The hunt for mispriced stocks

Alan Kohler here with this week's fund manager, and it's Paul Moore, one of the most experienced fund managers in the market. He runs the eponymous PM Capital, which stands for Paul Moore of course. Well worth listening to on the subject of how to invest, because he's seen it all.  

Here’s Paul Moore, the Founder and CIO of PM Capital.

Paul, you’ve been operating funds for quite a while now, when did you start?

I started back in 1985 as an analyst and then PM Capital was set up in 1998 so it’s been 20 years running my own investment firm, 30 plus years in the industry so it’s been a while.

It’s been a while, almost as long as me, Paul.  What have you learned over that time?  Obviously, you must have developed a pretty solid grounding in the markets and how to invest, what’s your approach now?

To be honest the approach hasn’t changed a lot, the basic framework way back then you’re out there looking for stocks that have been mispriced by the market but I guess back then you’re pretty raw in terms of your understanding of how markets worked and the discipline you needed and making sure you do the work properly and identifying genuine anomalies as opposed to a story that sounded good.  I think the benefit of being around a while is that you’ve been through bull and bear markets and sideways markets and as you say you learn your lessons through experience, you learn what your strengths are, you learn what your weaknesses are.  Over time you can work to minimise your weaknesses and hopefully accentuate the strength but the interesting thing is the markets haven’t changed.  The reality is why these opportunities open up is the same reasons back then.  People just get fixated on short term issues and they kind of start pricing them into good businesses like they’re permanent rather than being transitory.  That’s probably the dominant reason why we think you can still make a difference longer term and to be honest if anything the markets are even more short term orientated and I guess the only other big change over that time is how process driven everyone has become.

Passive and ETFs dominate the world now and their investment decisions have got nothing to do with fundamentals, their decisions have just basically got to do with are you part of the index or not.

That increase in the passive investing that obviously everyone’s aware of, how has that changed your approach?

It hasn’t changed our approach but you need to be conscious that I guess these anomalies created by that process can hang around a bit longer.  Perversely it also means that sometimes they create an even bigger underlying discount which to me is fine because I’ve got the patience to hang around for a while so provided you got the right time horizon that’s where you can really earn your better risk adjusted returns but the way to think about it is the numbers that are quoted in the press are like $5 trillion that has moved to passive and ETF over the last decade and what that means is that a large chunk of the market is no longer traded.  The liquidity out there has shrunk dramatically which means the bid offer spread widens which is great for people like ourselves, that’s what we want to happen but you need a longer term horizon.  I think the other thing that probably highlights it is I think the gatekeepers are underestimating – we all know that there’s a correlation between size and the ability to add value to your strategy and if liquidity is shrunk dramatically the reality is that size hurdle has also shrunk dramatically.  I think you need to be operating well within your limits these days because it’s just a lot harder to kind of move around in terms of rotating your capital.

To some extent the shift of money into ETFs and passive investing generally is a vote of no confidence in people like you, isn’t it?

Yeah, I think we all understand the reason you’ve had that move in that unfortunately the industry shot itself in the foot in that it became so paranoid about the risk of losing their FUM that they drifted towards just replicating the index because then in theory you couldn’t be fired for making a bad decision.  That’s, I guess, when you’re investing longer term, look investors always make bad decisions and you’ve got to have the ability to obviously deal with that, but the majority of your decisions obviously outweigh your poor decisions.  What it means was that most of the industry claimed that they were out there picking stocks and miss-priced businesses but the reality is they were replicating indices.  Then the industry worked out I can do that for a lower fee so it’s perfectly rational what’s happened.  The problem now is it’s gone to such a big extreme that it in itself is starting to open up inefficiencies in the market.  For those who are genuinely active high conviction managers I would argue that it’s now making it even more favourable for investors like ourselves but you’ve got to be genuinely investing in the anomalies and not replicating an index.

Let’s just talk about philosophy for a moment, the way that you go about it is, as you say, looking for mispriced stocks.  How do you find them?

It’s as simple as most of our ideas start off with a simple observation on valuation versus business quality and I guess over time you end up looking at a lot of different businesses and getting familiar with how they should be valued and it’s as simple as just sitting back and getting away from the short term noise and looking for those glaring anomalies to pop up.  I always tell my investors the way to think about it is if you’re sitting on the moon and you’re looking at the earth you can see what really stands out.  Then once you make that observation on valuation it’s a matter of going and doing the work and confirming that in fact that is an anomaly because often once you’ve done the work you realise there’s a reason for the way something has been priced.  Typically, around sort of cyclical downturns in markets or with industries what happens is investors get fixated on what’s happening now and they start to price that as being permanent.  If you are prepared to kind of step back and have a look at it properly you can find some interesting opportunities.

