2020 economic outlook with Roger Montgomery
Roger Montgomery - Roger Montgomery Investment Management
Paul O'Connor (POC):
Welcome to the Netwealth portfolio construction podcast series. My name is Paul O'Connor and I'm head of investment management and research at Netwealth. In my role here, I'm managing govern the investments that are made available to you through the Netwealth investment platforms. Today we have Roger Montgomery founder and chief investment officer of Montgomery Investment Management. Welcome Roger.
Roger Montgomery (RM): Good to be with you Paul.
POC: Montgomery have a number of Australian and International equity funds available on the Netwealth platform. So hence, we thought it'd be prevalent to get Roger in to get his views on the global economy and the Australian economy and an outlook for 2020. Starting with really given the attention the Coronavirus has been receiving in the mainstream press. What are your views on the economic impact to the global economy as a result of the pandemic that's unfolding at present?
RM: So got a couple of perspectives on this. The first thing I want to say is there's this terrific little, I guess, story about a King once asking his advisors thousands of years ago, asking his advisors to sum up the world and the future and everything in forwards. They came back to him and they said this too will pass. Coronavirus will pass. That's the first thing to remember. If you have that perspective, it allows you to realise that there could be lots of opportunities presented by when the market reacts negatively to a company saying, for example, yeah look, we've been adversely impacted by this, so we saw yesterday Kogan for example, we've seen lots of, well not yesterday, earlier in reporting season, we've seen lots of companies come out and say, we're seeing an impact. You think about a company like Lovisa, great retail opportunity, great growth prospects, and then very fast fashion, 78 new products a week.
RM: If China shuts down because the Coronavirus, where do they get their product from? They don't have product to sell. That's going to have, that's going to inhibit their ... Cause their inventory turnover is so fast. It's going to inhibit their revenue generating ability. Is that permanent? Well, it depends on how long Coronavirus lasts. But remember this too will pass. Now you asked me about the economy, what does it mean for the economy in Australia and maybe the rest of the world? Well, it could have a detrimental impact on growth. The longer it lasts, the worst that impact will be, but it doesn't really matter, Paul. What matters is how does it affect individual companies? Then you start to think, does it, is it going to impact on companies permanently? No, it won't. Some it could, we know for example, there are restaurants in Melbourne that have closed down.
POC: I'm seeing that in The Métis or a couple in Little Berge Strait or little Berge Strait, here in Charlottetown.
RM: Yeah. And maybe for different reasons. George Calombaris has gone. Retail's been doing it tough in Australia already. We've seen a lot of retailers go broke in Australia and closed their doors permanently. So it's not just Coronavirus. The point to make is that it will affect companies differently. It's your job as an investor to think about how they're going to be impacted and ask yourself this one question. Is it permanent? And if it isn't permanent then it's probably an opportunity.
POC: Yeah. Interesting. I think a timely reminder that equity markets continue to overreact at times.
RM: Of course, they do.
POC: For short term use.
RM: That's what's so great about equity markets.
POC: That's where if you keep that long term investment strategy it's does present an opportunity good investor there. So...
RM: It just requires you to realise, ask yourself, how do I help investors think about how to think long term is to ask yourself, if I was a bear and I hibernated for five years, would this issue be gone when I wake up? You can almost guarantee we're not going to be talking about Coronavirus in five years time. That's how to think about it.
POC: We'll probably be talking about Coronas, but a different type of Corona there Roger. Maybe gone to the U.S. economy. What are your views at the moment on the U.S. economy and the outlook and particularly given the phase one of the trade deal with Trump? The trade uncertainty and the trade war seems to be playing at this. What are your views at the moment there?
RM: Well, I think interest rates are going to stay low for a while and that's because of the very high level of corporate debt. The economy itself with the traditional measures that we look at. For example, retail sales, we look at employment. Employment's strong in the United States at the moment. They'd like it to be stronger, but it's not getting worse. Wages look like their okay. It's not growing at a great rate of knots, but that's good. It's not inflationary. But it's not going backwards either. So you're in this sort of Goldilocks position where you've got low rates and the economy's plotting along. That's good. On the other hand there are risks around the level of corporate debt. There are risks around the bubble in private equity valuations. It's an enormous amount of money that's been poured into private equity.
