote about them. You can see the four companies up on your screen. Hopefully it’s QBE Insurance, Sigma Healthcare, AMP, and Nufarm. And the lines that correspond to each start at the point where we wrote about them.
Sticking with the first one, QBE Insurance, we wrote about that in September 2017. And then the lines are indexed to a hundred. And so essentially where the line ends up, if it’s above the horizontal axis, it’s outperformed the stock market. If it’s below, it’s under performed. Recapping very briefly on what we said and what has gone wrong or right. With QBE, we wrote that they had about $12 billion of insurance premiums that they wrote every year and we thought then that a 10% return on that would be a reasonable expectation going forward. And based on those expectations the company looked quite cheap relative to the stock market.
Of course that 10% margin comes from both its underwriting profit and the return on its investments or floaters is often referred to as, and in QBE’s case, the returns are roughly half and half. And whilst the thesis hasn’t played out exactly as we had intended, fortunately for us the share price has done quite well. Interest rates have fallen so the return on the float or investment portfolio is lower than we had forecast. But conversely, the insurance premiums have strengthened and as a result, the underwriting profit that QBE is being able to report has been perhaps a bit better than we had expected. And net-net, the outcomes have been quite similar to what we had written about. You know, unfortunately that’s where the thesis good news ends really because the next one was Sigma Healthcare.
When we wrote about it, we commented that the market was concerned if not obsessed with its significant exposure to one single customer, Chemist Warehouse. There was some antagonism in the relationship already and there was concern that that customer would leave and take its distribution business to another competitor. And at the time of writing we said that that may well happen, but Sigma share prices already priced for that to happen. And you know, if it didn’t happen, there’d be quite a lot of upside.
What eventually unfolded is that customer, Chemist Warehouse, did in fact take their business away. They took it to a combination of the old Symbion, now EBOS, and DHL. But as you can see, the share price performance was particularly bad and that was as a result of something we hadn’t anticipated and that was particularly weak trading conditions. Sigma is still a company we own. Subsequent to all of this, Chemist Warehouse have decided to hand back some of the volumes to Sigma because DHL hadn’t performed particularly well, and Sigma has managed to take some cost out. Nevertheless, it’s underperformed the stock market quite significantly since we wrote about it.
AMP is the next point along, which we wrote about in March 2019. Not a lot has changed since we wrote about AMP. And whilst it’s underperformed the stock markets, we haven’t tried to adjust for a diluted and discounted equity placement, which probably make it a performer-in-line. But at the time of writing, we felt that the part of AMP’s business that seems to plague everyone’s mind, wealth management, its platform business and the financial advice business, is a business with a lot of hair on it, but not one that you pay for.
And that the other parts of AMP’s business, its funds management business AMP Capital, its bank AMP Bank, its New Zealand business and the very significant surplus capital that it had more than explained what investors had to pay for AMP. It’s still our view, but the hair hasn’t gone away. There are several things with AMP that could turn out to be much worse than we expect. And you know, those are things like additional client remediation or customer remediation, a buyer of last resort liability, which we wrote about, and the potential for class actions, which could be quite costly.
Nufarm, the most recent one we wrote about in June 2019, has done particularly well relative to the stock market, but for reasons which we hadn’t anticipated at all. And I guess in the same way it’s the bus you don’t see that kills you, it’s the bus you don’t see that gives you a lift home. And in Nufarm’s case, it was the sale of their Latin American business for a very tidy sum, which single-handedly relieved their balance sheet of the pressure that shareholders had been very concerned about.
Despite having had another setback in January, it’s really outperformed the stock market and it’s been quite a good contributor to us. We think it’s very cheap and we remain a shareholder. And yeah, the next two September and December 2019, subject to request, we would continue to give this periodic feedback on how these companies have performed. We just felt that that was a bit too short dated. So Jules, I’ll hand back to you and take questions if they exist.
Julian Morrison:
Okay. Simon, thanks very much for the insights to those companies. Hopefully that’s useful for our audience. And we would always like to share a balanced view, so those things that have been challenging as well as those things that have done well. I think it’s also useful to remind our audience that in addition to these four, there’s probably 40 or so other stocks in the portfolio. So we are a diversified portfolio of contrarian ideas and if people have questions on those other holdings, we’d welcome them as well.
So with that we’ll move on to questions now. We have a few sent in advance by those who registered, which we’re grateful for. Thanks very much. Once again, if you do have questions, you can pose them now by hitting the button on the top right of your screen and type in your question. I’ll start off maybe by some that have come through already. Simon, Taryn has asked about ESG and wants to know if we discount or apply value for ESG considerations when you’re valuing companies. What is your view on that?
Simon Mawhinney:
Yeah, absolutely. ESG, environment, sustainability and governance, concerns are very important in assessing what the fair value of a company is. For Allan Gray, it’s not always a gate that you have to walk through. In fact, most often it’s not a gate that you have to walk through, but it does inform the value that one is prepared to pay for a particular company. At its extreme, a coal company, for example, it may well be in 15 or so years’ time that that coal company is unable to sell its coal if the world moves to a hydrocarbon-free world. And as a result it’ll have significant stranded asset risk. And so that needs to be taken into consideration before investing, and even whilst invested.
We have no coal assets currently in the portfolio, but we do have quite a lot of gas exposure and the ESG considerations around that are very front of mind. You know, at this stage it’s our view that the gas exposure in the portfolio is part of the solution towards the lower hydrocarbon consuming world. But yes, even they have some stranded asset risks, which need to be taken into account in the valuations. The same with sustainability and governance. At the end of the day, a company’s only worth the present value of its future earnings stream or cashflow stream, and so if there’s anything about a company’s earnings stream that is not sustainable over whatever period of time horizon that must be taken into account in determining value.
