Looking for growth and income among industrials

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Lex Hall: Interest rates are set to remain low. What does that mean for investors? What does that mean for people looking to generate income? And what does it mean for the outlook in 2021? With me to discuss that and a few other things today is Max Cappetta. He's the CEO and Lead Portfolio Manager at Redpoint, where he oversees the Redpoint Industrials SMA strategy.

Max, welcome to Morningstar.

Max Cappetta: Thanks, Lex. Great to be here.

Hall: Now, let's talk about the strategy, the SMA Industrial strategy. It's diversified portfolio, benchmarked to the S&P/ASX 100 Industrials Accumulation Index. It finished up pretty well last year. Can you tell us how the strategy works briefly and what it aims to deliver for people?

Cappetta: Absolutely, Lex. So, when we set up this strategy, which is coming up to about six years ago, we specifically looked at the SMA structure, which is a structure whereby individual investors actually have beneficial ownership of the underlying shares in their own name, which gives them their own tax position and gives them a very transparent holding to a group of what we believe are good quality, larger cap industrial stocks. We try and keep the portfolio well diversified to try and capture the overall growth and in particular, the income characteristics of larger cap Australian industrial shares.

Hall: Now, it holds 40 stocks. We're talking about the big four, CSL, Wesfarmers, Macquarie, Woolworths, Telstra—some household names there. You have said in a previous update that you expect monetary policy to remain accommodative. Where do you expect to see the dividends? Or where can investors expect to see dividends this year?

Cappetta: So, what we've seen through 2020 is, certainly even a larger cut in dividend payments that we saw through the GFC in 2008 to 2009. Now, what's happened back then a dozen years ago that cutting dividends was concentrated in the banks. And certainly, we've seen the same cuts in the banks, but we've seen cuts across the broader spectrum of almost all paying stocks. There are a few exceptions and we might have a chat about those later on. So, what we see as an opportunity today is that while prices have actually risen in the last nine months quite substantially to pretty much end up 2020 with about the same capital you started a year ago, there are now, I think, a range of opportunities back towards companies that actually do have quite strong cash flow and have the ability to continue to grow with this supportive monetary and fiscal stimulus that's being put out across the world, but in particular here in Australia, to potentially give a positive surprise. That leads us back to seeing some opportunities within the banks as well as through to some of the cyclicals in the industrial space. And also, beyond that, we're seeing obviously great dividends being paid and consistent dividends being paid by the consumer staple stocks and also by some consumer discretionary stocks as well.

Hall: Okay, okay. Now, let's talk about your outlook and we'll do that by looking at the model portfolio's exposure. You've got a roughly 36 per cent exposure to banks. What's your outlook on banks for 2021? I know they sort of relaxed the caps on dividends, that's surely good for investors.

Cappetta: Yeah, we believe so. I mean, it's going to obviously get back to earnings and cash flow. One of the things that we saw as a negative for the banks actually over the last few years was a number of negative metrics on the ESG front. So, in terms of client loyalty, shareholder loyalty, innovation, we saw some negatives there that we thought that the banks needed to address. And I think at the moment there's probably a degree of negative sentiment towards the banks and their income generating potential, which I think could actually lead to a positive surprise over the course of 2021, assuming everything goes positively for COVID relaxation in Australia and across the world that we might see a positive surprise there in dividend payments and profitability and expectations for the banks going forward.

Hall: Now, travel—we can't talk about the year ahead without talking about travel. You were telling me that Flight Centre did very well, as did Qantas. But we ran a piece last week saying about why airlines don't have economic moats, i.e., they don't have strong economic advantages. What do you think about travel, about the sector, about airlines, about companies like Flight Centre?

Cappetta: Yeah, a great question. So, one of the key things that we look at when we're building our portfolio is both the financial quality of a company, so the strength of their cash flows, their financial position, as well as their sustainability metrics. When we look at travel, particularly in airlines, we've always seen quite strong and consistent cash flow, particularly over the last few years from Qantas, and I think the way that management has positioned that business, we knew that COVID was always going to be a challenging environment for a business like Qantas, but within that business there are a range of other businesses. There's two domestic businesses, a standard airline as well as the leisure airline, there's an international business, and also there's a freight business. But more importantly, they just have a very strong brand and that then goes beyond travel into their frequent flyer business as well. And that along with Sydney Airport was one of the reasons why we've actually maintained our positions in both of those stocks whereas we actually exited our position in Flight Centre once we saw the bounce back through April and May of 2020.

Hall: And just a note on tech Max. Afterpay, Xero—I noticed you favour Xero more.

Cappetta: Yeah, look, we do. I must admit it's been one of the challenging positions in the portfolio. We actually increased our position in Xero in March and it's always a little bit humbling when you increase a position, it's up over 100 per cent and yet it is an underperformer in its sector by a factor of 10. So, while we continue to like Xero's position, again from a quality of cashflow perspective, we actually see that they have quite a market-leading product and people don't just switch over to Xero and then switch off to something else. Whereas we still have question marks over Afterpay, and in our view, while we are starting to see some positives in terms of them being able to deliver earnings profitability from their growth, there is just so much priced in at the moment that in many ways they probably need a decade of calm waters to be able to build the business to justify the current valuation. We know there's a large total addressable market, the T-A-M, the TAM. I sometimes wonder whether there's a bit of TIM, a little bit of total investment madness, that's maybe put that price up at a point where we would find it unattractive and still at this stage don't have a position.

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This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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