Do you use screens, is that how you go about picking the valuation opportunities?

Well I mean everyone uses screens but you do that in your head when you’ve been in the industry 30 years.  You kind of understand what the qualities of different businesses are, how they should be valued.  We’ve got valuation screens, we’ve got sort of market conditions that we typically know will throw up good opportunities.  When any industry goes through a cyclical downturn typically investors give up on even the good companies.  People kind of get nervous about macroeconomic and political events when the reality is that’s usually just a distraction, Brexit, Trump, all those sort of issues.  Sometimes people just fall in love with certain areas when the underlying fundamentals are clearly deteriorating like the consumer food stocks last year.  There’s a whole range of simplistic things that can actually point you in the directions of really good opportunities.  I guess the hard part is doing the analysis and confirming that it is in fact a long term opportunity.  Hopefully that’s where we add our value longer term.

Can you give us a sense of some of the main stocks that you’ve invested in?

Yeah.  At the moment if you look at our portfolio the big ones we own are Bank America and JP Morgan in the banking side.  We own KKR which is private equity.  We own Visa and Mastercard which is a unique toll on the payment system.  We own some residential housing recovery plays in the US, Ireland and Spain which is really just an extension of that big recovery that you’re getting in housing offshore after the GFC crisis where it absolutely got torched.  We own some of the financial exchanges which we bought post GFC because they’re great monopoly franchises but people started to think that volatility and transactions would disappear forever.  They’re probably our big ones at the moment, we tend to run a pretty focussed portfolio.

It sounds a bit like you’re bullish on American financial stocks, financials and banks in general.

Yeah, we have been because a few years ago we kind of highlighted that CBA was selling at three times book and the equivalent of CBA and Bank of America, was selling at discount to book so there was a huge arbitrage opportunity there and as you know obviously the Australian banks there was a lot of headwinds starting to blow in its face, whereas the offshore banks because they’d been cleaned up post GFC, their capital has gone up enormously and then the Fed approved that they could now return 100% of their earnings to shareholders in terms of dividends and buybacks.  Bank of America is a classic, you’ve now got a pristine balance sheet on a 10 PE and returning all that to shareholders, you’re on an effective 10% yield which in a 3% bond environment is quite remarkable.  Even though it’s done well we still think that there’s good mileage left in that stock.  So I guess GFC threw up quite a few areas of interest in the financials.

Do you think we’re getting late in the cycle now?  Obviously, there’s always debate between the bulls and the bears, and people saying that we’re about to have a crash or whatever but where do you think we are?

That is the debate at the moment, if you look at the way stocks have been valued the market is valuing those typical late cycle stocks as though that’s an eventuality.  We don’t think that is the case because if you look at how nervous people were in ’15, ’16 with Brexit and Trump, and even throughout ’17 with basically believing that nothing would get through congress.  Consumers overseas have been conservative, corporates have been conservative and it really wasn’t until the tax reform went through that you really started to see that pent-up demand in the United States being released.  So the economy, we think over there, is probably going to surprise people that they’ve got another few years left in it and therefore good earnings growth.  If you have a think about Europe it’s not as though Europe has been booming but periphery is doing better than people realise.  There’s still plenty of room for Europe to raise interest rates, etcetera.  I think the markets are reacting like it’s been a normal cycle but as you know GFC really pushed out the recovery into a much longer and slower process and so I think that’s why the market might be getting it wrong in terms of whether we are in fact late cycle.

The other thing to look at is if you look at the way interest rates have moved they’re still pretty much zero in Europe.  In the US even though they’ve moved back to 9 on the 10 year compared to where they were 3, 5 or 7 years ago that’s not exactly choking off interest rates, wages are going up.  I think we’ve still got a few years of traditions that will allow companies to grow earnings.  Ratings won’t go up because interest rates have backed up and won’t be any help anymore, but you can still get acceptable returns if you’re very selective.

Are you worried about anything?  I’m thinking in particular about trade war.

