203. Why the stocks everyone falls in love with can end up being the riskiest of all

21 July 2022 (pre-recorded 11 July 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]
Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re considering the global equity market through the lens of a contrarian. Is inflation here to stay? What’s the impact on dividends and how does human behaviour play a part.

Chris Salih (CS): I’m Chris Salih and today we’re joined by Nick Clay, manager of the Elite Rated TM Redwheel Global Equity Income fund. Thanks for joining us today Nick.

Nick Clay (NC): Thank you, thank you for having me.

[INTERVIEW]

CS: No problem. Let’s start with what’s going on today. So obviously you’ve been in the management industry for more than three decades, so you’ve actually experienced a world of higher inflation and higher interest rates. Do you think that gives you maybe a bit of extra insight at the moment given what’s going on?

NC: A little bit, I mean peak inflation was in the seventies, so I wasn’t quite, I’m not quite that old. But I guess what that really tells you is how long it’s been since we’ve been in an environment of inflation. And I think the lessons that we need to learn from there are twofold.

One is that back then you got rich slowly. You built your wealth slowly by compounding dividends. And we’ve become very used to in this world dominated by QE and zero interest rates of getting rich quick. And I think people will come to realise that we need to return back to a more achievable way of building our wealth through time rather than the way we become accustomed to.

But also I think was gonna be interesting over the next few years. Given that inflation looks like it’s going to be more persistent than anybody feared at the beginning of the year, is that there are many business models which have been born during this period of low inflation. And their whole business models are based upon keeping prices low. They run off low margins and they’re not really able to suffer an increase in their cost based. And of course that will crush their margins from already low levels. And I think there’s quite a few of those kind of companies in lots of different industries. And it’s those where I think the biggest risks will be faced if we do transition to a far more permanent and volatile inflationary backdrop.

CS: Is that something that you could spot from a while away or is that, is that something that you know, as things became sticker with inflation, that sort of become more apparent?

NC: It’s become more apparent quite frankly, rather short term. You know, even I was saying at the beginning of the year, that inflation was more likely to be transitory, of course Russia’s invasion in the Ukraine and more importantly, the sanctions imposed upon Russia, which I think is fair to say will probably last longer than even the war, make inflation a bit more sticky. And of course what the seventies, particularly taught us is that the longer inflation remains elevated the greater the chances that it gets baked into expectations and then starts to filter into other stuff like wages, et cetera. And then that’s when it becomes more stubborn and more problematic.

So I would say it’s more really since started this year, but already we’ve been starting to see evidence of that coming through from results last time around where Target, for example, which is a discount wholesaler, general merchandise, works of 8% margins. And within four weeks told us those margins are gonna be 2% because as they said in their first profit warning, you know, we do not want to put our prices up to our consumer. That is their whole modus operandi as a business. And therefore it means they have to take a lot of the pain on the cost themselves. And of course, they’re not really in a starting position to be able to suffer that.

CS: I mean, even if inflation halved from here, we’re still in a completely different world to what we’ve seen before that, aren’t we?

NC: Exactly right. And we’re still comfortably above the 2% target that all the central bankers seem to still be sticking to. And so that means that the pressure is up for interest rates and the pressure will remain for wage inflation.

CS: You quoted at conference recently that markets tend to assume the current regime, whatever that regime may be, and that it’s just gonna go on forever. What do you mean by this and how does that influence investments?

NC: Yeah, certainly. I mean, one of the features of bear markets, particularly, but it has been a feature of the market for a few years now, since the pandemic, which is to take the now, whatever is happening now and extrapolate it forever into the future. So obviously during the pandemic, it was, we were all gonna sit on the back of Pelotons, streaming our Netflix, whilst doing Zoom calls. And of course that proved not to be the case.

Whereas right now everyone’s particularly obsessed about the recession that’s coming particularly obsessed about China and their rolling lockdowns and the sanctions being posted upon Russian Oligarchs and the impact that has on certain sectors, particularly in the luxury retail sector. And of course the market being very short term, extrapolates that dynamic as if it’s going to be the dynamic forever.

