InvestSMART

Is the market coming into value?

Alan Kohler speaks with Portfolio Manager at InvestSMART, Nathan Bell, about whether the market is coming into value and which individual stocks could be appealing for investors.

Nathan Bell is the Portfolio Manager at InvestSMART, my employer. Nathan is a colleague, just bear that in mind as you listen to the interview. I’m treating him the same as anyone else, but he's got interesting things to say.

He's been around a long time and he's a value investor. And the question is whether the market and in particular, individual stocks are coming into value, and if so, which stocks?

So here's Nathan Bell, a portfolio manager at InvestSMART.


Table of contents:
View of the market
Why this crash is different
Building material stocks
What investors should look for 
PE
Banks
Transurban
Fees
Performance


Nathan, Intelligent Investor is the hotbed of value investors, that's what you are. And it's been a tough time over the last few years for value investors. Do you think that you are now coming into your own?

I do actually yeah, funnily enough, I'm just writing our quarterly reports this morning and one of the lines I've used is that value investors have been pulling their hair out for the last five years, watching these growth stocks take off and you're trying to protect people's capital because you knew what was coming. You obviously didn't know what the trigger was going to be. No one was forecasting a virus was going to knock the market over, but it was extremely expensive.

But, you know, I've probably seen half a dozen things in the last month that I didn't think I'd ever see in my life. And now, I think while the market is probably somewhat cheap, I think if you actually look through to just the cheaper stocks, I think some of them are at extraordinary prices. I look at Star Entertainment, it's trading for $2 billion today, and yet at the end of 2022, they're going to open the Brisbane casino which will really change Brisbane, particularly the area it's in and the city and that's valued at $2 billion alone. So essentially, you're getting the Gold Coast Casino and the Sydney Casino for free. I mean, these opportunities don't come around very often.

Well, that's fascinating really, and the thing is, I suppose, perhaps we can talk about the market as a whole, but the market as a whole is a little bit irrelevant in the sense that there is such a wide dispersion between prices, between the stocks going up, other stocks collapsing and so on. What's your sense, I mean the market obviously had an interim bottom on March the 23rd. What's your sense about the market as a whole? Do you have a view about that at all?

Yeah, I think, normally when you see bear markets, they don't usually just hit a bottom and then recover straight away. People are talking about that as the V-shaped recovery. But even when we've had a V-shaped recovery, which you could say the GFC was, normally you have multiple tests of the bottom, and it's just been incredible how quickly things have happened this time around. Never before have we seen the size of the falls happen in four weeks as what we’ve had, and it probably speaks to just the nature of the connected world or in the digital world and the nature of the virus, as well. Given that I've seen probably half a dozen things I never expected to see, it's not beyond reality. That may be the recovery will be a lot faster this time than perhaps what it has been in the past.

But if you look through all the bear markets in history, normally you at least get one re-testing of the low, which really shakes people's confidence because what you’re seeing is, and we see this in our own membership base and our investors in Intelligent Investor, most people have been prepared for this. We've helped prepare them for it. They're really excited about the value on offer. But normally bear markets don't recover when people are optimistic. Normally it's when the last value investor has had his soul destroyed, and he doesn't even want to buy any stocks anymore, that's when generally markets make a bottom. It's just a guess, obviously no one knows what's going to happen, but I would have thought there's at least one more downswing in the market. But again, it could be completely wrong.

Sorry, I was just going to say that's the problem this time. The time is quite different, isn't it? I mean that's the problem. Trying to extrapolate from the past now is quite challenging, isn't it?

I think what would be really interesting if the market, I mean if this was the start of a new bull market, what we've seen in the last week, it's really going to catch a lot of fund managers, very overweight in cash. If you read just about what any fund manager is saying at the moment, they're all saying pretty much the same thing that we're not at the bottom yet and we're holding some cash for future opportunities. Even we've got anywhere from 10 to 15 per cent cash still in our portfolios because there's going to be a flood of capital raisings and we want some money to dip into those. But I just want to go back to the earlier point you made, Alan, which I think is the most important point for me, and that's the dispersion of valuations within the market. I pumped this chart out as much as to anyone over the last five years and anyone leading up to this downturn has seen a chart showing the value discrepancy between the growth stocks and the so-called value stocks.

