Market outlook for investors in Australian equities

Rhett Kessler - Fund Manager, Pengana 

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In this episode, Rhett Kessler, Fund Manager of Pengana's Australian Equities Fund joins us to discuss the recent performance of Australian equities, provide a macro update on the Australian economy, share his key takeaways from reporting season, and share where investors might look for stock opportunities in the current environment.


Transcript

Paul O'Connor (POC): Welcome to the Netwealth investment podcast series. My name is Paul O'Connor and I'm the head of investment management and research. Today we have Rhett Kessler from Pengana Capital who is Pengana's chief investment officer and senior fund manager. Pengana is a listed equities manager founded in 2003 and based in Sydney. The manager has over three billion in funds under management and operates a number of boutique investment teams across global equities, Australian equities and alternatives. Rhett has over 30 years investment experience and joined Pengana in October 2007. He's responsible for leading Pengana's Australian equities team and managing the Pengana Australian Equities Fund. Prior to joining Pengana, Rhett was head of research for IAG Asset Management as well as being a joint portfolio manager for various wholesale funds totalling 3.3 billion dollars. Rhett was previously a rated media analyst for UBS Australia, having emigrated from South Africa in 1996, where he successfully managed wholesale and retail equity portfolios as Deputy General of investment for Liberty Asset Management. Rhett holds Bachelor degrees in commerce and accounting from the University of Witwatersrand in South Africa. He's also a chartered accountant and a chartered financial analyst.

Pengana specialises in listed and unlisted equities and have a number of managed funds available on the Netwealth Super and IDPS Investment menus, covering Australian and International equities large cap, small cap, income biassed, sustainable and impact strategies.

For today's podcast we'll focus on Australian equities and the outlook for the market over the short term. In line with global equities, Australians equities sold off heavily in the first quarter of 2020 and then staged a remarkable recovery in the second quarter but for the 12 months till the end of the September, the market is still down by over 9%. The Australian monetary and fiscal response to the economic downturn post-COVID has been extraordinary and played a major hand in supporting markets but questions remain whether current valuations are sustainable and the outlook over the short to medium term, which we will explore today with Rhett. So, to start with Rhett, how have you coped with the restrictions imposed due to COVID and has this impacted on your meetings and your interaction with companies?

Rhett Kessler (RK): Hi, good morning. I think it would be difficult to say that anybody has been unaffected, however, our industry, and particularly my team, has probably prospered during this period. Working from home means that my team doesn't have me looking over their shoulders and they've been a bit more efficient but I guess more importantly, access to management I found, has never been easier. We have a lot of dialogue with company management teams and it's a lot more efficient. You don't actually have to get there. Zoom calls means you get the full facial expressions, the intonations or whatever other non-verbal signals you're looking for but most importantly access, which is so important to management, has been really forthcoming.

POC: So, companies have made themselves more available, have they, to managers such as yourself?

RK: So, to them, I think it's also been a lot more efficient. So, they've been able to do group meetings, they don't have to travel and it's very easy to jump in and out of conferences. I should also stress that part of our process is not just speaking to the companies that we invest in but as part of our research we need to cross the much wider net and speak to their peers, their competitors, their suppliers, their customers both domestically and globally and access, again, has been a level playing field. You don't actually have to be in the geography that's required.

POC: Yeah, interesting. It certainly resonates your comments around meetings being more efficient. I've certainly noticed that as well, the lack of travel and movement to meetings. You can certainly, in some areas, work a lot more efficiently.

So, moving onto economics, at a macro level, what are your views on the Australian economy and do you believe we are passed the low points of the economic downturn?