Think, people have, I think on mass thought that it's going to be their road to riches, but the companies that they've supported are only making money ... Are only employing people because of the altruism of
private equity investors. Eventually when they run out of money, private equity investors don't want to put more money in, not at increasing valuations at least. You might find a lot of those people become unemployed and that could change the unemployment picture for the United States and we may end up with a recession down the track. But there's no risk of that at the moment.
POC: Yeah. Now interesting you comment on private equity. We've certainly seen an increasing interest, the number of products available on the investment menu. But I guess as an investment consultant, the returns out private equity as an asset class over the last decade have not been that great.
RM: Well, they've been boosted by the fact you don't contribute all of your money up front. That's the big issue.
POC: So true. I think also impacted by who are you buying the equity off of. Is it an investment bank or is it a family that's built up a business and looking to sell it and go public.
RM: Paul, the big issue which I talked about in our webinar recently was the fact that this is an illiquid asset class. Now, I remember the GFC really, really well. I can remember investing through the GFC. I remember that there were funds around me that were closing, liquidity went, there was no liquidity, they'd shot. They wouldn't allow redemption's at all. So what did people do? They got their money out of the funds that were performing really well. So here's a scenario, let me paint a picture. If for whatever reason, whatever the left field black swan event is, that triggers people to go risk off, they can't get their money out of private equity. So where will they get their money out of? They'll get it out of the other assets, equities, for example.
POC: They're better quality assets typically was what they were selling.
RM: Well that's right.
POC: I think to your point.
RM: Yeah. And so they're getting, they're going to take their money out of equities. You look at U.S. equities, the top 10, the largest 10 U.S. companies are on an aggregate P of 45 the top 10 Australian companies by size are on a P of 19. U.S. markets are pretty expensive. Now, they're justified by low rates, But those ... And it's true that the market is pretty much surmounted every obstacle put in front of it because of those low rates. It's ignored pretty much Coronavirus. It's ignored Presidential impeachment. It's ignored a trade war with China. It's ignored Korea sending missiles over Japan. It's ignored all these things. It's just keep going on its merry way because interest rates are low, but at some point the process get too high and when they get too high, people start to say, you know what, maybe it's time for a risk off, but I can't get out of private equity and that's where a lot of our money is. So I'll take it out of the equities.
POC: An interesting point there about the evaluations of the large or the mega cap companies listed on the U.S. exchanges. The New York or the NASDAQ stock exchanges versus Australia's top 20 companies listed there on the pay of 19 to what was it 44 I think you mentioned.
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RM: 45 for the U.S. top 10 and 19 for the Australian top 10. Big difference.
POC: Absolutely. Sort of fading a little bit off those comments are about the U.S. economy. The current economic cycle, it's now what, 11 years long now and I think it's the longest expansion rate period ever recorded. Mind you, this will be a period studied very closely by finance and the economists, academics over the years to come. Do you have any thoughts on what's really pushed the cycle out so long?
RM: It's the greatest monetary experiment of all time, now called modern monetary theory. The idea is that the level of debt you accumulate as a sovereign doesn't matter, the amount of money that you print, doesn't matter. How low you cut interest rates, doesn't matter.
Just keep doing it and keep kicking the can further down the road. That's what we're experiencing right now. Asset prices are high because interest rates have been cut so low that people don't want to keep their money in cash. That's precisely what central banks wanted to do. They wanted to engineer a wealth effect. They wanted to engineer rising asset prices so people who had assets felt wealthier and then went and spent money. Hasn't worked. Hasn't really worked cause we haven't had significant growth in economies. So it's really synthesised, it's artificial. It's gone much longer than any rational person would have thought that it would. You look at where Warren Buffet sits. Warren Buffett's arguably the smartest conventional or traditional investor in the world and the best performing one.
Yes, there are companies like Renaissance Capital that run quant funds that have done better than Buffet. They had an appalling year last year, but over time they've done even better. But put that aside, let's look at somebody who just thinks about businesses and equities as pieces of businesses. Berkshire Hathaway sits at about 40% cash at the moment, 40% cash. That's telling.
POC: How would that compare to, I guess historically the cash holdings?
RM: In the GFC, during the GFC, he went down to about 8 or 10% cash and now 40% cash in the largest single position in Berkshires portfolio is cash. That's telling. Forget about all the positive things he says about investing in America. Put that all to one side. All those sort of paternal statements and just look at what he's doing. He's holding a lot of cash, can't find things to buy. He thinks the market's expensive and he only puts that cash to work when it's cheap.