And the problem before this downturn was that if you had a look at the stocks within that value group, they really were just very low-quality businesses and they were really risky and just because they had low statistical valuations, didn't make them attractive investments. But I think what's happened now is that you know, we just talked about Star Entertainment. We can talk about Tabcorp, for example, where at the current valuation you're basically buying the lottery business and getting the wagering business, which made about $400 million in operating profit last year for free. So those sort of stocks are now sitting in that value basket. So this isn't a time when you want to own the market or the index, which worked out really, really well for you. If you did that coming out of the GFC, this is the time when you actually want a portfolio with your biggest positions in those cheap stocks.

Just before we move on to particular stocks, tell us what are the half dozen things you've seen in the last few weeks that you've never seen before?

I think, first of all, it was just how fast the market crashed. I just, you know, it was four weeks with a 30-odd percent fall or less and even stunned senior analyst on our investment team. And like the GFC took 18 months before it really hit those sort of lows and this was done in four weeks. It was just incredible. The other one is we're talking about potentially having negative oil prices. This is costing so much. There's such a surplus of oil at the moment that people are talking about having to actually pay people or customers to actually take the oil off them because they're running out of storage. There are companies like Schlumberger is the gold standard in oil services around the world. It's listed in the States and last time I looked their share price was $16 or $15. This used to be a stock that was, you know, $80, $90 or $150 stock, I think maybe even if you go back, I just never thought I'd see such a high quality, well-managed business trading at a share price like that. I mean that's just two of the things.

Yeah. I saw something the other day where you wrote about James Hardie. You’re talking about Tabcorp and Star Entertainment, but tell us about James Hardie.

So the broader, I guess, 10,000 foot view for James Hardie and the US housing market is that there is a shortage of affordable housing in the US. There's been a rapid increase in house prices in most of the very popular cities in the States since the GFC. So New York, San Francisco, but what there hasn't been, is there hasn't been a real recovery in house building. So before this recent crash in the market, and I guess what's going to be a recession the number of housing starts had only basically just recovered in the US and remember this is after, it's been nine or 10 years, a decade since the GFC. The housing numbers had only recovered to what were previous troughs in housing starts through previous cycles. So that's how really slow and weak the housing recovery was in the US and if you look at the next 10 to 12 years, the largest population cohort, which is the millennial population coming through America, and they go into that sort of early 30 to around 40 years of age, and that is primarily the age where they start having babies and buying homes.

So remember this is the largest cohort or population ever in US history to come through. And so that aggregate demand for housing should be coming through at a peak rather than actually being at one of the lowest trough levels in history and James Hardie is perfectly poised to ride that recovery. And the other one is probably Reece Holdings as well, which has made a large acquisition in the plumbing market in middle America.

What about other building material stocks, in particular, those that are in the US like Boral?

Yeah, Boral is one I don't like, personally, I just think it's been poorly managed and I think they did an acquisition at the worst possible time. Basically, right at the peak of the market and they borrowed money to do it and that's the last thing that I want to see from management. So sometimes you see these very statistically cheap stocks but the reason they're cheap is because they're either poor business and/or they're poorly managed. The one we're actually having a look at right at the moment is Adelaide Brighton. And that's been much better managed with family running the business and just much more conservatively managed. The last thing you want to see, I think at the moment is seeing, and this is what is potentially going to frustrate me with Tabcorp is that management is really poor.

I'm the of the belief that the share price is so cheap that it makes up for poor management. But they went in off and paid far too much for Tatts, amazing business, but they paid too much for it and they had to borrow a lot of money to do it. And now it looks like they're going to potentially have to do a capital raising, which dilutes the value of the business. And you might've seen in the paper today that the chairwoman was selling shares in a complex situation and it just really, really smells bad. The reason that companies do this is because they don't have skin in the game. Like it doesn't matter to them, all they have to do is keep their jobs. It doesn't matter to them whether they dilute shareholders with a deeply discounted share raising.

