Paul started his career in the engineering sector in the 1997 Asian crisis. What are some of the key lessons and how has this informed your approach?
It was a fascinating time. I had just come out of London Business school and was a freshly minted analyst at Fidelity in the London office. I was looking at engineering and the Asian crisis was just getting going. All the growth in the engineering sector was in Asia. Engineering stocks were just falling. People would often say, look, don’t try and catch a falling knife. When stocks are collapsing, don’t try and step into it.
As a new analyst without much experience, I didn’t know how to approach this. The beauty of Fidelity is that we had so many different fund managers with so much experience. I still remember travelling to our Boston office and catching up with a range of world-famous portfolio managers.
One of them was Rich Fention, our deep-value fund manager at the time. He was fantastic. He gave me a lot of time and I asked when do you step in with these stocks and what do you do?
His advice in that period was that you really just have to do hard asset-backed valuation. So forget profits, forget everything. If these stocks trough at 0.4 enterprise value to sales and you’re getting below 0.4, get interested but you still have to have the balance sheet.
Balance sheets are super important in that scenario. It has to have the balance sheet to come out the other side. If it’s a cyclical downturn, you need to get to the other side to make your money on the other end of it.
He would say hard asset value, whether it’s price-to-book, price-to-net tangible assets, enterprise value-to-sales, enterprise value-to-order book, that’s a really basic level.
If it’s hitting those trough levels and they’ve got the balance sheet, you just need to step off the cliff. It’s easier said than done, but you just need to step off it. He’d say if it troughs at 0.4x, that doesn’t mean it can’t go to 0.3 enterprise value-to-sales but you know that you’re stacking the odds in your favour.
It might average 1x enterprise sales-to-value. You’re stacking the odds in your favour at that point.
As long as you’ve got the balance sheet, the likelihood is that you’re going to get back to where you started.
To me, that was a very early and important lesson. It was great to get that from a fantastic portfolio manager as well. It’s one that has stayed with me.
I worked out the other day that in the almost 26 years I’ve been at Fidelity, I’ve had 10 different crises. Everything’s a little bit different but I think we learn a bit more from each crisis.
How do you think the current inflationary environment and rising interest rates are going to affect Australian equities this year?
It’s a different scenario again and it’s been a while since we’ve had to deal with inflation as well. Whether in Australia or around the world, inflation is high.
The Reserve Bank of Australia put interest rates up to 3.6% and they separated out goods inflation from services inflation for the first time. Goods are calming down but there’s still a lot of inflation in services. The RBA might need one or two more rises based on the data as it comes out.
What that means is a big impact on the consumer. Even across the last month, there’s been a lot of pressure on the RBA, the governor and a lot of complaints. That tells me there’s pain coming into the economy and the market. People are feeling it.
The other thing happening is a bit unusual. Australia is a variable rate market. All of our mortgages are typically variable. The people that took out mortgages through the pandemic typically fixed it because it was so low. We’ve got about a third of the market that are fixed-rate mortgages, which is a bit unusual.
They’ll start to unwind as people move from fixed rates to variable around May, June and July, with a peak around June. That will go out over the next year as well. It’s going to be an interesting time as people move from a low fixed rate to a much higher variable rate. It will definitely impact the consumer.
We don’t believe, at this point anyway, that Australia will go into a recession in 2023, but it will definitely slow. It could go into a recession if interest rates have to go a bit higher.
We’ve just come out of a fairly solid reporting season. Do you think much of the pain will hit when full-year results land, and mostly in the consumer discretionary sector?
It will definitely be felt in different areas.
If you just look at the banks and the reporting season, they had a great result. But often, they went down on the result despite great results. This is the market saying this is as good as it gets. They’ve seen their net interest margin expand because interest rates have been going up. They’ve got short-term tailwinds but there are potentially long-term headwinds in that. As interest rates go up, system growth and lending growth are going to slow but then loan loss provisions are going to start to go up. It’s probably short-term tailwinds and long-term headwinds in financials.
Insurance is actually in a really nice spot.
We’re seeing a lot of capital come out of the market and tightness in premium rates going up. It’s a much better environment for insurance companies. They can earn a bit of money on their deposit rates as well which is beneficial.