RK: I think that the government, the Australian government, has done a fantastic job in building a bridge across what we're calling the lockdown valley and they're using a number of tools to do that, including the banks, changes to regulations, fiscal stimulus, cash flows from their government organisations, providing liquidity into the economy. So, I'd give an 11 out of 10 for the way they've managed it. However, there's still a few risks. There's no doubt that there will be ongoing ramifications from both the changes in consumer behaviour, the impact on cash flows, particularly in the hospitality and the sport events sectors, incoming tourists, et cetera. However, Australia as a country does seem to continue to be the lucky country. The timing of the drought and now the rains, mean that we are going to have a very good agricultural period. I mean, a world-class, iron-ore producing companies continue to be the one commodity that seems to be very difficult for our global customers not to buy and Australian's importantly are not travelling as much as they used to. Believe it or not, the nett outflow of money out of the country is actually a lot bigger than the nett inflow of money from students and tourists and so the domestic economy is benefiting from that range of factors.

POC: Interesting. I always assumed that we would earn more from tourists coming in than what Australian tourists spend abroad but no. Interesting comments there, Rhett. So, do you believe the federal government and the RBA will need to provide any further monetary and fiscal stimulus? I guess, we saw the announcement on Tuesday of the cash rate being cut to 10 bips and the RBA also introducing quantitative easing in terms of buying federal government bonds. So, where do you think the further lifting will occur? In monetary or fiscal stimulus?

RK: So, I'm going to plead ignorance in those very big macro issues but if I look at it maybe in a slightly different way, in that the government, or the RBA, has a dual role. One is to obviously provide a boost to the economy as needed but also you've got to remember it's playing in a global environment and the big guns have been pulled out around the world in all the developed economies and the developing and emerging economies and the shock absorber that balances countries is the currency, and so I think the RBA's focus has been to keep our currency at a level that continues to make us globally competitive both in terms of cash flows or monetary flows around the world, as well as our goods and services and I think that's the real issue and they've done a good job of that but will have continued to match what other countries are doing.

POC: Yeah, it's interesting. You comment around the A dollar there and particularly with some, I guess, which certainly A dollar appreciates significantly in the second quarter of this year but it seems to have stabilised. So, I think I would agree with you there that the RBA have done a great job in that area. 

The good old mining sector appears to be holding up and supporting GDP but what other areas of the economy are showing promising signs of growth?

RK: There's a number of areas that we're extremely active in. So, healthcare has been phenomenal, and here I'd like to just maybe run a slightly different view past you and that is that if you have resilient... I mean, consistently resilient top line or revenue coming in, most management teams take an advantage of the crisis to contain costs very efficiently and so a great example would be ResMed, that managed to keep its revenue line ticking along at 10% growth and held costs steady in their global operations. The operational leverage dropped down to us as shareholders, is absolutely enormous, so the bottom line grew by 30% and we're looking for that across companies. So, your healthcare, your discretionary retailers, your supermarkets and a range of other businesses would be benefiting.

POC: So, with reporting season now behind us, what are the key takeaways you can provide the listeners with, Rhett?

RK: So, we took advantage of reporting season, not so much for the numbers because there was a lot of noise in the numbers, given the unusual COVID related trading activities but rather we sought to discover whether our investment thesis about which companies have power over their stakeholders, was correct or not and I guess, another way of thinking about that is that when you shake the tree really hard, you get to see who falls out and who manages to hold on and... So, the learnings that we took away was the strong will get stronger and there were good examples in that, in that if you built the business resiliently, you tend to do well through most difficult times and so examples would be discretionary retailers that have omni-channel ways of getting to their customers, had the power over their landlords. They were able to negotiate quite good rents. Companies like the healthcare companies where the resilience of the demand for their product was very, very strong. So, a good example would be Ramsay Health Care, was able to negotiate with government that the government would fund the ongoing operating costs for the business during the lockdown. That put them in good stead and  examples like that... And so that was the main learnings we took away from the reporting season.

POC: So, perhaps moving to the stock, sort of traditionally paid, higher dividends, some of those companies appear to be the most impacted by the economic slowdown. So, do you think the dividends will recover and I guess, typically across and banks and the stocks that have been typically been held by dividend-paying equity funds.