And in contrast to that as a company, which it's a small stock, but 360 Capital is its name and it's been preparing for this moment for at least the last couple of years and about three or four weeks ago it's a fairly illiquid stock or it isn't a liquid stock. The share price fell 20 per cent in one morning because someone who probably just woke up out of bed and jumped onto his couch traded $40,000 worth of shares and was just desperate to get out and the stock fell around 20 per cent. And if you look at the business today, it's gone up about 40 or 50 per cent since then because the company is so flush with cash at that bottom point, the stock was actually trading at a 15 per cent discount to the cash on its balance sheet. So that's before actually any other assets within the business. Now it's launched or announced, it's going to buy up to 20 per cent of the shares outstanding in what looks like an off market repurchase plan.

So they're the sort of companies we really want to look for is that they’re conservatively managed and well run because a company like TGP or 360 Capital, this is the market they've been waiting for, cheap assets, cash on the books, ready to go and pick up these distressed assets. So the more of those we can find the better.

So, so just broadly, what do you think the number one thing is, that investors should look for when they're poking around? Is it cash or is it valuation? PE?

Yeah, this is the perfect question. I think, first of all, you've just got to be looking because I think there's a lot of people who are frightened out there, but the thing is you don't want to wait and wait to pick a bottom. Maybe we’ve seen the bottom, maybe we haven't, but you've actually just first got to be looking to buy assets because the way central banks are intervening in markets these days, who knows, this might only be the last chance in another 10 years to buy things this cheap. So the fact that you're looking and on the front foot in the first place is the right thing to do. But the really important point I'll push at the moment is this is not the time, in my view, to be buying the safest, highest-priced stocks like CSL, at 40/45 times earnings.

I understand that's a great business and I recommended it, at Intelligent Investor a decade ago and so I’m not biased against this company. Every time the share price goes up, it makes my old recommendation look better. But at the moment, if you're paying 40 or 45 times earnings for a business that still has risks, and even if it grows at 10, 12, or 13 per cent for the next five or six years, if the price earnings multiple comes down to something more normal, you won't make any money. I think very much rhymes with buying Microsoft in 1999 where it took 17 years for the share price to regain the high in, I think it was 2016. So right now what you want to own is the companies that have been absolutely whacked in this downturn, like the casinos, like Tabcorp. I'm not just picking on the wagering and gambling type businesses here.

But those that are going to recover when things get better. Now I don’t know whether things get better in a few months because remember the market's always discounting things in the future well before they actually happen, or whether it will take a bit longer than that. And I mean, industries like tourism are obviously going to take longer to recover than others. But people will be absolutely busting to get out to go to the races, come November, if we can, to get to sporting events, I'm sure Crown will fill up. I'm sure we'll be able to go up to Brisbane in two or three years and look out over the river and just marvel at the fact we could buy this share at a share price for $2. So these are the stocks that are going to lead the market's recovery. It's not going to be the ResMeds, the CSLs, which everyone's still infatuated with at the moment. So for me, absolute valuation is the number one thing now

And as a rule of thumb, would you say buy below 10 times PE?

I don't have a rule on that sort of stuff. I think the first thing you just got to make sure of is that the company's going to survive. So you want to be looking at the balance sheet and it was interesting this morning, Sydney Airport is one that we've recommended for a long time and we really liked, but something that's become really important right at the moment, which was important for about six months after the GFC was debt covenants. You might remember, that's all you heard about for about 12 or 18 months after the GFC because this was the way the banks essentially forced all these companies to lose the value in their companies by raising capital at these really discounted prices. The banks have got a little bit less control, I think, this time but Sydney Airport, for example, has debt in US credit markets where hedge funds are the buyers of a lot of this debt and under certain circumstances, because bearing in mind Sydney Airport's closed at the moment.

And so there's certain triggers whether it's, you know, interest levels like how much profit there is, to interest payments or the level of debt or based on earnings and some of those triggers are going to get triggered over the next three to six months. And this morning there was a group of companies that come out and ask the government to intervene to stop these hedge funds and that from being able to trigger these situations. So the broader point of that is that one, you've got to make sure the company can survive. So you've really got to check the debt. And the second thing is just because it's got debt doesn't necessarily mean you should avoid it. So the reason that Star Entertainment, Crown Casino, Tabcorp, have all got share prices now at roughly half on average from what they used to be is because people are fearing a capital raising.