POC: Yeah. It's interesting there and I think you know in my mind the huge amount of debt built up that led into the financial crisis in 2008 has never been paid off and in fact it's simply been moved from the private sector to the public sector.
RM: Correct. Socialised.
POC: And continues to increase.
RM: Yeah, indeed.
RM: Yeah, indeed. I don't know how it ends. I don't know if it does. Maybe it doesn't end in our lifetime. But if you think the background to what's going on is, and that's not going to change, that is that central banks are cutting rates to incentivize businesses to invest. The theory goes that by investing by those businesses investing, they'll employ more people, but it's not happening. What's happening is they're investing in technology that displaces labour, that replaces people. And so central banks have to cut rates even further to try and get more people employed. That's the difficulty. That's the corner that central banks have backed themselves into. So I don't see rates rising anytime soon. For the time being, it's steady as she goes.
RM: Yes, we seem to be lucky all the time.
POC: We are the lucky economy. Saying that is quite in the front of my mind at the moment that when China sneezes, Australia catches a cold or catches Coronavirus. So what's your view on the outlook for the Australian economy over the year and I guess given your really comments around the Coronavirus, any sort of takeouts of the impact that will have on Australia other than a couple of restaurants closing that we mentioned earlier?
RM: Well if the Coronavirus issue lingers longer than SARS. SARS was an issue for about three or four months. Hard to compare the SARS Coronavirus to the current Coronavirus. That's because you had the Iraq war at the time of SARS. It went for three to four months. If this goes, the market is currently betting that it goes, the current Coronavirus goes for a similar amount of time. If that's wrong, then the impact on the Australian economy will be felt in tourism. It will be felt in GDP. I think that's why the reserve bank recently kept their powder dry and decided not to cut rates because they wanted to be able to do so if it did get worse. Having said that, and there's an issue obviously for iron ore prices, if the lockdown in China continues. I'm getting some wrought iron work done on some gates at home back in Sydney and I've got a Chinese factory.
I've got an Australian designer who's using a Chinese factory. They have told us that they told us back on the third or fourth of January that the factory would be closed until the third or fourth of February cause of Chinese New Year anyway. Then there was the Coronavirus issue, so they said it will, factory will reopen on the 10th of February. Now they're telling me the 22nd of February and it could be longer than that. These sorts of things have an impact. Take Lovisa and I talked about it in our recent webinar, but you look at retailers for example, that have very high asset turnover, they're going to be adversely impacted. They can't get stock. You look at travel companies, Sydney Airport, it's going to be adversely impacted if Chinese tourists aren't coming to Australia. That's 10% of their inbound passengers. They spend an inordinate amount of money at the more expensive shops at Sydney Airport, at the international terminal.
You look at individual companies, the longer this goes it's going to have an adverse impact. Your question was about the economy as a whole. If I aggregated all the impacts on all the companies and on all the sectors, I would say it's a negative the longer it goes on. I just don't know how long it will go on. Wherever there's risk and volatility, there's opportunity. The green shoots are that we've seen dramatic increases in property prices in Sydney and Melbourne for example, up 11% for the year, for the last 12 months. That's fantastic. That's going to have a positive influence on construction activity. We've already seen a little jump in approvals that's going to lead to a jump in construction activity again, which slumped last year as we predicted it would. So we're sitting on about 18% cash looking at where these opportunities are going to present themselves.
Should we be buying CSR building products? Should we be buying James Hardie? Should we be looking at flight centre who said the Coronavirus is going to be a negative for them? We know in five years time Coronavirus isn't an issue. Am I buying flight centre for the next month to hold for a month or am I buying it for five or 10 years? Of course, I'm buying it for five or 10 years. So when we think through these issues, yes Coronavirus could be negative for the Australian economy, but it could be a huge positive for investors who think longterm.
POC: Yeah. Interesting points. I guess the next question in my mind is the view that you have on the RBI and current interest rates and I think given the comments you've made, the Coronavirus and how long this plays out will be the number one determinant. But the RBI we'll be looking at before that we'll make a call to fill the cut rates. Would that be rotting?