And what gives us the advantage of that and most active investors quite frankly, is that you can harness that time to your advantage. I.e. you think over a longer term, you’re investing over a longer term and the market, particularly in bear markets, obsesses about the short term. So you use that opportunity you’re being presented where the market gets very scared about what’s happening now to your advantage, and be able to pick up investments which are being overly discounted for either too bearish a scenario or the length of time that bearish scenario lasts. And that is your evaluation opportunity into companies, which as long as they’re strong and they’re good and they can suffer and they can cope with the short term pain, will present you with really good opportunities to invest in them.

CS: We talked about inflation and the fact markets are sort of short term. Could you maybe give us your outlook on the market? I mean, are you positive at the moment and maybe explain why?

NC: I’m probably a little bit more positive about certain areas of the market and less so about others. So the areas that I’m positive about are those companies which have been treated as hyper cyclical and therefore when the market’s obsessing about the size and depth of the recession that works coming marking them as if we’re almost going into another pandemic like backdrop, which I think is sort extreme.

So likes of fast fashion in Inditex, the likes of the retail companies, the likes of semiconductors, but other areas of the market like mega tech
, big tech, Microsoft Apple, etc. I think they are still looking too expensive. And we are going to go into a global slowdown. We’re most likely going to go into a recession of some sort. And yet they seem to remain priced as if everything is going to trundle along quite nicely, despite the fact that almost every one of their customers is treated as if they’re cyclical and we’re going into a down cycle. So there’s a sort of a disconnect there in the market. So I think the mega tech area of the market has still got quite a bit of pain to come and other areas of the market, which have been treated as very cyclical and yet their companies are able to suffer that are the opportunity today.

CS: Okay. You’ve also said that dividends could be the solution for investors while central banks are in a bit of a conundrum with markets, could you maybe explain that and go into a bit more detail?

NC: Yeah, certainly. So I mean that comes back to this growing and well slowly, rather than trying to get rich quick. Which is that, you know, over time over almost any timeframe apart from this last sort of 15 years of QE, the compounding your dividend has been the largest driver of your total return. And I think as we now move away from QE and zero interest rate policy because of inflation you are going to find that the compounding of your dividend income is going to be the largest driver of your total return going forward and not the capital gain. And so I think that that’s gonna hold you in good stead. If you focus upon that in the way you generate total returns for your clients.

But the other thing though which people are now being reminded about is that when you go back to facial periods, dividends can be grown by their companies and actually MSCI World Dividend Growth keeps pace very well with US CPI, i.e. you can increase the dividends to compensate you for inflation. Now, obviously you need to be in companies that can raise their prices. Obviously you need to be in companies that increase their dividends and not all of them can do that, but if you can find the right ones, then you are able to compensate yourself for the inflationary backdrop and generate decent real returns in that environment, which again, we think is gonna be quite apt or quite appropriate for the environment we find ourselves in.

CS: In terms of the dividend of bucket that you’ve got Nick at the moment, are you finding quite a lot opportunities sort of attractively priced or are they in certain specific areas? Maybe just give us a quick idea on the landscape of that.

NC: Yeah, there’s certainly the way the market has behaved over the last few months has certainly started to introduce some stocks into our buckets. Which are particularly in the retail area, some of that as we said, the semis area, but also in things like insurance, et cetera. Companies which are certainly able to suffer this environment. I think one of the most obvious ones that’s in the portfolio at the moment is Inditex.

Inditex is barely off the price it was in March 2020, and in March 2020, we were going into the global pandemic. Every single one of Inditex stores were closed. And online was only about 10% of its business. It barely got going. Where now online is 35% of this business, and most of its stores are open. And yet it’s on the same prices as if the recession we’re gonna go into is gonna be as bad as the pandemic, which I think is somewhat extreme. And so that’s where I think the opportunities are being presented to us at the moment.

Whereas the more traditional areas you’d find in coming things like healthcare, things like utilities, things like consumer staples, they’re all getting a bit expensive at the moment.