Julian Morrison:
Sure. Thanks, Simon. Yeah. So do these companies deserve to exist long into the future and will they exist long into the future, is a key consideration in whether we invest on behalf of clients. Another question we’ve had, which is also probably the front of many people’s minds after very sad events recently with the bushfire tragedies that have been going on and indeed ongoing. The question that’s come through is, what are the overflow implications of this situation? Is that, specifically it was asked, is it likely to impact investments in financials, maybe with regards to insurance or other things like that. So maybe we start on financials, if there’s anything else you’d say about it more broadly as well.
Simon Mawhinney:
Yeah, so the insurance companies have already, to some degree, made some disclosures as to the claims that they’ve received and they will definitely be impacted. Many of them, in fact all of them have re-insurance agreements where they can hand some of the elevated claim liabilities off to people or other insurance companies who’ve reduced their risk. But yes, there will be some impacts. I mean, that’s probably the most obvious one. And then of course on the banks, there will be some loans to some people’s whose houses unfortunately, have been destroyed and their ability to service their loans may well be in question and I suspect the banks would have to take some losses there.
I think a lot of the second order outcomes from the bushfires are yet to be known and are difficult to quantify. Many of the retailers have already announced bushfire impacted reduced trading activity levels and there will be other companies that are impacted because, of course, the economy doesn’t and none of these companies exist in a vacuum. And as one company’s fortunes change, so too does part of the economy. So there will be impacts. We’re keeping a close eye on it and where possible we’re trying to invest opportunistically to benefit from those companies which are sold off aggressively on the back of the bushfire impacts if it doesn’t reduce the long-term valuation outcomes significantly.
Julian Morrison:
All right. Thank you, Simon. We had a question just come through in response to your previous comment on the ESG question. So this question is, why is a gas investment any less of a carbon risk? And I guess that’s versus coal for example.
Simon Mawhinney:
Yeah. So without getting too technical, for the same unit of energy, burning gas emits half the greenhouse gases as what does the cleanest coal. So for the same amount of electricity that one might consume if it’s gas-fired, it’s half as polluting as coal-fired. So it’s polluting, but you know, if we’re going to transition away from a coal-dependent economy or world, gas would play quite a significant part in that transition. But it’s not a renewable and it’s not a zero-emission outcome.
Julian Morrison:
Okay, sure. We have a related question, Simon. This says that last quarter you made a compelling case for the energy sector being one of the most contrarian sectors in the market. Again, it relates to the same subject as the last question, but more so on the case for energy as an investment. Is this still the case and what impact will the US-Iran tensions have, if any?
Simon Mawhinney:
Yeah, so energy has underperformed since I last spoke about it. So, to the extent that it was compelling previously and I think very little has changed with respect to the oil and gas sector, I think it’s equally compelling today. It’s hard to know how the Iranian-US tensions will impact oil and gas prices going forward. I think there are much bigger issues at play here, mainly on the supply end of the spectrum where significant supply has been added in the US onshore producers. And I think as that evolves, so to might oil and gas prices, rather than Iranian tensions, which, if anything, are likely only to create oil and gas price spikes, which would be positive for the thesis. But it’s not something that we can bank on, some tensions between the two countries.
Julian Morrison:
Okay. Another live question just coming through. I’m not sure whether this impacts any stocks in your view in the portfolio or whether you can assess that even, but do you think the recent Coronavirus and its impacts on various listed travel companies could provide good buying opportunities? With the caveat that I think the question is global rather than Australian.
Simon Mawhinney:
It’s very hard to know what the impact of the Coronavirus will be longer term. I had a look this morning and I think the death toll was 106, which isn’t up on yesterday’s end of day number. But, the death toll was initially doubling every day and it now seems not to be. So perhaps it is under control and perhaps, whilst tragic that people are dying from this virus, it may not be the world pandemic that everyone fears. And so yes, I think, like all things when there is some bad news attached to them, markets often overreact and so there will be some opportunities with some companies where the stock market reacts particularly badly and the future turns out to be less unfavourable. That will almost certainly be the case. It’s just very difficult to identify which those companies are at this stage.
Julian Morrison:
All right, Simon, I think we’re close to the end. We can maybe take one more question that’s come through. This question was, can you comment on interest rates and how does lower for longer interest rate policy impact your portfolios? We talked about interest rates before with regard to shorter duration positions in fixed income, but I think this is specifically with regard to equities. Is that something that you can assess? Is it something that you can comment on in terms of whether and if interest rates stay lower for longer, what is the impact of that?
Simon Mawhinney:
Yes. So I guess the big question is, how much longer? And I don’t know the answer to that. But because a company is worth the present value of its future earnings stream, by definition, if interest rates are low for a long time, that present value of that earning stream is much greater than it would otherwise be if interest rates were higher. So of course lower interest rates do impact equity valuations and certainly impact the amount that people are happy to pay for companies.
I don’t think equity markets are pricing in current interest rates into perpetuity. So if we do have low interest rates forever, I would expect very, very significant asset price inflation. But equally, that’s a scenario which I think is not practical. So it depends. I know I unfortunately don’t have a good answer for you. It really depends on how much longer and potentially how much lower. I think the answer to the second question is a lot easier to answer and the answer is not much. But the first question, it’s very hard to know.
Julian Morrison:
All right, Simon. Thanks very much for addressing that. We’re almost right on time, so I think we should draw to a close there. Simon, thanks for your time and sharing your insights today. And to all of our audience, thank you very much for joining us today and for all of your questions, and we’ll look forward to seeing you at our next update.