RM: I think the reason why they'll be reluctant to cut rates is property prices are picking up. Mortgage brokers are reporting a lot more inbound inquiry and so we're starting to see the bank sort of caught where it would like to cut rates because Coronavirus but it can't because it risks fueling another property bubble. I think they're going to sit on their hands. They'll keep their powder dry. The Coronavirus issue gets really bad and it really affects our economy negatively they probably will cut. But I think they're reluctant to given the performance of housing.
POC: Moving into the markets now, do you think Australian or international equity markets offer a bit of value? Which market do you think offers a bit a value ultimately and I guess F of the markets? What are the opportunities? What are the themes and the trends that you're observing and are just uncovering in the fundamental research that your business undertakes on all the companies of investing?
RM: An answer to the first question I'll go, refer back to the comment that I made about how expensive some U.S. companies are compared to Australia. Our 10 most expensive companies or our 10 largest companies are on a P of 19 versus 45 for the U.S. So that's something to keep in mind. There's always going to be opportunities in the U.S. market. We've got a global team, global investment team that are finding terrific opportunities even in an expensive market. There's a lot more growth overseas than there is in Australia. Because companies have longer runways, they're expanding faster at the U.S. market is much bigger than the Australian market and then they've got overseas to expand into and they've got a good track record of doing that.
In Australia, most of the growth has been coming from companies that do expand overseas. That's where a lot of the highest PE companies are in Australia. The ones that are looking at growth and succeeding overseas. That's the answer to the first question. I think there's probably slightly better value in Australia, but there's good growth in both markets, both economies, both jurisdictions. In terms of the second question, I do think that ... How do I answer the second question? I think ultimately if investors are cognizant of companies that downgrade. Right? So you think about companies that down
If companies downgrade in reporting season now or in their outlook statements for FY 20 and if they downgrade for FY 20 analysts are going to have to downgrade FY 21 as well, because you've got a lower base to start off in the current financial year. I think that's the theme to take advantage of. Ask yourself is this permanent or is it temporary? It's probably temporary and that presents an opportunity. I think that's a great theme. Coronavirus providing opportunities amongst downgrading companies where the risk is temporary rather than permanent. grade is a consequence of Coronavirus. You asked me about themes, where do I see the themes.
Watch Roger Montgomery's investment presentation where he shares his thoughts on the S&P/ASX 200 for the year ahead, impacts of a potentially slowing Australian economy and the advantages of a flexible investment strategy across sector, size and equity/cash.
POC: Yeah interesting there. But I guess a key, well a couple of key points I take out of your comments there Roger in there. For starters, investors really need to consider having a good balance of both Australian and International equities in their portfolios. Regardless of the valuation of the market as a whole, there are always opportunities...
RM: Which is what I was saying.
POC: When you're undertaking that fundamental research on all of the stocks that you're looking at and buying in your portfolio.
RM: You're absolutely right. What I think you're alluding to is that growth and value are two sides of the same coin. If you've got solid growth, you can find value. If you've got a company that's growing very strongly, even if the share price has gone up a lot, it's still could be very cheap.
POC: Now, interesting. Just briefly, have you got any comments or thoughts on Australia's major banks and given all the ... I guess the press coverage that they've received over the last couple of years. Whether you think the worst is behind them, but also what is the impact of the nontraditional lenders that are growing in the market? Like a latitude or an after pay?
RM: Yep. I'll answer the second question first. In terms of fintech's and startups that are nipping at the heels of the market shares of the four big banks. Let's never ever forget the amount of inertia that people have with their bank accounts. You think about it, Paul, you think about if I said to you today.
POC: I'm guilty of inertia with my own bank account.
RM: Think about the palava you have to go through to change banks, especially when you're my age and you've got a family trust or you've got a corporate beneficiary or you've got your companies that you work for.
POC: Your bills are getting paid out of it at all your different debit. You've got all your debit cards and you've got your passwords. It's all sounding to hard already.
RM: The banks know have that. Do you know what, you compare that to the fact that it's not really much better anywhere else and you get inertia. People don't move. Think about OS Forex. Remember the OS Forex business, everyone said that they were going to massively disrupt foreign currency transactions for banks, which is a very lucrative earner for banks, right? They give you terrible rights when you're trying to switch currency with a major bank and they don't care.