You go back to ’15 it was the oil price collapsing and China, ’16 it was Brexit and Trump, now ’17 it’s trade war and there’s always some sort of macroeconomic event for people to fixate on.  I don’t think we’re going to get a trade war, trade issues do need to be dealt with, the US can’t run a perpetual trade deficit, they have to address it at some point and that’s what’s being done now.  Macroeconomic concerns is basically the core reason why people have been scared out of the market since 2009 and if you look over that period the market is up like 150, I think our fund is up 250.  There’s been a great opportunity cost with people being scared about macro.  The one difference now is that clearly the risk/reward has changed because markets have done well.  There’s a lot of sectors that are selling at their highs and on full valuations.  I think you’ve now entered an environment whereby there’s parts of the market that are fully valued and might come back, there’s parts that are undervalued and might go up.  You get more of a sideways market and those companies that can grow earnings will deliver acceptable returns.  I still think it’s going to be a few years before we get genuine tightness in liquidity and then you might need to be genuinely concerned about the market.

I know when you were going through the stocks, the main stocks that you own, there was no mention of Amazon or Facebook or Google or Netflix, those sort of things.

We do own Google because we bought that a long time ago when people were worried about mobile disruption.  It’s now reasonably valued but it’s still got very strong underlying earnings.  You won’t find us in Amazon, Netflix and those sort of companies because they’re clearly not structurally mispriced and I think that’s one area of the market that is very crowded.  If there’s any hiccups along the way – it’s the old story, the next hiccup it’ll be a totally different set of stocks from the lost hiccup that will get impacted.  Strangely people get comfort in the ones that weren’t affected last time and they’re very nervous about the ones that were.  From an investment point of view it should be the other way around.  They’re not the type of stocks we would typically buy because we need an entry point that we’re very confident that we’re buying something that is genuinely undervalued.

Just on that subject it does seem in the past few years, possibly five years, that the investment strategy that’s worked the best has been what they call growth investing or momentum rather than value investing.  I get the sense that you’d regard yourself as a value investor but the growth investors have been winning lately because stocks like the ones you mentioned, Amazon and so on, they’ve been pretty fully valued, they’ve just kept going.  How have you found that?

I think over the last 12 months if you judged a discrete period there’s definitely those who were highly concentrated in those sort of stocks obviously by definition, would probably be at the top of their peer group, but having said that over the last five or seven years despite that in December we were kind of ranked number one over five, six, seven, eight and nine years so investing in these value stocks has also been well-rewarded.  The comment I make – because to me you shouldn’t distinguish between value and I mean it’s a very category world, I know, but no matter what the type of business and what sort of category that someone puts it into it’s an investment longer term, you shouldn’t invest in anything unless it’s value.  The concept that you would invest in a stock thinking that it was overvalued is kind of crazy to me.  There’s a price for Amazon that’s good value, there’s a price for Google that’s mispriced, there’s a price for Bank of America that’s mispriced, they also deserve different multiples because they’ve got different qualities but if you were going to invest in anything I would assume that everyone is a value investor because why would you invest in something that doesn’t have value, it’s just kind of a strange phenomena to me.

It’s a matter of how you define value I suppose.

Correct, I define value as something that’s mispriced and that’s why you’ve seen a growth stock like Google in our portfolio because at a point in time there was a disruption in the market that allowed us to buy that at a discount to what was really worth so we thought it was good value.  On the other hand Bank of America is a generic low growth old economy type stock but there was a disruption in the market that allowed us to buy that at what we thought was value.  Everything we do we think is value but we would recommend that to all investors and we also recommend only buying Amazon if you thought it was mispriced.  Amazon is a hard one to value and the growth is quite strong, it depends on the metrics that you like to use to invest but every investment should ultimately be based on being mispriced I would have thought.

Can you give us a bit of a profile of your group, PM Capital.  Obviously, the PM is you.

Correct.

Do you own the business?

Yeah, so basically, I was the founder, I’ve been the portfolio manager of our global fund since inception and I’m the biggest investor in the fund.  I have a team of very senior portfolio managers that have been with you between 10 and 20 years.  There are also shareholders in the company and then we have a number of analysts who have been with us obviously for a less period of time and helped with the work we do but they’re also shareholders in the business.  Obviously, I have a CEO and sales and back office, etcetera, and in a nutshell all our staff other than those who have recently joined and haven’t reached the minimum terms yet are shareholders in the business.  We kind of see ourselves as an owner/operator, what distinguishes us is the fact that we co-invest with our clients in our funds.  I think that’s our big distinguishing feature.  We’re typically the largest investor in each of our funds and we think that’s really important from an alignment of interest point of view with the shareholders and the unit holders.  Also from my point of view to me it’s a way of making sure everyone else is part of the business and kind of gets locked into that mentality of being an investor first and always putting the shareholder first.