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RK: 
It's a good observation and again, I mean, the view we take is that the banks, which were the big dividend payers, have been used by the government to ensure that we have very good pillars to hold up this bridge across the lockdown and so, together with the regulatory authorities, the boards of the big banks took the view that they need to make sure that they will survive in good shape, this crisis and I think they have and so I take the view that by cutting their dividends in the short term, they've bullet-proofed the businesses so that they will continue to be good cash flow producers in the future and I think we run a risk, a very real risk here that due to a short term cut in the dividends, people are selling their stocks but in actual fact, these are exactly the businesses that in three to four years we're going to look back and say, "Wow that was temporary, it bullet-proofed the balance  that they can continue to be the good cash-dividend payers that they were in the past." 

And I think that goes for the as well. It was a very unusual interruption to some of the business processes and Paul, if I could just throw in one more observation is that it's very hard to know... One of the key conundrums we have is what is a dollar of cash in any currency worth in an environment where everY single printing press is being turned to full speed and so I think owning businesses or hard assets, businesses with pricing power, is going to be your only protection against this surplus of liquidity and the impact it might have on your buying power if you hold cash.

POC: And DID the financial disruptors such as Afterpay, concern you that they might attack some of the traditional learnings of the banks?

RK: There's no doubt that disruption is happening across the board and so the combination of digitalization, great customer experience and nimble and clever management teams is having an impact. I think it always has. It's probably a bit more intense now than it's been in the past and it's created enormous value for those who've got it right. Absolutely, a company like Afterpay and it's peer group, pose some challenges for the banks and they do appear to have retreated INTO focusing on being pure business leaders and lenders and homeloan lenders, so more utility type, but I do think, as always, in an economy, there's space for lots of different players within the value chain.


POC: 
So, perhaps moving to your fund, your Australian Equities Fund really does not look like a typical benchmark-aware Australian equities fund. So, perhaps for the listeners benefit, what are you trying to achieve?

RK: So, we see our mandate as essentially managing money for high net worth and retail investors and myself... I'm one of the big investors in the fund and the reason I invest is to either preserve or grow purchasing power of my money because I invest for financial independence in the future and so, when we go out and look for investments, we're looking for two core things. One is that we preserve our capital in real terms and the second is that we grow our purchasing power or the wealth at whatever the risk free rate is plus an additional 6% to cover ourselves or for the risk of investing in growth assets and that's really all we focus on.

POC: Yeah, it's interesting that, that focus on an absolute return objective because I think, as I'd mentioned there, that most of the Aussie Equities funds are focused around out-performing a benchmark. So, I guess it's a different way of thinking about managing an Australia Equities Portfolio but it certainly makes rational sense there that about maintaining purchasing power and growing some capital, to be able to save for retirement ultimately there, I guess.

So, moving on there, government actions have supported vulnerable investors and asset prices but economies are still fragile. You have the ability to hold a concentrated portfolio of stocks and high cash levels, so what's your current positioning?

RK: I must say, if you ask me, I've never been in a period where if you'd asked me a couple of months ago, it would be quite different to what it is now. So, maybe, at the moment we've got just over 10% in cash and if you'd asked me probably a month ago, we had 15%. So, it does swing around a bit. For us, cash is not an objective, it's an outcome of whether there are opportunities or not and so maybe the best way to describe that is we went into COVID with about 20% in cash and a very big position in insurance and that was back in February, not because we knew COVID was going to have the impact it did, or that we even expected it to turn up but because we found valuations very, very high.

Bizarrely, that once COVID hit, we were probably as concerned as anybody about the outlook for the economy, valuations became so compelling that we spent so much money buying stocks that we ended up in our lowest cash holding that we've ever had in the fund, which was about 4%. Perversely, after the big bounce, we then turned sellers of some of the stock we bought and since then we have found lots of opportunities again and been actively buying over the last month.

POC: Yeah, it's an interesting, I guess, way you view cash there, that it is an outcome of the investment opportunities. It's not there really as to make some asset allocation call but in terms of the concentrated portfolio, have you been increasing the number of stocks held in the portfolio over the last two or three months or have you been becoming more concentrated?

