The Atlas High Income Property Fund gained by +2.5% over the month of July in a quiet month that had limited news flow with the majority of listed companies in “blackout” prior to the release of their half-yearly results in August.
The key news over the month was the RBA cutting the cash rate by 0.25% to a record low of 1%. The falling official cash rate has seen the major banks cut their benchmark 180-day term deposit rates fall to 1.4%. While this looks grim for savers, the situation is likely to get worse with six-month interest rate futures at 0.78% which points towards further cuts.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.
Over the past few weeks there
have been several headlines in the financial press discussing investment
styles, along the lines of “Is
value investing dead?” Such articles generally centre around the triumph of
growth investing and the demise of value-style investing. Investors looking for
professionally managed equity portfolios face a vast array of options, with the
different portfolio managers building portfolios based on their individual
investment philosophies or investment styles.
In this piece we are going to
look at some different investment styles used to manage equity portfolios, the
underlying theories underpinning these investment philosophies as well as the
time in the cycle where they tend to outperform. Additionally, we are going to
look at the quality style used in constructing the Maxim Atlas Core Australian
Equity Portfolio.
Index Funds
When investing in an index fund
(such as Vanguard’s Australian Shares Index ETF) the manager attempts to match
the return of the underlying index less a small management fee. Here the
manager will automatically buy Fortescue to its current index weight of 1.3%
and makes no judgement as to the company’s valuation, or whether iron ore will
stabilise at US$120/tonne or fall back to US$60/tonne. If Fortescue’s
weight in the index increases due to its share price outperforming, the manager
buys more Fortescue and if it underperforms the manager will automatically sell
some of the Fortescue shares held by the index fund. As AMP’s
fortunes have declined over the past 18 months, index funds have mechanically
sold AMP shares in line with its falling index weight, thereby exerting
downward pressure on AMP’s share price. The growth in index funds over the past
year has increased the impact of momentum and over-valuation, as there is a greater
weight of funds automatically buying those companies whose share prices have
been rising.
While index funds can be a cheap
way to obtain exposure to the equity market, investors are exposed to all
companies – good or bad, overvalued or undervalued. For example, in 1987 and
2007 the index contained companies such as Bond Corporation, Qintex,
Allco, Babcock & Brown and Centro, all of which
subsequently went into liquidation. I observed a more extreme example as a
young analyst working in the Canadian market, where telecommunications
equipment company Nortel in 2000 comprised 35% of the benchmark Toronto Stock
Exchange 300. As an investor in these markets albeit a younger one in 1987, it
seemed quite clear before their fall that these were companies with shaky
business models reliant on high levels of leverage, and in the case of Nortel
irrational market valuation. Not owning
companies such as these caused many fund managers to underperform relative to
the index, however their investors avoided the losses as these former
high-flyers lurched into administration.
Index Funds tend to
outperform active managers towards the end of a bull market. At the end of bull
markets most fund managers will be reducing risk in their portfolios,
increasing the cash weight and moving into safer stocks; whereas index funds
will be mechanically buying those stocks whose prices have upward momentum.
Growth Funds
Funds managers using the growth
style of investing tend to select securities based more on the brightness of
the company’s prospects, rather than the company’s current profits and
dividends. Here the growth manager seeks
to build a portfolio comprised of companies such as accounting software company
Xero or payments company Afterpay, based on the
assumption that the market is underestimating their growth prospects.
The rationale is that Xero’s
earnings and dividend yield are expected (by the growth manager) to rise
rapidly. This justifies buying a company that is trading on a price-earnings
multiple of 246 times next year’s earnings per share (EPS) and does not pay a
dividend. Unlike an index fund, analysts at growth funds would spend many hours
meeting with a company’s management team and industry contacts to understand
why the company’s long-term profit growth is likely to exceed the market’s
current optimistic assumptions. In 2009, CSL was trading at $31
per share and had earnings per share of A$1.92 and the company was viewed as
expensive, trading at a PE (price to earnings) ratio of 16.1 times. In August
2019 CSL is expected to deliver earnings per share of A$6.05 which, based on an
initial purchase price ten years ago, puts the blood therapy company on a very
reasonable PE of 5.1 times with an 8.8% dividend yield.
Growth as an investing
style tends to outperform during times where the stock market is rising sharply
as during these bullish times investors tend to overestimate company earnings
and minimise potential problems such as debt refinances and the entrance of new
competitors. Also, in the case of growth companies such as Afterpay,
when the company’s share price is up 63% in the past 12 months investors don’t
care about not receiving a dividend.