But for us, if we get a capital raising and we get this wonderful opportunity to buy more shares at a lower share price, then that will be absolutely brilliant. And I know some friends outside of the business who are investors as well are actually looking at companies with these really high debt levels that we'll likely have to raise capital to do what one of your colleagues, Stephen Mayne did to aplomb during the GFC, which was take advantage of the share price plans where as long as you're a shareholder, when it's announced, you can buy up to, it used to be $15,000 and now it's $30,000 worth of shares. So even if you don't want them, you can make a quick risk-free profit even just by selling those shares on market at a higher price.

Yes. What do you think of the banks in this situation, in particular, the big four banks, they've rallied hard in the past week, but obviously they're well down from where they were, and their yielding, goodness knows what? I mean, the other day, I mean, the other day come off bank was, was selling for a yield of 10 per cent. I mean, what do you think of them?

Yeah. The frustrating thing for me personally is our income portfolio seems to do good or bad depending on whether the banks do good or bad because we’re well underweight the banks and just, some of the share prices, they're moving 10 per cent on a day. So given they’re sort of 20 per cent of the market, if you're underweight those it can really hurt your performance compared to the market. My view is that Commonwealth, we've always owned Commonwealth and Westpac and the reason we've always preferred those over ANZ and NAB is for two reasons. One, if you look around the world, usually the biggest bank has the most pricing power and the lowest costs and therefore they can sustain more attractive mortgage rates and still have higher profits than its competitors. So that's a massive advantage, and Westpac and Commonwealth are the largest in Australia.

The other reason we prefer them too is because, in the past, management hasn't gone abroad and blown up shareholder's capital, like ANZ and NAB have. So NAB and ANZ always look cheaper than the other two. But if you have a look over time, particularly CBA, it's done far, far better for shareholders than the other two. In fact, I remember one of the first shares I ever bought was National Australia Bank about 25 years ago when I got a rights offer in the mail for $19.50 and at the moment I think that’s trading around $16 and I just marvel, this is another thing I never expected to see my life. Can you imagine that after 25 years and the greatest credit boom in Australia's history, the greatest housing boom that NAB share price is currently below where it was 25 years ago. I mean I just marvel at that, but the problem for the banks is that while the bad debts, which will increase over the next month or two will be temporary what won't be temporary is the impact on margins from low interest rates.

So I think Commonwealth Bank is definitely around fair value. And if you look at the other banks and compare their returns on equities with overseas banks, they're still actually a little bit expensive. I'm not in a rush to buy them and I think you can be a little bit patient just to see where the earnings land. But I'm expecting those dividends to come down by around 25 per cent, just as a rough guess.

Do you think that the banks will cut their dividends by 25 per cent?

I think they’ll have to, and what will determine the longer term value is how much capital they have to raise. We're very lucky in Australia in this sense because they are a regulated oligopoly. They've got huge dividend reinvestment plans, which are very popular. So they raise a lot of capital through that. So it's not like all the big dividends they pay actually end up as cash going out of the business. But we saw Commonwealth Bank's earnings went backwards last reporting season and a few of the banks have to report over the next month or so. And I expect you'll see dividends getting cut to a more sustainable level. But I think what's more important is they don't have to go and raise a huge amount of capital. But even if we have I guess the worst case scenario where the recession lingers, the analogy for me has always been Wells Fargo in the US. Wells Fargo wasn't hurt anywhere near as bad as some of the other banks in the US and across Europe. It borrowed a bit of money through the TARP, but it was actually forced to take that money. They didn't want it.

What happened was after the GFC passed, they actually recorded record profits or earnings per share. But you know, not well, well ahead of where they used to be, but at least it was ahead. Whereas most other banks never got anywhere near those old profit figures because they had to raise so much capital. But the problem was once interest rates went down to effectively zero, they’ve had these $1 trillion deposit bases, which looks like a huge advantage, but they’ve just got no one to lend the money to. So credit growth is really slow and the lower interest rates crunch profit margins and that's why I think that's a permanent feature of the four banks, and why I’m in no rush to buy them at these prices.

I don't want to sort of run through the whole market or something, but there's one other stock I just wanted to ask you about is Transurban do you have a view about them? I mean they’ve been a bit all over the place lately. Are they coming into value?

