Navigating volatility: Insights on equity markets and growth stocks

Don Huber, Senior Vice President and Portfolio Manager at Franklin Templeton

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In this episode, Paul O'Connor, Netwealth's Head of Investment Management, interviews Don Huber, Senior Vice President, and Portfolio Manager at Franklin Templeton. Given the recent volatility in equity markets, Don provides his views, with an emphasis on growth stocks. He unpacks the impact of inflation on growth stock valuations and identifies potential opportunities for long-term investors. He provides examples of exciting companies with unique qualities and highlights what sets them apart and explains characteristics of the growth companies they invest in and why.

 

Transcript

Paul O’Connor:

Welcome to the Netwealth Portfolio Construction Podcast series. My name's Paul O'Connor and I'm the head of strategy and development for investment options. Today we have Don Huber from the Franklin Equity Group, who will provide his views on equity markets and particularly the outlook for growth stocks, which I guess is topical at present, given the volatility we've experienced in equity markets over the last 12 months. Don is a senior vice president and portfolio manager, responsible for managing institutional and retail global large cap equity portfolios. He also served until last year, as the investment team's dedicated ESG ambassador, a role focused on ensuring effective integration of the ESG into the team's fundamental bottom up analysis, to provide a more comprehensive view of the potential risks and rewards of an investment.

Prior to joining Franklin Templeton in 2002, Don was with JP Morgan Chase, where he focused on portfolio management, strategic planning and relationship management in private and corporate banking. He entered the financial services industry in 1981, holds a BBA from the University of Michigan, is a member of the CFA Society, New York and a chartered financial analyst. Good afternoon Don, and thank you for joining us today for Netwealth's Portfolio Construction Podcast.

Don Huber:

Good afternoon, Paul. I'm happy to be here. Thank you for inviting me.

Paul O'Connor:

And welcome to Australia, I should add as well, although as we mentioned earlier, you've been down under a few times, so you're probably starting to get to know your way around Melbourne and Sydney and Brisbane and what have you.

Don Huber:

I am getting to know my way around, but I will say that this is the first COVID trip, so it's the first trip in a while. It's great to be back and kind of refresh my memory and acquaintances.

Paul O'Connor:

The Franklin Equity Group is part of Franklin Templeton Investments, that is a subsidiary of the New York Stock Exchange listed Franklin Resources Incorporated. Franklin Resources is one of the largest publicly traded investment management companies in the world, with offices in over 30 countries. As at 31 December, 2021 with the integration of [inaudible 00:03:04], total assets under management was US $2.1 trillion, of which $734 billion is invested in equity assets. Franklin Templeton is a large global investment manager, comprised of a variety of investment management firms, covering equity, fixed income and specialised strategies. Each of the investment firms operate separately and maintain their own investment processes and approaches, as well as their own styles and specialties under their own brands. There are 18 funds on the Netwealth Super and IDPS investment menu issued by Franklin Templeton Investment Management firms, covering Australian equities, international equities, Australian fixed interest and international fixed interest, and including the Franklin Global Growth Fund and Manage Model where Don is a portfolio manager.

So 2022 was a volatile year for equity investors, with geopolitical risk, inflation, sharp interest rate rises and still COVID economic hangovers impacting on the markets. The return of inflation particularly impacted on growth stock valuations and appeared to catch the market by surprise. Given inflation has been benign for many years, I'll be interested in Don's views as to how it has impacted on growth stock valuations and if the market has overreacted and potentially oversold a number of these stocks. I'm sure this volatility has created some opportunities for the patient long-term investor.

In addition, the recent failure of SVB and Credit Suisse has also turned the market's attention to the global banking sector. So I'll be interested again in Don's take on this sector, and if he believes we may see further pressures on other banks. Positively the Franklin Global Growth Fund returns were in line with the MSCI World ex Australia Index over the last 12 months and the strategy has generated strong outperformance over the medium to long term. Maybe just to start with, Don, you've been with the Franklin Equity Group for 20 years and worked in equity markets for almost 40 years, so what drew you to such a long term career in financial markets?

