222. A deep dive into the US economy and why Netflix is now a bargain buy

Maneesh Bajaj, the Elite Rated manager of the Brown Advisory US Flexible Equity fund, talks about his fund, the outlook for US markets in 2023 and the fund’s approach to investing. He comments on several of the fund’s holdings, including Berkshire Hathaway and why that conglomerate’s culture of corporate responsibility and attitude towards its shareholders makes it an important, long-term holding for the fund. He also reveals why he believes there’s still mileage in the FAANG tech stocks, and why Netflix has come good.

Apple PodcastSpotify Podcast

Brown Advisory US Flexible Equity fund was launched in the UK in 2014, and a retail share class in 2016. However, a parallel version has been managed by the same team for more than 20 years in the United States. The fund has been run by Maneesh Bajaj since 2017. Its strategy is unconstrained, meaning Maneesh is free to select companies from across the market cap spectrum. This has enabled the fund to become of the few to consistently outperform the S&P 500 over long periods of time.

What’s covered in this episode:

  • The state of the US economy today
  • The problem of persistent inflation
  • Challenges for the Federal Reserve
  • The outlook for the US tech sector
  • The fund’s bottom-up investment approach
  • Why Berkshire Hathaway is a long-term holding
  • How Netflix’s future initiatives have made it a bargain buy

TRANSCRIPT: EPISODE 222
10 November 2022 (pre-recorded 8 November 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.

James Yardley (JY):
Hello and welcome to the Investing on the Go podcast. I’m James Yardley, and today I’m joined by
Maneesh Bajaj, the Elite Rated manager of the Brown Advisory US Flexible Equity Fund. Maneesh, thank you very much for joining us today.

Maneesh Bajaj (MB):
Hi James. Thank you for having me.

(JY):
Thank you for being here. Now Maneesh, I mean, there’s so much going on at the moment, it’s difficult to know where to start, but can you give us some idea of the economic environment in the US today? Where are we with inflation? Have interest rates now peaked? And, you know, are we going to head into a nasty recession in the US next year?

(MB):
Great. So, [I’m] happy to kick it off. If you just look at the snapshot today of the US economy, things don’t look as bad. Spending and production in nominal terms has been growing. Job growth has been robust – till recently – and the unemployment rate is near its historic lows, roughly 3.7%.

Simply said, the US consumer is still in good shape as they’re holding onto their jobs as we speak. The access savings from the pandemic-era policies is providing the consumer with a cushion in the current environment, where inflation is running at historic highs, as you talked about.

So, that’s on the positive side, but there are some real concerns. The biggest concern staring at us is the persistent inflation, which is unusually high due to the supply and demand imbalances. Food and energy prices in the United States are significantly higher, which is hurting an average consumer.

So, the Federal Reserve in the United States has a dual mandate of keeping inflation in check and maximising unemployment, maximising employment, I’m sorry. The current employment picture is robust, as I mentioned earlier, and which is of course helped by the extremely loose monetary policy which the Fed has had in the recent past.

But now the Fed has had to reverse course, due to high inflation. The Fed has adopted an aggressive path of raising short term rates, and the rates have moved quite high. The Fed fund rate today is 3.75% to 4%, and, just as a reminder, at the beginning of the year, the rate was zero. So, this is really an unprecedented move, and which eventually will flow through the broader economy and certainly slow down demand.

So, we know that the borrowing costs for consumers and businesses are significantly higher today because of higher rates, which of course is going to impact their budgets and spending. And we are seeing consumers and businesses begin to slow down their spending. In addition, we expect there’s going to be a negative wealth effect, as trillions of dollars have been wiped out in asset values because of dramatic sell off of financial assets, which includes both equities and bonds.

So, to your question on recession and slowdown, I think most people are factoring in a substantial slowdown in the economy in their base case. The real question is, how long and how deep will the slowdown be? And no one really knows the answer to this because this is a complex and a dynamic world. It could get even more difficult if [the] Fed continues to raise rates aggressively to curtail inflation. So, if inflation proves sticky, we will have even higher rates.

However, there are reasons to be optimistic as well. And there’s a possibility that we could avoid a deep recession. So, for example, there could be a resolution to the war in Ukraine, which would ease energy prices. China could move away from the highly restrictive zero-covid policy, which could ease supply chain pressure and reignite growth in the region. Inflationary pressures could ease and then the Fed wouldn’t have to be on its current warpath of continuing to raise rates. But again, none of this is a certainty.

Now, from our perspective, we think it’s very difficult to forecast [the] macro environment including a recession, accurately. And, as such, we don’t base our investment decisions purely on macro factors.

We invest in businesses that we believe have strong business models, and have strong balance sheets to weather such storms, and hopefully emerge stronger at the other side of the recession. So, those are my thoughts related to inflation and interest rates.

