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Local equities a chance for active managers to prove their worth

Anshula Venkataraman  |  05 Jun 2018Text size  Decrease  Increase  |  
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Stretched valuations, value traps, and positioning for defensiveness were some of the key topics discussed in the Australian Equities session at the recent Morningstar Investment Conference 2018.

Kate Howitt, portfolio manager at Fidelity International, and Vince Pezzullo, Perpetual’s deputy head of equities, discussed the high valuations with the Australian market, potential value traps, and the difficulty of defensively positioning portfolios in the current market environment. 

Howitt manages Fidelity Australian Opportunities (19483), and Pezzullo runs the flagship strategy Perpetual Wholesale Australian Share (4361).

The Australian market has seen strong growth for almost a decade, which has raised concerns over valuations.Howitt emphasised the importance of identifying long-term opportunities, even if they may look expensive on short-term metrics. 

Howitt used A2 Milk (ASX: A2M) as an example. She bought a position in the infant formula maker for Fidelity Australian Opportunities in 2015. A2 Milk was cash-generative, showed growing market share, and had strong management.

True-to-label, this was in line with Howitt’s emphasis on valuation metrics, a company’s potential growth, and the sustainability of that growth. Such strong performers come with the risk of derating, however, as we saw earlier this year. A2 was a part of this, but Howitt felt that the stock was pricing in aggressive growth targets and exited the position in December last year. 

Pezzullo went as far to say that anything above 25 price/earnings is speculating, and that investors should always think about “what can go wrong” with a stock. In fact, Pezzullo prefers to find opportunities in unloved stocks, such as Woolworths in late 2015 when the market had given up on it.

This thinking highlights the greater emphasis Perpetual puts on valuation factors compared to Howitt. The holdings-based style trail shown in Figure 1 demonstrates this - the Perpetual strategy has a value tilt compared with Fidelity’s growth-leaning portfolio.

But Howitt and Pezzullo both agreed that while there is a clustering of expensive stocks in certain sectors, there are also pockets of opportunities.

Pezzullo described the market as split between expensive stocks and cheap stocks but emphasised that the latter can often be value traps. The manager used Telstra to illustrate this.

He believes that the telco may appear cheap, but poor management and corporate strategy are letting it down. Telstra has already cut its dividend (2017) and its earnings were downgraded in the middle of last month.

Howitt added that the communications industry is very capital-intensive, and while firms like Telstra (ASX: TLS) invest in the physical infrastructure, such as fibre networks, others that have asset-light returns such as social media giant Facebook and streaming service Netflix benefit the most.

Banks were next. The managers argued that while these seem good value, their business models are challenged. Specifically, fines and sanctions from the banking royal commission have taken a toll, and regulatory uncertainty looms.

In a "best-case" scenario, however, Howitt argued that banks remain cash-generative, high-yielding stocks with limited earnings growth potential. For investors looking for exposure similar to that of utility stocks, banks may have a role to play.

Overall, the Australian market still looks expensive compared with the start of 2009, which begs the question: how do you position the portfolio for defensiveness if the market comes off? According to Howitt, this task is particularly difficult in the current low-interest-rate environment.

Given that traditional defensive businesses typically behave as bond proxies, the threat of rising rates makes these companies most vulnerable. This includes some listed property and infrastructure names, which don’t see enough cash flow growth coming through to keep up with rising rates.

The discussion highlighted that while there is no simple solution to defensively position an equity portfolio, active managers now have a chance to prove their worth and navigate the challenging market environment.

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Anshula Venkataraman is a manager research analyst with Morningstar Australia.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is an Analyst in the manager research team at Morningstar.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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