Don Huber:

It's interesting, Paul, I didn't start out thinking that I'd have a long career in equity markets or investing markets, probably like most people who end up in a career that they didn't necessarily start out looking at. But I started out actually in commercial banking after interviewing with someone on campus as I was graduating, who talked about the great thing about commercial banking is you get to look at a variety of businesses and understand them as you're thinking about lending to them and making credit decisions. And from that, investing was very similar. You're looking at companies and analysing them, in this case kind of lower down on the balance sheet, but still getting to look at a number of different companies and ultimately, as far as we approach markets, getting to look at the fundamentals of companies and kind of distancing yourself from day-to-day stock price movement and really focused on investments that we plan to have and hope to have for the long term.

Paul O'Connor:

Yeah, well I guess that makes sense if you started in corporate banking and dealing with the, I guess, the debt requirements of companies and looking at corporates and their models, that you then evolved into equity management there. So you've certainly stayed true to form for almost four decades there, so you've certainly got a lot of experience cross investment markets. 2022 was a very remarkable year for investment markets and one we won't forget quickly, where aggressive tightening of monetary policy by central banks led to a selloff in growth equities. Can you provide some context for our listeners around the severity of the rotation witnessed and what were your key observations?

Don Huber:

In terms of severity, this was a dramatic rotation after growth had outperformed in the early part of the COVID era and for a number of years. As the Fed was recognising that inflation wasn't transitory and was going to begin to move, you saw in January in particular, a very quick, very sharp movement from growth and into value, that really continued for much of the year, certainly in force through the first six months or so of the year. To put that in context, 2022 was the second most dramatic underperformance of growth relative to value since 1975 when data's first available. The most significant period, probably no surprise for people, was the year 2000. Almost all of that was realised in the first half of the year and then we saw something very interesting, I think, in retrospect, happening from mid-June to mid-August last year. At that point we saw the first economic statistic reporting that was talking about the global economy or looking at the beginning of a slowdown in the global economy.

The language expectations for the Fed moving to control inflation began to reach the closer to the end than the beginning. There was a lot of talk about the Fed moving in September and that might be the last time that they raised rates. Clearly wrong in retrospect, but that was the kind of the mood of investors, the thought pattern of investors at that point. During that period, you saw a rally in equities and in particular, a rally back into growth equities, which I think had been and we felt were oversold during the first five and a half months of the year. Clearly, as I say, that was wrong, in August you started seeing inflation numbers that were concerning and moving up in the wrong direction, and so you saw this rotation back, that kind of zigzag back and forth during the year.

Paul O'Connor:

It was a remarkable period and I think it was only in early last year that the governor of the Reserve Bank of Australia had put forward guidance that he did not believe that there would be any real movement in the cash rate until 2024. So I guess everyone, from central banks, through to investment markets did not quite see the significant spike in inflation that then eventuated later in the year. The sharp increase in interest rates here and overseas, shapes a very different set of challenges for companies at a time when economic growth is slowing, and I guess we haven't had this sort of period for decades almost now. So can you refresh our knowledge of the characteristics of growth companies and what does this new operating environment mean for these companies?

Don Huber:

In particular, I can talk about the characteristics of the growth companies that we invest in in our strategy. We look to be long-term holders, we're looking for companies that we can own for three, five years, if not longer and have, in many cases, companies that we've owned for much longer than that. But one of the things that we look for that we think about in terms of looking for sustainable growth companies, is companies that are generating free cash flow or on the verge of generating free cash flow that they can use to drive the growth in their business and drive shareholder returns. We also look for a durable competitive advantage that we think will be sticky over a number of years, and strong shareholder returns or improving shareholder returns. If you think about those characteristics, particularly from the cash flow standpoint, it leads to companies that are better able to fund their growth internally, rather than relying on debt markets.