(JY):
Very interesting. And I guess, I mean, is the US consumer strength, is that a good thing or a bad thing? Because I guess, the stronger the US consumer is, the more work the Fed needs to do, which I guess may be bad for markets? So, perhaps we’re better off if we do go into recession perhaps, and just get this out the way? I mean, do you have any thoughts on that? I mean, it feels like, you know, a lot of negativity has already been priced in, given the big fall we’ve already had in the US stock market this year.

(MB):
Right. I think there’s a fine balance to your point. The Fed really is trying to rein in spending and slow demand and doing it by this blunt tool of raising rates. So, in some ways, one does wish that this is quickly behind us, and we see the slowdown in demand and a softer spending environment, which would eventually mean that the interest rates would stabilise and [the] Fed could reverse the path of increasing rates. So, it’s a delicate balance, which the Fed is trying to strike. And let’s see how this translates, but I do agree that the equity markets have taken a step down. And hopefully, that slowdown is being reflected already in the prices.

(JY):
Yes, and the US stock market has struggled this year, and obviously a big component of the US market is the tech sector. I know you’ve got a number of tech names in your portfolio. So, I mean, what are your thoughts on the recent earnings misses and the outlook for the sector going forward? I mean, are we seeing a big shift here? I mean, obviously the tech sector’s driven the US market for so long. Are we seeing a change in leadership or is this just temporary?

(MB):
Yeah, I think, again, this is to be seen. There was an environment, especially in 2021, where tech stocks were really doing very well, and every day you would wake up and the stock prices were higher. And now we are at a period where there is a significant correction, not only in the business outlook, but also the stock prices. And when you [are] thinking about these, some of these big tech companies, the likes of Google, Amazon, and Facebook, these were several trillion-dollar companies and did extremely well during the pandemic. And now it seems like some of … they’re beginning to lose some of the lustre.

Now, generally speaking, the Covid era has been [a] difficult period for lot of businesses, as well as government entities. We were at a time when the economy nearly stopped due to the health scare. And then there was a period which was a period of rapid growth because of the stimulus, which we all experienced, by the government. And then there were shifting consumer preferences, which created a lot of distortions. So, it was really a difficult environment to manage.

Many of the big tech companies had to scale pretty rapidly during Covid because of the unprecedented demand they were experiencing for their products and offerings. Think about companies like Amazon, where everybody was buying things online, and Google and Facebook, and all these companies really went on a hiring binge. They had rapid rise in headcount but the revenues were growing faster and expenses on a relative basis were still contained. And so, these companies were posting record margins and profitability, and as a result, the stocks did really well especially during the early part of the post covid recovery.

But now the winds have shifted, and their business is slowing down, but unfortunately, expenses have continued to grow, and especially in the case of Facebook, which we saw just a couple of weeks ago, where expenses have continued to climb because the head count today is significantly higher, which is resulting in compression of their margins, and poor quarterly results compared to investor expectations.

So, these businesses really have to adjust to the new reality where they have to adjust their expense base and they’ll have to slow down hiring and, in many cases, move down to cost cutting. And we’ve seen that with Facebook this last, past weekend. We saw some news where they are announcing some layoffs, etc.

So, but the fact remains – to your earlier point, James – that these are good businesses. They are fine businesses and, and especially the names I mentioned, they have strong moats, they have [a] very attractive financial profile, they have good margins, and they still have decent growth ahead of them. It’s just making sure that these businesses are able to align their expense base relative to their revenue. So, we do expect these businesses to continue to make progress over time and they are investments in the portfolio.

(JY):

Very good. And do you have a preference for large, medium, or smaller companies in this environment? Obviously, we’ve had a very strong dollar recently, which has hurt many of the big multinationals with their overseas earnings. So, is now more of a time for perhaps smaller companies which are more domestically focused in the US or has that already been factored into prices? What are your thoughts?

(MB):
It’s a very good observation, James. Now, we are primarily a large cap fund and we do have investments in midsize companies, but we are more bottom-up based. And what this really means, is that we are looking at investments on a case-by case basis, and we base our investment on the franchise quality and the financial attributes, and we don’t necessarily factor in size of the company in making these decisions.

Now, however, to your point, we do think about, you know, revenues etc., which are being derived from abroad. So, and it does have an impact where many of these large companies have higher exposure outside the US, and when you translate the currency, the profitability has been impacted. But you know, this trend is not going to last forever.

So, you know … and oftentimes [in] the equity markets, these adjustments happen pretty rapidly. So, as of now, we don’t have any strong preference for large, medium versus small. You know, it’s on [a] case by case basis, just thinking about these businesses and the prospects of the business. And our lens is simply that, are these businesses going to be more valuable in the future and are we getting bargains?

And this is an environment when stocks sell off, it certainly creates more bargain opportunities for us.

(JY):
And what is your outlook for 2023, do you think things will improve? Do you think the stock market can do well in 2023, even if we do head into a recession?