RK: I think the answer to that is a bit of both. So, we have noticed that some of our holdings have increased and examples would include things like CSL, some of the banks, Credit Corp, to name a few... Woolworths, maybe even ResMed and Aristocrat. On the other hand, we have found a plethora of new opportunities that we started building holdings in, which have added to our spread and we've sold a few stocks but probably our new positions have been greater than the one's we've sold.

POC: So, perhaps can you provide a few comments around the stock opportunities you and your team have been uncovering and are they in the smaller caps section of the market or more towards the larger caps stocks?

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RK: 
Some of the new investments have been across both large and small cap. I'll deal with some of the smaller ones to start. [Bapcor has been a new holding for us that I think has served us extremely well, buttressed by the underlying demand for motor vehicle spares and parts. On the larger side, we have taken a view that Mirvac  represents a very, very attractive opportunity to get set in one of the best managers of hard assets in this country, as well as Charter Hall. So, for the first time in the fund's history, we have almost 10% in what you'd call the sector; what we've identified as hard assets.

POC: Yeah, waste management certainly appears to becoming bigger business these days and I would imagine there's some investment opportunities there with businesses like Cleanaway there, Rhett. So, no, interesting. Interesting.

What keeps you up at night? And conversely, what would make you more broadly bullish on equities given current valuations?

RK: That is a great question. So, what keeps me up at night is exactly the fact that it's hard to find an environment that is more bullish for equities and I guess, if I had to, succinctly using anagrams, talk about what keeps me up at night, we've had FOMO... Fear-Of-Missing-Out, driving the market, we've had TINA, which is There-Is-No-Alternative to Equities because every other asset class has no yield and now what keeps me up at night is what I call FONGO and that's the Fear-Of-Not-Getting-Out because at the moment, all roads point to equities. Cost and money should be low. As I've mentioned earlier, the penalty for staying in cash at absolutely no interest rate and a chance that your cash holdings will be to some extent inflated or demonetized away because the printing presses are turned on, everybody is turning to hard assets and so, I have a saying that when the elastic band stretches in one direction, remember that it doesn't snap back to its previous level. It actually over-reaches on the other side as well and so we've had such rampant bull markets, we've had such rampant valuations, we've got such cheap money. Certainly the music's been playing for quite a while and that's what keeps me up at night.

POC: I see you're holding in Rio Tinto, which has obviously had a bit of negative press recently. Given environmental, social and governance issues are becoming more prevalent in investment management, how do you think about ESG, Rhett?

RK: Right, so I'm going to use the example you brought up, our holding in Rio, as an example of how we think about ESG. We take it quite seriously. Our underlying pragmatic thesis around a ESG, is that sustainable business practises that sustain the environment in which they operate is the best way to ensure both the future of our country, our environment, but also for our returns because you can only predict returns if you have a sustainable environment, which Rio, in particular, we take a view that we were quite surprised by some of our clients views that we should sell our Rio shares immediately once they'd committed this activity and we take an almost opposite view in that if you're a shareholder, we feel it is our duty not to dump and run but to stay and make a change particularly given that we were shareholders during that time, we have a responsibility to do that and so we've made some noise... I think the changes have been on the right side of what we expected. We're pretty small so I don't know how much impact we would have had; probably nothing but we absolutely take the philosophical view that you stay and do your best to change from the inside.

If after a lot of activity, you see you're not making any progress, then obviously we would move on but certainly our first reaction is exactly the opposite of dumping and running. Hopefully that answers your question.

POC: And finally, any thoughts or comments post the US elections on the new governments impact on markets?

RK: So, I'll offer maybe a humorous view in that markets have reacted very powerfully and positively to the fact that politicians are now, i.e the power lies split between the Senate and the presidential-elect. What that's telling us is that the less politicians can actually do, the better it is for markets and I probably support that view.

POC: All right. Well, Rhett, thank you very much for joining us this morning. It's certainly been interesting getting your thoughts and insights into the broader Australian economy and the Australian equity market and certainly, thank you very much to the listeners for joining us today. We certainly appreciate you, having you onboard, and we wish you all the best for a great week ahead. We look forward to joining you on the next instalment of the Netwealth Investment Podcast series.

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