And so as we think about higher interest rates and the impact that they'll have on the companies, the kind of growth companies that we invest in, our growth companies have less financial leverage than average, and as we've looked at these companies, we're comfortable certainly with their ability to manage through. It's similar, as we think about moving forward, it's similar to the analysis that we did in the early COVID period, where we were looking at companies and looking at the structure of their debt, their exposure, the covenants that they had in debt agreements and making sure that they could get through a period, where in many cases, they were all but shut down for a period of years, for an indeterminable period I should say. So really have the same outlook now, the company's less reliant on debt, they're in good shape financially. Due to the natures of many of the companies that we own, they're not tremendously economically cyclical to begin with, so we think that they manage through this and what we've seen so far anyway is that they manage through this period of higher rates in a very strong fashion.

Paul O'Connor:

I guess my key takeout from your comments there, Don, is the companies are generating some or about to generate some free cash flow. So rather than just being a corporate or a company with a long-term idea about a disruptive technology, a great growth potential, it's a company that actually is starting to earn some profit. And I guess my perception would be that it's going to be a lower risk type of growth company then that you're typically investing in.

Don Huber:

I would agree with you. We don't, in our portfolio, own any of the formerly known companies as FAANGs and in a couple of cases, it's because we looked at them, we couldn't tell in what environment they were ever going to generate positive free cash flow. And you talk about a company then that is reliant on the debt markets and the equity markets to fund their growth, and you've got a more challenged business model in this environment.

Paul O'Connor:

So have the secular trends or tailwinds favouring companies in technology and healthcare dissipated or do you and your team continue to see opportunities in this sector?

Don Huber:

We continue to see opportunities and I think clearly in any point in an economic cycle for an individual company, you could see their growth drivers dissipating as they move past the more attractive part of their growth cycle, or they lose competitive advantage, or technical advantage, or any number of aspects of the business deteriorate. So that can happen in any environment.

Would say for every company that we've invested in, certainly in the healthcare and technology space and any of the space right now, is we look out over the next three to five years and even the next year in terms of companies being able to perform through a slower economic environment. The growth drivers haven't changed. From the beginning of the COVID period, we felt that the world would ultimately get back to normal. It's taken a little bit longer from a financial standpoint than I think we or the Fed might have liked, but ultimately we thought business kind of returns to normal and like it was in 2019. And I'd say that for the companies, the growth drivers haven't changed as a result of what we've gone through, they're just as strong as they have been and we expect them to continue to execute.

Paul O'Connor:

Can you highlight for us a couple of examples of companies whose future prospects excite you and what is it that differentiates these names from their industry peers? And I'm guessing potentially positive free cash flow and lower debt could be a couple of those attributes.

Don Huber:

Yes. One company that we have owned for a few years now, that I think has just a tremendous ongoing competitive advantage, an ongoing need for their products, is a company called Synopsis, a technology company dedicated to providing IP for chip design. It's one really of two companies, maybe a distant third company that provides this kind of technology, and it's technology that goes into any silicon chip. They are seeing expansion of their business through the approach of internet everywhere, internet of things, putting chips in every device that you can think of, companies like Apple deciding that they want to design their own chip, and so it just increases the number of companies that you can send to. As I say, the critical nature of this, the strong competitive position and ultimately what that means is that engineers in college and early in their career that are doing this chip design, are trained on one of these two systems and you join a company that uses one or two or both of them, it's not likely to be displaced. You'd have to train a whole large group of semi engineers to use a new system.

So it's really been a kind of steady Eddie performer for us, from a fundamental standpoint in particular, not tremendously. One of the aspects of it that we like in terms of the semi industry, is not tremendously exposed to cycles. This research chip development is going to go on regardless of the economic cycle. Unlike some markets for chips, you don't go through kind of a boom and bust period for inventory corrections or over purchasing. So it's really, I think, a strong business that continues to be as valid as it always has been. So I think that's one attractive business that I would really highlight. Another company that I think has very strong prospects over the future years, not an explosive growth company, but is a company called DSM, which is a Dutch chemicals company specialising in materials for human and animal nutrition.