(MB):
So, I do agree that there has been a lot of volatility this year and hope it doesn’t get much worse! You know, as we talked about this, we started the year with some very high inflation – and [the] Federal Reserve clearly was behind the curve, and they have woken up with a vengeance – and the Ukraine war, which led to a dramatic increase in energy prices. So, there is going to be volatility and we do expect that the volatility will be with us until there is clear evidence of a pause in inflation, or the Fed backing off from raising interest rates.

So, again, this is a complex and a dynamic world, very, very difficult to make predictions if in 2023 is going to be significantly better or worse than 2022. But we do know that eventually things recover. We are going to be in a better spot than we are today.

So, whether it’s the second half of 2023 or 2024, we do expect that these challenges [are] going to be behind us. But that is, of course, predicated that on the fact that we are not subjected to any other catastrophic event or a, you know, a meltdown of a large financial institution, which could jolt the market. But as of now, I do think that things will get better from where we are.

(JY):
And tell us about one or two of your holdings. Maybe start with Berkshire Hathaway, Warren Buffett’s company of course. What do you like about it? Another manager we spoke to recently said it was ‘the sum of the parts was more worth more than the whole’. I mean, did you sort of concur with that view?

(MB):

I do concur with that view. So, Berkshire Hathaway is one of our top holdings in the portfolio, and we have held this position for a very, very long period of time. And so, Berkshire Hathaway is a collection of some very good, long duration, cash generative businesses. And, as you pointed out, it’s managed by Warren Buffett, who is one of the greatest allocators of capital of all time. And this collection of businesses ranges from P&C insurance [Property & Casualty insurance], reinsurance, utilities and railroad, which are very, very large businesses for Berkshire Hathaway.

But Berkshire Hathaway also owns some very … smaller businesses that are household names like See’s Candy [See’s Candies], and Duracel and Dairy Queen, which are much well known in the United States. Now, over time Buffett has been able to deploy the cash generated by existing businesses to buy other great businesses outright, and also makes thoughtful investment in other businesses which are publicly traded.

And over time these investments have proven to be great investments, good investments. More recently. The example is Buffett’s investments in Apple, which he made a few years ago, which is a home run. And then, more in the last one or two years, Buffett invested large sums of money in the energy sector, where some of these names had traded down with low oil prices, and there was significant value in those businesses.

So, shareholders of Berkshire Hathaway have been rewarded as this entity has consistently been able to compound in value. And this we attribute to Berkshire’s unique culture of corporate responsibility and attitude towards shareholders. And we expect this to continue. So, we are, you know, … this is an important holding of ours. We have been inspired by Buffett’s way of thinking and we incorporate many of Buffet’s principles into our own investment making.

(JY):
Yeah, well he’s certainly having a very, very good year relative to the market this year, that’s for sure. And maybe some of your other holdings as well, Maneesh?

(MB):
Sure, happy to talk about it. I can talk about an investment which is more recent. We have recently made a purchase of Netflix in the portfolio, which happened during the last quarter. So, we have been watching Netflix for a long period of time, and this is, they have a very strong offering, we are all familiar with it.

And Netflix was the darling of the stock market as it was part of the FAANG stocks, which refers to the five prominent technology companies like Facebook, Amazon, Apple, Netflix, and Google, which we talked about some of these names.

So, Netflix stock had done very, very well, and especially during the Covid period where all of us were sitting at home and watching … spending more time, watching videos on Netflix. And the stock had peaked roughly at $700 during the Covid period. But since then, the stock has retracted quite a bit. And not too long ago, it was trading at $200. And part of the reason is that their user growth had slowed down and some of the gains – because during Covid – which they had made, had started reversing.

So, in the past we had evaluated this company for potential investments, but we had refrained from making an investment because, in our view, the company was not generating adequate free cash flows.

But now that is evolving, with their management team announcing three major initiatives that, if successful, we believe will drive significantly higher free cash flows in the future.

First is that the company is moderating its spend on content and instituting more discipline, which we like. The second is that Netflix has announced another offering, which is based on a combination of subscription as well as advertising, which really lowers the monthly cost to the consumer. But and at the end of the day, it is revenue-neutral for Netflix. And the third is that they’re planning to curtail password sharing by the customers, and charge based on the value they’re delivering to their customers.

So, we think these three initiatives are good initiatives, which will help their free cash flow generation. And just given the price move, we thought this is a good investment opportunity and [it] falls into how we think about businesses, which is buying good businesses at bargain prices. So, that’s the thesis behind Netflix. Hope that was helpful.

(JY):
That was very helpful and very interesting as always, Maneesh ,thank you very much for joining us today.

(MB):
Wonderful. Glad, glad to be here. Thank you, James.

(JY):
And if you’d like to learn more about the Brown Advisory US Flexible Equity fund, please visit fundcalibre.com. And please also remember to subscribe to the Investing on the Go podcast. Thank you very much for listening today.

[Outro]
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.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.