Yeah. So it hasn't got there yet for us. One of the mistakes I made, because I was our infrastructure analyst, coming through the GFC, was not upgrading Transurban and just underestimating I think two things. One was what we call the operating leverage in the business and this is what the market is grappling with at the moment. Toll roads are amazing businesses. They are extremely profitable and when you've got more and more cars going across your toll road, all of that revenue falls straight to the bottom line because there's virtually no costs in running the toll road. In fact, I believe the marginal cost of a car going across a toll road is negative because it actually keeps, helps keep the tarmac flat. Trucks don't do the same, trucks actually tear up the road.

But so what you've got at the moment is what you might call a fixed cost base at Transurban, and now they're talking about traffic levels have fallen, I think 36 per cent I saw this morning. So basically, all that revenue that used to just fall straight to the bottom line is now going in reverse. And so what you get is the bottom line, the profits actually fall much, much more than the revenue falls. In a sense, you're getting that leverage working in reverse.

So operational leverage works much the same as financial leverage really.

Absolutely, and I underestimated that on the recovery in 2009 and 2010 but now people are starting to get used to it going the other way. And you can see that Atlas Arteria is another one which we came close to upgrading, it's I think 90 per cent reductions on its French toll roads in terms of traffic so basically, you've got no revenue and therefore you can't pay out the distributions. But the other thing, you don't want to underestimate with the toll roads, Transurban in Australia, if you have a look at some of the deals they've done with the Victorian government they've actually absolutely cleaned up. So if you're frustrated with paying the tolls and the government seems to keep making these really dumb deals, Transurban's a nice way to play it and get some of your money back.

But I suppose the other thing is that the operational leverage works in the recovery as well, this time, presumably the traffic will bounce back at some point.

It definitely will. And the only thing I'd say is Transurban, Sydney Airport, all these infrastructure type stocks and these ultra-high growth stocks have all benefited, you've had your cake and eaten it too where you've had enormous operating and financial leverage in the business, but also just investors being willing to pay incredible amounts for these businesses because interest rates were basically zero.

And I think this is something that incoming investors need to think about really, really carefully is not just Transurban, but when we come out of this, interest rates are going to be 0 per cent and there's really no scope for them to be increased without causing major economic problems. We saw the US try to increase interest rates and then about, was it like two weeks or three weeks later, not even that, the market fell and they reversed course and put them back down again and Australia is going to be stuck in that same place as well.

So the only way you're going to be able to get a return on your money is through stocks and to a lesser degree with property, which is still extraordinarily expensive in Australia. So if you don't take advantage of the opportunities in the market today, you’re going to have very, very few options when the market recovers.

Just before we finish Nathan, I always ask fund managers for what their fees are and what their performance has been like. Firstly, so you run the active funds at InvestSMART. Obviously, there are passive funds as well. But what's the fee in the active funds?

The fees for all our funds are just a flat fee of 0.97 per cent, so just under 1 per cent and we don't have performance fees.

And what has been the performance?

The performance of the income fund, we've definitely underperformed over the last five years, so I'm very much looking forward to turning that around over the next 12 to 18 months. The growth portfolio has sort of quite similar, although a little bit better than the income fund back again, underperformed, as we typically do at the peak of the bull market. But that's the fund I'm most excited about because I think that portfolio from where it is today could double over the next few years and that would far out-pace the market. And the other fund we've got, which is a listed actively managed ETF, which is the ethical fund. And since inception, which was only in May last year, I think it's down 14 or 15 per cent versus down 21 or 22 per cent for the market. But I wouldn't say that's because of great stock picking although I'd love to say that, it's really been because it's had more cash than the other portfolios.

But again, I think that portfolio is very cheap. So if you want income and some outperformance over the next two or three years, I believe we can definitely do that with the income fund. But if you want to maximise the opportunities in the current market, regardless of getting a higher dividend than the other two funds are definitely worth looking at.

Thanks Nathan. Good to talk to you.

My pleasure, Alan.

That was Nathan Bell, portfolio manager at InvestSMART and the leader of Intelligent Investor.

 

Click here to view the Intelligent Investor Equity Growth PortfolioEquity Income Portfolio and Ethical Share Fund.


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