RM: The fee was that they would, that OS Forex would take massive market share for the banks and they haven't. They've got maybe 4% share or 5% share and I could be wrong on that, but that was the last time I looked, it was a couple of years ago. It's not worth the banks changing their model for a company has got 4 or 5%. When we talk about other disruptors like latitude and so on, you've got to ask yourself, how much share do I think they're going to take? If it's only 4 or 5%, you get two things. You get the bank surviving and prospering and you get those companies still doing really well. They're growing off a low base. They'll still grow very fast. You can make money off both. Now back to your first question, what do I think their prospects are? What do I think about them?
I think the next five years is, and we're two years into it now, so I think the next three years the remaining three is still going to be tough for the banks. I think their credit growth is not going to be as fast as it was before. I think their net interest margins is not going to be as attractive as they were before. I also think that they've got increased compliance costs that are permanent associated with the Royal commission that's not going away anytime soon. Finally, I actually think that they've actually, they've got record low levels of provisions for bad and doubtful debts at precisely the time that those things could start increasing. There's pressure on the banks. I think that's where the opportunity is. I think there's so much money in tech that any sort of disruption to the tech story, you might see money being pulled out of those high risk, high beta plays and move into more defensive stocks. The banks are sitting there as prime candidates to receive that money.
POC: And earning great profit.
RM: And institutions are underweight. Earning great profits and the institutions are underweight. We've got, the four banks are 27% of the index and we've currently got 4% of our portfolio, 5% in the banks. We're incredibly underweight.
POC: Very interesting. Very interesting. From an overall portfolio perspective, would you say then that your 18% cashews, a defensive position or an opportunistic position, given some of the comments you've made about the shorter term risks and volatility, that then creates a buying opportunity?
RM: Having any cash is a huge drag on returns. Being in the stock market is much better in the long run than being in cash. There's no doubt about that. Bu, it does give you optionality. It allows you to take advantage of lower prices when they present themselves. We saw in the December quarter of 2018 the YOZI market came off about 9% the Montgomery fund was only down about 5% during that time, or 5.7% or thereabouts. That's because of that cash. It provided a buffer. I'd rather not have the cash. I'd rather find opportunities that are attractive, but in the absence of finding attractive opportunities, I don't want to buy our 37th best thing. I'd rather put our client's money somewhere safe and cash provides that safety. And remember, Buffett's got 40% cash at the moment.
POC: Yeah. Yeah. And I guess I, in my experience, I do find that many active fund managers feel compelled to invest 100% of their portfolio into the equity or listed property or what have you.
RM: Yeah, they have to.
POC: I guess even managers that do have a little bit of tolerance in the main diet, it's, they're very weary to make that call. So that really does set you apart, I think, from a lot of the other managers that we have available on our platform.
RM: Well, I mean with all sincerity, you've raised a massive differentiator. It's a huge business risk to a funds' management firm to underperform the index. Right? You'll have a lot of clients leaving if you under perform the index. You have to be invested because you can't take that risk. At Montgomery, we do things a bit differently. We know our clients, we've grown a lot slower than other fund managers because we only want to invest for people who understand that three years out of 10 we will underperform because we're willing to hold a lot of cash. So when we don't appeal to everyone, we play a particular role in a portfolio and we only want to invest for people who understand that we've got that cash flexibility.
Which means that we will underperform when markets are booming, but we expect to outperform materially when markets are in more challenging times. And we've seen that over the course of, we've outperformed the market since the inception of the fund with 23% cash. But what we've delivered is 80% upside capture and only 58% downside capture. When the market falls in any month, we've only captured 59% of that downside. That's what clients really want. They want to go up with everyone else but not go down with everyone else. We've been able to deliver that.
POC: Yeah, now interesting. I think in a closing remark, the multi cad again and certainly for the listeners, is that really we all need to make sure that we understand what we're investing in and style of the management.
RM: Exactly. Correct. It's got to fit.
POC: Correct. It's then got to fit into the overall portfolio and what the need and objective of all of our listeners today are trying to achieve with their life. So on that note, I will, I'll thank you for coming in.
RM: Thanks Paul.
POC: For sharing the portfolio construction podcast with us. Some really interesting comments. Thank you very much and have a great afternoon.
Views expressed are of the interviewee and may not be the opinion of Netwealth or its related companies.