Ten quality picks from an award winning PM

This interview was conducted by Livewire on the 28th April 2021

After more than two decades working in funds management, Fidelity International's James Abela has proved himself a force to be reckoned with. 

The portfolio manager's successful Aussie small and mid-cap strategy saw him take out Morningstar's fund manager of the year award three years running. And now, with a newly launched globally-focused fund under his belt, he's ready to take on the world.

As a matter of fact, $10,000 invested in his Aussie Future Leaders Fund at its inception in July 2013 would be worth $25,982 now - $3,500 more than if you had invested in its benchmark S&P/ASX Small Ordinaries Index - and a hell of a lot more than if you had let that cash sit in the bank. 

And yet, Abela is refreshingly down to earth, wonderfully charismatic and completely free of ego. Characteristics that can be all too rare in the hustle, bustle and billions of funds management. 

In the video and editorialised wire below, Abela shares some of the wisdom he has gained throughout his career - including the secret to long-term success in small caps, as well as 10 quality compounders that have his tick of approval. 

After more than 20 years of analysing small caps, Abela says high-quality small caps all have three things in common; high Viability, Sustainability and Credibility (VSC) scores. 

"Viability is about the level of returns, the S curve, the market structures. So it really tells you what the return level is," he says.

"Sustainability is how long that return profile lasts. Is it one year? Is it 20 years or is it more than 20 years? That comes down to customer entrenchment, again, market structures and the competitive elements of the marketplace. 

"And then credibility is trusting yourself, trusting the accounts, trusting management and the governance structures ... If that credibility score is low, the duration is going to be low and potential of blow-up risk will be high."

In small caps, stocks with high VSC scores will typically be in the healthcare, technology or global consumer sectors, Abela says.  

"A good example of that is Pro Medicus (ASX:PME) ... a medical software company that scans and then distributes images through hospitals and networks of hospitals," he says.
"This is an Aussie business that has been around for quite a long time, but it is leading the edge in terms of how they distributed and package software."

It's been a really strong performer over the last five years, with its share price rising 964% over that period. 

"That's a great business that sits across that VSC score very highly. And that is what you want to see when you look for a future leader," Abela says.

The two types of winning small caps

Abela argues there to be two types of winning small caps both locally and abroad: unique, quality companies and momentum plays.

He dubs the former "beautiful compounders"; companies with high-quality business models that are doing something unique in their market, like Seek (ASX:SEK), REA Group (ASX:REA), Fisher & Paykel Healthcare (ASX:FPH) or ResMed (ASX:RMD).

"It's like a long-term, beautiful marriage of 20-30 years where you're doing something very unique," he says.

"And these companies are up 20, 30, sometimes 100 times over a 20 year period because they have very high-quality businesses."

Momentum, on the other hand, can reward investors with returns aplenty, but can be dangerous nearing the end of the cycle, he says.

"You need to be very self-aware because it can get basically too hot and too popular, which is what I call peak momentum, peak sentiment, peak earnings, and peak valuation. And ... that's pretty much the end of the party and you need to leave before the market realises," Abela says.

Momentum, for better or worse, has been a big driver of the market today, he says. With high risk, high beta, micro-caps, concept stocks, and loss-making stocks all benefiting from the current heavy-handed monetary and fiscal stimulus environment.

"Interest rates are the lowest in hundreds of years, the attitude towards risk is erring on complacency. And you've got people using words like the 'everything bubble' and 'bubble market'," Abela says.

"And there's a lot of concern about the fact that there's a lot of momentum present in the market today. You need to be aware of that."

Why pricing power is key in a momentum-driven environment 

Given where valuations are today - the likes of healthcare and technology companies trading on 100 times PE - Abela says investors need to be wary of the sustainability of valuations. 

"Value names are up 50-100%, quality names are up 100 times, and that is pushing you in directions that you're not normally getting pushed," he says.

"And that's because you have a very significant fiscal monetary stimulus, zero interest rates almost, and everyone's very, very euphoric."

One way to ensure the sustainability and duration of a business and its valuation is a particular focus on pricing power, Abela says. 

"Pricing power comes from market structures. And market structures are the number of players in the market and also the uniqueness of what the companies within the market are solving as a problem for the world," he explains.

Three examples of companies with this feature are Aussie- listed Fisher & Paykel Healthcare and Resmed, and multi-national conglomerate Philips (AMS: PHIA), Abela says

"These three players dominate in sleep apnea and sleep medication/application in terms of software and also hardware," he says. 

"And that is a very unique and very specific solution that they're providing to the world." 

The key to these businesses' success is a "deep element of trust" between the companies and its patients and customers, Abela says. 

"There's a very significant trust element, a very significant research and development element. And because of that, it has pricing power," he says.

However, to retain this pricing power, businesses need to consistently invest in innovation and leadership, he says.

The next major trends set to sweep markets 

Abela points to advances in software (SaaS, data centres, internet of things) and new energy (decarbonisation, electric vehicles, green materials, zero emissions) as the two key themes that are currently emerging around the world. 

"For me, when the cost of capital was a little bit higher, the world, as in businesses, households, individuals and companies had to get more productive. And basically, technology is the vehicle for global, personal and corporate productivity," he explains. 

"So, for me, technology is a massive theme that I'm a big believer in and I think will be a trend for multiple decades." 

In this theme, he likes companies like Altium (ASX:ALU), which is currently trading down 20.94%, as well as NEXTDC (ASX:NXT) and Megaport (ASX:MP1), both up 20.63% and 12.11%, respectively, over the past 12 months. 

The decarbonisation or green energy theme will be equally as big, Abela says. Pointing to ASX-listed OZ Minerals (ASX:OZL) as a possible winner in the thematic.

"It's got a really strong copper-gold mix. And it's a very big deposit," he says. 

"Copper, nickel, and lithium are three big metals that are going to need to go into the electric vehicle thematic and copper is one of the main ones. So for me, that is a good business to own longer-term." 

While Copper prices have had a strong rally recently, Abela argues OZL's strong management team and large deposit put it ahead of its competitors.

The #1 thing investors need to get right going forward

Abela says valuation discipline is key over the next three to five years. After all, money is cheap, yields are low, and attitudes towards risk are "very, very complacent". 

"The next decade is not going to be a straight line," he says. 

"The markets are up 20-30% above pre-COVID levels in some parts of the world, rates are at all-time lows, fiscal and monetary stimulus has just come through similar to what post-World War II was. This will normalise in time." 

To navigate this environment, Abela says investors must keep sustainability and valuation front of mind - to generate consistent returns over the coming years.