Extremely innovative, they have a new additive out called Bovaer, which helps reduce methane emissions from cattle and from other feedstock. So really innovative, kind of supporting environmental progress globally, but also just keyed into taking a very large global footprint and research capability and then a sales force that can bring that down and a technology force that can bring that down to a sheep farmer in New Zealand in a particular region and determine what the best additive for them is. An added support for DSM, we like the business in and of itself, but it's in the process of likely combining with a company called Firmenich, which is one of the larger flavour and fragrance, particularly fragrance businesses throughout the world, which we think will create a nice powerhouse in an expanded market.

Paul O'Connor:

How would a fragrance business be complimentary to, I guess, DSM there?

Don Huber:

It's often the additives, you think of the additives that are added to food. I mean, certainly perfume and fragrance in a traditional sense is something that kind of stands on its own, but if you think about additives that go into food in terms of fragrance and managing that, the smell that comes out in processed food for example, along the same lines, you're adding nutrients or chemicals that improve the digestibility of food. So they share many of the same customers that you might not think of if you're thinking of fragrance as just perfume.

Paul O'Connor:

No, interesting. Interesting. The mind certainly gets expanded when you see the way these companies are developing. Yeah, very interesting, the DSM story there.

Paul O'Connor:

The nature of equities investing dictates outcomes are not always perfect and I think just that comment takes me back to studies as a younger fellow, that where I think top quartile fund, active fund managers typically get maybe six to seven out of 10 stock calls correct. So can you share with us an example of a company that did not deliver the returns you expected and how did your team go about reassessing such a company and decide when it's time to exit your position?

Don Huber:

I think a good example here is a company called Veris, which we had owned for a number of years and exited late 2022. The core business was one that was and still is, tremendously attractive. It's data and information service for largely property and casualty insurers. Our analyst discovered it when she was talking to insurance companies years ago and they talked about this database and this company, Veris, where they supply information on claims and on risk to this central service or central company called Veris, and then they pay Veris to get data back from the, industry-wide data back because they're sole source of collecting all this, they pay them to get the data back only in a better analysed framework. So it's kind of a competitive environment and a source of information for them to run their business. As you can imagine, when you're getting your data for free and then paying same companies to buy the product, very high margins, strong cash flow generation.

Over time we saw them investing in similar data-driven businesses outside of property and casualty. They got into banking to a certain extent, they got into healthcare information services. Most notably they bought a company called Wood Mack and moved into energy, oil and gas information services. And those businesses never were able to generate the kind of returns that matched their core business and were really disappointing in execution. We saw them moving then to exit those businesses, which we thought was the right thing to do, but what we ended up then with is a core business which again was very attractive, generating free cash flow, but with limited options in terms of growth. They can invest tangentially into their markets, but they have an intention to stay focused on insurance data. And ultimately a nice cash generative business but not one that really had strong avenues for growth, and so we parted ways with the position last year

Paul O'Connor:

That must cause some amount of competitive tension within the team and from the analysts potentially starting with the idea in the business and then the portfolio allocating capital to it. Yeah, it must cause for, I guess, some level of competitive tension there in arriving at that decision.

Don Huber:

There could be, but we're very open. Nobody has all of the answers and nobody's viewpoint is perfect. So we rely clearly on common sense and kind of stepping back and thinking about the business. We rely on the analyst who knows the business in depth. And in this case, like most cases, we had an ongoing discussion for a couple of months as we thought about what the potential growth drivers were and for a business that we really liked in terms of the fundamentals, really came to a hard decision and the analyst came to that decision on her own that this really didn't fit into our growth portfolio any longer.