CS: One of the sort of around the philosophy of the fund is the idea that you buy the controversy and sell the consensus. I mean, there’s a lot of controversy and there’s a lot of people with the consensus views out there. Could you maybe give us an example of this please, and how that works?

NC: Yeah, certainly. So I mean, a really good example of that at the moment we say Tapestry, which is Coach and Kate Spade handbags. So a luxury goods retailer aspirational band. And of course everybody is obsessed with the fact that, you know, we put sanctions on what 40 Oligarchs and their sort of 400 surrounding families, as if they were the only people who buy Coach and Kate Spade handbags. And then of course the close down in China as if that’s a permanent feature and therefore, again, the Chinese are never gonna go out and buy any handbags ever again. And of course we feel that that’s rather short term in our view and isn’t something that is going to be sustainable over the long term.

And yet Tapestry is on a market cap of around $8 billion. And it’s returning up to 15% to 20% of its market cap back to shareholders every year. And basically what that’s saying from the market is that Tapestry or Coach is gonna go bust within about five years. I don’t think that that’s gonna happen. I think it’s a very low probability and therefore your risk rewards very much skewed to the upside and it’s marred in controversy at the moment. But of course, when everyone will tell us that’s stupid, cause look, China’s going into another lockdown who would buy another handbag retailer going into that environment?

Equally the consensus view is some of our technology stocks did get very expensive towards the beginning of this year. So Mphasis in India was trading on a 3% free cash flow yield. I mean that is demanding an awful lot of that stock. And it has been interesting that even though it’s continued to deliver very good results over the course of this year and very strong growth it is still underperformed. And it’s something that we halved our position in the portfolio in Mphasis earlier this year. And it’s now derated back to a 4% free cash flow yield so far more reasonably valued today.

But again that’s the point, it was at the point when expectations are really great consensus view of these stocks has become everyone’s in love with them. That’s when they actually turn out to be some of the riskiest stocks out there, because even if they deliver on those amazing results, they’re still not enough to justify the valuations they’re on and that’s when you need to be very careful.

CS: Okay. And just to build off the, buy the controversy sell the consensus philosophy, obviously that feeds into contrarian approach and you look at a number of different buckets to sort of feed into those ideas for that approach. Could you maybe take it one of them in turn and explain them to us please?

NC: Yeah, very quickly. So there are five buckets. This process over the 15 years has kind of taught us that these five repeating areas, the market presents to us with regards to controversies. The first two are high ROIC (return on investment capital) companies, companies that generate really good and high returns. They have great balance sheets. The first one, the trouble compounding machines are ones where those growth companies hit a speed bump for some reason, a really good example of that was Pepsi for example, back in 2018, when the sugar tax came along and everyone got really worried about the impacts on soft drinks, even though soft drinks is only 9% Pepsi. So it offered you an opportunity to buy into those great companies when something very short term has sort of knocked them off their course.

And then there’s second one, the cash generating machines is the ones which are growth. So they’re not growing like bucket one, but now they’ve been priced if they’re going bust. And actually the reality is that their business are far more resilient and stable and Cisco Systems in the portfolio today is a great example of that. Both of those first two buckets make up about two thirds of the portfolio through time hence the sort of quality the reasonable yield do you get from this strategy.

The final three buckets are profit transformation, which is you wanna buy the bottom of the cycle. You are hoping for something to mean revert, whether it be within the company or within its own industry cycle or economic cycle. And then you’ve got capital intense buckets. They are companies that make much lower returns, far more boring quite frankly. But if you can get the ones which are made consistent returns above their cost of their capital, then you’re still gonna make decent returns. So utility companies, et cetera, but the market just gets bored of these ones when, particularly when the backdrops all about sex and violence and growth.

And then the final one, which is by definition is rare which is special situations which is things like spinouts out of companies, hidden pension assets, litigation impacting on companies of buyer which had litigation on its business recently presented us as a good opportunity to buy into a good business.