How many funds have you got?

We have four strategies, global, Australia, Asia and cash enhanced.  For each ne of those funds we might have a couple of different funds because you have to have certain structures for different platforms but basically the way to think of it is that we’ve got four different strategies.

And that includes one or two LICs, right?  Listed Investment Companies?

Yeah, so for our global strategy we have our unlisted, we have our listed TGF and what we’re doing at the moment is the roadshow for our P Tracker which is a new security but it’s exactly the same structure in terms of the portfolio, it will be in portfolio composition as the TGF and practically we’re effectively raising money for TGF and we’re doing it in the new structure that addresses the issues with LICs around premiums and discounts and getting diluted, etcetera.

How does it do that?

It’s really simple, actually.  I guess that’s the beauty of it, is the structure provides a redemption option in seven years time at NTA plus franking so what that means is over the seven year period you’ve got the guarantee of getting the underlying return that the shareholder delivers which is the big problem in the LIC market because if they go to premiums or discounts you don’t necessarily get the underlying return.  Now in seven years’ time you don’t have to redeem, it’s only if you want, it’s like a safety net.  You can also convert into TGF at NTA plus franking so the beauty of what we’ve done with the redemption facility means that we can raise money at NTA and therefore new and existing shareholders don’t get diluted and that’s the big problem with the LIC market, is that historically when managers do capital raising someone gets diluted.  The other benefit is because we now have two structures that will be identical the arbitrage opportunities that would open up with either vehicle gets away from NTA or from each other should mean that they should be kept in a tighter band around NTA and so more confidence that the share price will stay in a band between pre and post tax NTA that it should trade in.  I guess that’s the other big problem with the LICs is that they go through periods where sentiment is positive and they go to premiums, they go through periods where that’s negative and they go to discounts.  As a result the shareholder doesn’t necessarily get the underlying return of the shareholder.

That’s a pretty good idea.  Well done.

To be honest I think if you really have a think about it it’s simple but it really nails the issues related to LICs and my CEO spent the last 18 months really looking at all potential structures and I basically gave him an edict, I’m the largest shareholder in TGF so I refused to be diluted to even one cent so that’s what we’ve got to solve, and I think he’s solved it.  The other issue is we’re paying more than the upfront cost but the new shareholders 100 cents in the dollar is invested for them from day one.  We’re hoping the simplicity of what we’re doing but also the fact that it puts the control back in the hands of the shareholder, because if you think about current LIC structures effectively they’re perpetual securities which means once the money is raised the reality is the shareholder has not control so on a worst case scenario if the manager doesn’t perform to expectations or change its objectives the shareholder can do nothing but typically sell out at a big discount and the beauty of this is that if the shareholder decides that we’re no longer a good custodian of their money they can take it back. 

Obviously we need a time horizon consistent with our strategy to invest the money and prove to the shareholders that we are good custodians but bottom line is when they’re in control we’re hoping that it really does change the LIC market because Australian investors do need to get offshore because they’ve got single digit exposure to offshore markets at a time when there’s better risk/reward offshore.  The problem is as you know is there’s structural issues with the LIC market that can create a bad outcome for shareholders.  If we’ve solved that with this structure and the industry moves to it it facilitates that ability on a consistent basis to get offshore.  We’re hoping that people do realise the simplicity and importantly the governance factor because again you’ll know this as well as anyone that if things go wrong what does the shareholder do.  They can talk to the board but typically it’s in one ear and out the other.  That’s why these things go to big discounts and ultimately it can wipe out any underlying returns the manager delivers.

Finally tell us about your fees, what do you charge? 

Obviously for the different strategies there’s different fee structures so for the structure that we’re raising the money for at the moment it’s just a flat fee structure.  We thought for simplicity purposes it’s easier not to have a performance fee.  For our existing TGF it’s a 1% management fee plus an outperformance of the MSCI.  We have some funds are a management fee and an excess over the RBA, others are on the MSCI or the ASX or the Asian fund depending on what strategy it is.  The cash fund is a lower management fee but a performance fee over the RBA rate.

Right, and what’s the performance fee?

Sorry?

What is the performance fee?

For which fund?

I don’t know, are they all different are they?

Yeah, so for TGF it’s a 1% fee and you get a 15% share of the outperformance over the MSCI index.