Paul O'Connor:

So should investors be anticipating continued volatility in equities as we move through 2023? And do you think we'll see any further problems in the banking sector? And what do you see as the catalyst for a return to a more steady or predictable investing environment, if any such environment exists?

Don Huber:

Well, we've been thinking just intuitively and I will highlight, we're not market strategists, we're really bottom up investors, but what we've been thinking intuitively and we saw to a limited extent in June, July, August period last year, was that totally what the market investors have been concerned most about was inflation. And when we begin to see the light at the end of the tunnel or we see at least on our GPD platform, that we're closer to the end of the Fed hikes and to inflation being under control, that will get back to a more normal environment, an environment where investors trade more on fundamentals than they do on macro drivers. So that's one thing that we are thinking will bring about some stability in the markets and we'll see, I mean, we'll move beyond that and then the discussion will be on recession and how companies will be impacted by that.

As I mentioned, I think and have thought, in a slowing economic environment, owning growth companies where an environment where growth is scarce is a good thing to do. But in the meantime, I think there are a number of tea leaves that are going to be read between the inflation figures, the banking system, in the States, small, medium-sized banks. I don't think we're at the point of really knowing what the broad impact is going to be and how that works out. Certainly the Fed and the FDIC in the States, are doing everything they can to contain the contagion, but I don't think we've really seen enough yet in seeing how this will play out in effect.

I think the one thing that we can assume is that this is going to have a dampening impact on the US economy. Banks, I think, will probably be more conservative, although credit issues were not what the concern is and are not what the concern is with small and medium-sized banks right now, but I think it may result in banks being a bit more conservative, which will have a dampening effect on the economy.

Paul O'Connor:

Yes, well we certainly saw the regulators and central banks act quickly, both to try and quell potential contagion post SVB and Credit Suisse, and I guess learnings and long learnings from the global financial crisis from 2008 there. The Franklin Global Growth Strategy typically holds a number of mid-cap companies that most Australian investors are not familiar with. What is it about your business investment process that leads to this portfolio composition and why should investors view the mid-cap characteristic as important within their own broader portfolio construction?

Don Huber:

You're right, Paul. We are known and I think a differentiator for our strategy is our inclusion of a number of mid-cap, as well as large cap, but mid-cap companies in the portfolio. And it really grows out of our investment process and strategy and what we look for in companies. A part of it is that I think on average we're buying companies maybe a little earlier in their growth cycle as we're looking for companies that we can own for a number of years, but it's also a desire to own more pure play businesses, rather than companies in one, two, three lines of business, as opposed to say a conglomerate. If you think about it at kind of the extreme, a conglomerate that has maybe a couple of businesses in it that are really attractive and where they maybe have a strong market position and strong growth, but then other commoditized type businesses, I think of Nestle and bottled water for example.

Well, as growth investors, we would prefer to not own the bottled water component or commoditize slower growth type businesses, and focus on the businesses, the business models that are stronger growing and have better drivers for their growth going forward. So we'll buy a pure play in a business that might otherwise be buried or contained within a conglomerate. And in that way we've got better visibility into the growth drivers, better access to management, to understanding the business, better visibility into the capital allocation decisions that management is making. And so that, if you think about it, just an example, not owning a large cap conglomerate and owning a pure play business model and company, brings us down the market cap spectrum to a number of pure plays. The reason that I think this should matter to investors is a couple fold. One is certainly by including mid-cap companies in the portfolio, you expand your horizons tremendously, in the opportunity set tremendously.

It leads to portfolios that are less correlated with other managers that invest up the market cap spectrum, may look for different things, it differentiates in lower correlation from the benchmark, from passive strategies which are market cap driven and so we'll own those former FAANGs in great quantity, we think ultimately, can lead to strong performance. The saying goes, you can't outperform the benchmark if you look like the benchmark. So we think including these companies and having our own strategic view of what works for us anyway, can lead to better returns or stronger returns and help differentiate or diversify an investor's portfolio.