Value Investing
Unlike growth funds that tend to
buy well-loved high growth stocks, value-style funds adopt the strategy of
picking stocks that are trading below their net worth. Benjamin Graham and
David Dodd famously developed this style in their seminal investing text from
1934, Security Analysis (not a light read by modern standards with 725 densely
packed pages and few graphs). Value investing is based on the concept that
undervalued stocks will revert to their intrinsic value, thus allowing the
investor to buy (for example) $1 worth of assets for 80c.
Characteristics of this investing
style include buying companies that are trading on a low price to book value,
low PE ratio, or indeed buying companies whose liquidation or wind-up value is
greater than their current market value. A classic example of a stock that
would have featured in many value-style portfolios over the past year was Telstra.
In July 2018 Telstra was trading at $2.60 which equated to 13 times its
projected earnings per share and with a dividend yield of 7%. Here the market
was concerned about increasing competition in the mobile phone market in
Australia and the impact of the NBN on profit margins. Over the past year
Telstra’s share price has rallied to almost $4 due to a combination of
decreasing price competition in mobiles, and government decisions to block
rival TPG from both building a 5G network (using Huawei technology) and merging
with UK-based Vodafone. Telstra currently trades on a PE ratio of 25 times with
a 4% dividend yield.
Typically, a value-style fund
will have a lower price to earnings ratio, lower beta (a measure of volatility),
and a higher dividend yield than a growth-style fund, with greater exposure to
more mature companies. One of the dangers of value-style investing is being
attracted to companies that are “value traps”, namely those that have a high
(albeit unsustainable) historical dividend yield and low PE ratio as they
operate in a declining industry. While department store owner Myer
has recovered in 2019, this company is viewed by many to be a value trap.
Value funds often
outperform during a recovery as the manager is likely to own disliked companies
that are priced on low PE multiples as the market views that the company may go
into administration or will only see low to negative growth. When the market’s
views on the prospects of these companies are proved to be too pessimistic, the
share prices of these value-style companies can see a substantial re-rating.
Myer is a great example of a value stock who’s share price recovered sharply
from 36 cents in February 2019 to 72 cents in April!
Quality Investing
Following the Dot Com Bubble of
the early 2000s and the aftermath of the GFC, investors have begun to pay more
attention to the quality of a company, rather than just its raw earnings
multiple or dividend yield. This approach or style has been called quality
investing and focuses on hard factors such as the quality of a company’s
earnings or balance sheet, along with softer factors such as the quality of
corporate governance and transparency of information being given to investors,
while still seeking to buy companies that are undervalued. Although their
strategy shares many characteristics with value investing, quality-style fund
managers are prepared to tolerate paying more for companies with higher quality
recurring earnings streams and tend to avoid very cheap companies that are in
the process of restructuring. This is the approach we use in managing the Maxim
Atlas Core Australian Equity Portfolio.
Quality investing seeks to avoid
risky stocks and focus on owning both high-quality companies and stocks with
improving quality. In the case of improving quality, here the market may see a
company as low quality, when in fact the underlying fundamentals of that
company are improving. For example, in early 2017 private health insurer Medibank
was added to our portfolios. At this time, we considered that the market was
not pricing the potential profit uplift that Medibank’s management could
generate from cutting out costs and inefficiencies that crept in over the
decades of government ownership. As the market recognised the improving quality
of Medibank and the steadily rising profit margins from reducing costs, the
share price has moved steadily upwards. We do however recognise also that the
Federal Coalition’s victory in May has improved the company’s prospects.
Quality style fund managers
tend to outperform during market falls and in the early stages of a recovery,
as investors abandon stocks whose business models now look fragile in a harsher
economic environment. During times of market turbulence, companies offering
recurring high-quality earnings derived from selling non-discretionary goods or
services look very attractive, with a high sustainable dividend yield
cushioning falls in their share price.
Our Take
In managing the Atlas Australian
Equity Funds, we strongly favour the quality investing approach which reflects
experience in managing funds across a range of different market conditions
including the Tech wreck in North America in 2000, the GFC in 2008 and the
collapse of commodity prices in 2015/2016. After investing in a few cheap
companies earlier in my career that ultimately turned out to be “value traps”,
I prefer paying a higher earnings multiple for companies that offer greater
earnings and dividend certainty. Nevertheless, when investors choose a fund
manager, the manager’s style must match the investor’s goals and their
investing temperament. If an investor is
looking for a fund that focuses on owning high reward (and risk) tech stocks,
investing with a manager looking to deliver low volatility and higher dividends
is likely to be unsatisfying.
The wagering and gaming company that acquired Tattersalls in 2017 is now a buy. Hugh Dive from Atlas Funds Management explains how the industry’s headwinds have now turned to tailwinds through legislative changes. At the same time new taxation regulation is applying to TAB’s competitors in a way to level the playing fired and enable the leverage of TAB’s size to favour their own odds.