China is reopening which is obviously helping our commodities. Australia is in a good position from China reopening. We’ve also got the whole decarbonisation argument which is really positive. It’s a very metal-intensive phase of development, especially for commodities like copper, nickel and lithium. We think they’re very well-placed.
If you think about what a higher interest rate means, it’s tougher for the property market, an important market in Australia. It’s also tougher for consumer goods.
As it stands now, we are heavily biased towards essentials, some of the transition metals and some of the cheap sectors like insurance. We think that’s the right way to play 2023 but that’s a fairly defensive positioning as well. It will be a tougher year.
The Fidelity Australian Equities Fund is approaching its 20th anniversary. It’s had returns of 11.46% pa since inception. What is your process for selecting stocks?
We’re extremely happy with that long-term result. That’s what it’s really all about for us. We have two key competitive advantages.
One is we have what is called waterfront coverage.
We look at the whole market. We’re out meeting the whole market every quarter, regardless of whether we like the company, hate the company or anywhere in between. We think that’s the best way because it institutionalises the process when you meet the whole market.
We’ve got one of the biggest teams in the market out meeting with these companies every quarter and looking out three to five years. We re-examine our thesis every quarter, still looking out for three to five years. We think that’s the sweet spot in terms of duration as well.
We’re also trying to create a 360-degree view of the company. We’re not only meeting the company, we’re meeting their competitors, suppliers and distributors. Often these are not other Australian companies. They could be, but they’re often not. They might be global companies. What Fidelity does in Australia, we do everywhere else as well. As an example, we have a big Shanghai team. There’s a steel analyst who is talking to Baosteel (SH: 600019). They’re talking to them to see if we should invest in them but they’re also asking Baosteel, what does your steel production profile look like? What do you think about the cost of iron ore? What do you think about the cost of coke and coal and what do you think about consolidation in the Chinese steel industry?
These are obviously fantastic inputs when we’re looking at Rio Tinto (ASX: RIO) or BHP (ASX: BHP). BHP and RIO sell most of their products in the steel industry.
Even domestic businesses like Coles (ASX: COL) and Woolworths (ASX: WOW) have key competitors Aldi which is German and Costco (NASDAQ: COST), which is American. We think you need to understand the strategy of these global companies in Australia as well to understand the industry dynamics.
The Australian stock exchange is listed in its own right. Looking at European and US stock exchanges helps us understand global thematics and trends that could occur in the Australian market as well.
We think those two competitive advantages are what have driven the outperformance over the past 20 years. We think it’s a very repeatable process as well.
What would you say are your highest conviction positions at the moment, particularly going into a tougher environment?
Some of our bigger positions in this environment would be in the insurance space. We’re invested in Suncorp (ASX: SUN). We think the whole insurance space is positioned well.
We think Suncorp has one of the better positions and is very attractively valued. It’s simplifying its business which the market really likes. It’s a tight premium market and they’re able to take up rates. They’re also earning a bit more on deposits. I’m sure you’ve seen your home insurance go up, your car insurance goes up. The money you pay on the premiums they invest and they’re used to getting zero. Now they’re getting 4%. This improves the business model as well.
In the insurance space, we’d put Suncorp as an essential - a cheap sector and insurance is one of the cheaper sectors.
Ramsay Healthcare (ASX: RHC) is also a major position for the portfolio.
Private hospitals went through a really tough time through covid because a lot of elective surgeries didn’t happen. They had to cancel them to focus on the pandemic. Now private hospitals are coming back to life. Those surgeries don’t go away, they just got delayed. Now the demand is coming back so they’re in a much better position.
We also look at a private hospital company like Ramsay as a really attractive infrastructure asset. You can’t replace those assets. We think eventually someone else might come in and view them as a longer-term infrastructure play.
We’ve also got companies like IGO (ASX: IGO) which is in the EV metals, transition space. They’re probably one of the most attractive miners in lithium and nickel. They’re becoming an employer of choice in that space.
The other major overweight position we’ve got is Coles. We really like the supermarkets in this context as well. Some food inflation is actually good for them and even if their costs grow, the margins don’t widen. Inflation drives the profit growth for someone like Coles. If we look back at the reporting season, Coles had a fantastic result.