Paul O'Connor:

Yeah, and I guess, Don, it makes sense to me that if you are looking to choose a active equity manager, I guess one that has a medium to higher tracking error is common sense, because you're actually paying for active management then. The other comment, well, the other thought in my mind as you were answering the question there, is that the mid-cap sector of the market has always been a more fertile area for active management. And I guess the larger cap the company is, the harder it is to pick up on the investment insight that your team, analysts and yourselves may be able to uncover. So it's sort of common sense to me that all clients' portfolios should have an exposure to mid-cap stocks within their equity allocations.

As a New Yorker, what's the general feeling regarding the US economy at the moment, within both the investment community and on the street? I guess does last week's interest rate hike by the Fed Reserve heighten the probability of a recession, and if so, how protracted do you think it may be? And I guess I'm asking you now to stare into your crystal ball about how deep a recession may be, but I'd just sort it would be an interesting way to finish the podcast today, Don.

Don Huber:

I agree, and depending on how long this podcast is available online, I may or may not be proven correct with my crystal ball. I'd say first, as a New Yorker, that the general feeling on the street is that they're hearing the news about the economy, they're hearing and certainly feeling the effect of inflation. But outside of a few select industries and investment banking being one and technology being another, in general, jobs are still secure, we've seen the wage increases moderate a bit. But I think that the average person is going about their lives and hasn't had a big impact yet from this. Certainly within the investment community, there's a lot of question about the very thing that you're asking, if there's a recession, how long is it? How deep is it? What does it mean for different investment styles? Value managers are saying that this is just the beginning of a turn for a multi-year turn toward value investing. Growth managers, like ourselves, are talking about how our companies are well positioned through an economic cycle.

So I think there's a fair amount of confusion in the investing world and certainly within the investment banking world, a lot of paring, a lot of layoffs going on, but it's not factoring in or filtering into the man on the street. In terms of the recession, I think clearly that's something that the Fed is trying to weigh here. Saw recently somebody said the Fed has, and central banks in general, but the Fed in particular have a balancing act between ensuring the banking system is working and doesn't freeze up, and fighting inflation, and I think it is a balancing act that they need to continue. I think to the extent that the small regional banks, medium-sized banks pull back on lendings, overall will have a slowing effect on the economy, maybe do some of the work for the Fed on its own.

In terms of the recession and duration of the recession, I tend to think that it's relatively shallow. I still think, and just in talking to our companies, that some of the inflation that we're still seeing in the system is companies raising prices to offset rising input prices. Going back a year, we were talking to companies that we're saying, "We put a price increase through now and we'll do another one in the second half of the year, and then maybe another one the beginning of 2023." So I think some of that has been filtering through, but I think as the economy slows, and I still say there's still supply chain normalisation to happen, I think, or at least would like to think that we see inflationary pressures ease off, which means the Fed can ease off.

Paul O'Connor:

Don, it's great to see you in Australia again, and I do hope your travels around are safe and enjoyable, and wish you all the best for your return journey back to home in New York. Thank you for joining us today on the Netwealth Portfolio Construction Podcast. It's been really interesting hearing your insights and your thoughts on, I guess not only the broader equity market, but growth stocks and the type of corporates or growth stocks that you look for, and those key takeouts that I guess I've got from the session, being that companies that are generating positive free cash flow and guess are having a less reliance on debt, but then also some of your broader macro views on the market. So I thank you very much and I'm sure that the listeners will have enjoyed and got a lot of out of your comments today.

Don Huber:

Thank you, Paul. It was really a pleasure to catch up with you and talk today, and I appreciate the opportunity.

Paul O'Connor:

And to the listener, thank you again for joining us on today's Netwealth Portfolio Construction Podcast Series. I hope you enjoyed the session as much as I have. And I'll look forward to you joining us on the next instalment. Have a great day everyone.

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