The point about all of those buckets and those controversies is every time we’ve got to try and work out whether those controversies are temporary and the opportunity or permanent and therefore the trap. And I guess the challenge over the last few years particularly has been that disruption and controversies are becoming more permanent than they would’ve been say 20, 25 years ago. So you have to be ever more careful today, I think, to try and get the right ones.

CS: And with a view of those permanent controversies, I’m gonna leave sort of give you the open floor here, in terms of whether it’s one of those buckets, a certain country or region or a style. I mean, where would you say you are finding those best ideas today? And maybe give us a couple of examples of that.

NC: So in bucket one, so those troubled compounding machines, it’s a strange bucket at the moment, because about half of the stocks in that bucket are looking expensive. So your staple stocks, which have all done very well this year for obvious reasons, things like your P&Gs and your Pepsis, and Diego’s, you know, we all have to clean our teeth and put our deodorant on and wash our hair, et cetera. So not only does your underlying demand remain very stable, but they also have pricing power. They can put the price up and people still need to this stuff. They’re very well positioned to be able to cope with this kind of backdrop.

But of course the market now knows that and it’s starting to make them fairly expensive. And quite frankly, if this trend continues over the summer then our disciplines in our portfolio will start to kick, which is the sell discipline. We have to sell everything that yields less than the market. They will start to kick on some of these stocks as we will come out over the summer if things continue as they are.

Whereas equally the other half of that bucket is these luxury retail companies which again history shows you have incredibly strong and resilient returns, not unsurprisingly given the nature of the things they sell. So we have things like Compagnie, which is Cartier jewellery, Kering, which is Gucci by the nature of the things they sell. They’re very high priced. And therefore they have a lot of scope to push through pricing. In fact, if anything, the nature of these goods is the more they put the price up, some reason more people want them. They’re like the classic gift and goods that’s out there. And yet as we spoke about earlier in this podcast they’re being treated as if the backdrop of sanctions and China is gonna last forever and holding these stocks back, treating them as cyclical companies. Whereas history will tell you they’re not cyclical companies by any stretch of the imagination. They incredibly robust. Not unsurprisingly the wealthy in the world tend to ride through economic slowdowns very well.

And then the thing we get quite excited about is that there is this sort of more thematic backdrop of a rebalancing of the quality across society and the growth in the more middle classes and the aspirational areas. And of course, wage inflation across the whole of the workforce piece is actually very supportive of these stocks and the growth in the middle classes in Asia, et cetera. So structurally you’ve got a great tailwind. We think they’re being treated as highly cyclical, and yet all the history will tell you that that’s not the case. So even within one bucket, you can get quite a bit of divergence.

CS: And just lastly, I just wanted to touch, cause you mentioned discipline in your last answer there. How important is it to sort of keep your discipline in times like this, where sort of things are changing so quickly and opportunities are appearing so quickly and perhaps disappearing quickly as well. Maybe just give us a quick sort of minute or two on that, if possible.

NC: Yeah, of course it is vital. And the reason why it’s vital to have objective disciplines imposed upon you is because as human beings, we’re very weak and fallible, just as we are on our team. And you fall in love with things very easily. You get scared and very fearful of things at the wrong time. And you need a discipline to try and encourage you to do the right thing at the right time, whether it’s buy or sell. And invariably, when you’re doing those things, it feels uncomfortable at the time you are doing it, buying those things when things are going horribly wrong, selling things when everybody loves it. They are difficult things to do. And so as human beings, I think we need those disciplines and in times of volatility and extreme environments for markets, which we’ve been in for the last few years now, those disciplines are even more important than they’ve been.

CS: That’s great, Nick, thank you very much for joining us today.

NC: Thanks so much, Chris. Good to speak to you.

SW: As Nick explained TM Redwheel Global Equity Income fund uses a “buy the controversy and sell the consensus” philosophy is this portfolio. It gives the fund a true contrarian nature backed up by a logical and disciplined philosophy. This leads to an attractively yielding income fund that also allows for capital return from a concentrated portfolio. To learn more about the TM Redwheel Global Equity Income fund visit our website fundcalibre.com and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.