We think those companies are really well positioned but more importantly, they tend to do quite well in a more difficult economic environment as well.
What triggers would lead you to sell down a position?
There are a few different things.
Obviously, we set what we think the stock would be worth. We’ll look through the valuation and say this is why we’re buying it. That’s our investment thesis. That’s what we think it’s worth. The first point would be if it hits that, it’s the best outcome. It hits our target. We look at it and no other fundamentals have changed, we would reassess. We re-examine our investment thesis every quarter.
The stock’s gone up and it hits our price target. Has anything changed? Has the world got better? Are there things headed there? Have they got a greater market share? Nothing’s changed and it’s hit our price target? That would be a catalyst to sell. That’s the best outcome.
The other outcome could be we just got the thesis wrong and we need to work out when we get it wrong. That’s the benefit of re-examining your thesis every quarter. Have we got anything wrong? Why is it not working? Is the company heading where we thought it was? At the end of the day, sometimes we get it wrong, we have to understand that and readjust.
If the fundamentals haven’t worked, say we thought it was structural growth but it was really cyclical growth, we’ve got to work that out as quickly as we can. Then we readjust the position or sell out of the stock because we just got it wrong.
Have you sold out of any positions recently?
If I think about stocks we have been in that were compounders and then we got out, a great example might be JB Hi-Fi (ASX: JBH). We haven’t been there for a number of years but we were an early investor in JB Hi-Fi.
That was the ultimate in that it was a high-returning business. They were able to roll out a whole range of stores and were one of the ones that beat the fade. They had a high return and were able to reinvest at a high rate. We made the assessment that they were coming near the end of the rollout. Most of the value had been created and that was the time for us to exit.
James Hardie (ASX: JHX) might be another example. That was more of a lead into the GFC. It had a good structural growth story in the US. As you know the house market changed completely as we entered the GFC. It typically takes us a long time to build a position and a long time to exit a position. It tends to be around structural things.
We also tend to trim.
Dominos (ASX: DMP) is a stock we’ve owned for a long time. We bought that in the IPO back in 2004. We’ve owned it for a very long period of time and have typically traded it up and down. We really like the long-term prospects.
In 2021, the stock had a great run because we were all stuck at home. It was all about delivery and it’s a great company that did an incredible job in that period. The stock rallied hard so we took that opportunity to trim. We didn’t sell out completely but we trimmed. Often you’ll find we might build up a position or trim down based on that valuation as well.
You hold a relatively concentrated portfolio of 30 to 50 stocks. What's your view on why that's the right number?
The way I look at it is below 30 is not really diversified but above 50, you start to get too close to the market. So 30 to 50 to me is the sweet spot for diversity. It’s concentrated enough to deliver outperformance for clients but you’re doing it in a risk-controlled way. We think it’s a real sweet spot.
Finally, what are your tips for investing in Australian equities across market cycles and in the current market environment?
My first tip would be Australia does very well. It’s time in the market rather than timing the market. I think Australia should be an important part of where people invest.
The other piece of advice is that you need duration.
If you need the money in 12 months' time, or two years’ time, equities are not the right place for you.
If you can put money in the market and you are happy to go five to seven years plus, equities are a great opportunity to invest in the market. We’ve got some great quality companies here in Australia. We’ve got a very good corporate governance environment and the dividend yield and real dividend growth is a big part of that.
I definitely advocate investing in Australia but make sure you’ve got the time to see through that environment. Especially now with a tougher environment in 2023. That doesn’t mean you should be invested. In fact, personally, I’m heavily invested in it. Don’t get caught up in what happens in three months, six months, or 12 months. It’s about the next five to seven years.
If you look at all the reasons why Australia has been a strong-performing market in the long term, those reasons are still in place. We’ve restarted immigration, we’ve got really good population growth, and we’ve got good demographics in Australia. We’ve still got an excellent and low-cost natural resource base, a good corporate governance environment and because of dividends and imputation, we’ve got good dividend yield and real dividend growth. All of those key drivers are still very much in place.