When reflecting on performance it is important that fund managers are up front about what was poor or inspired decision making and what was good or bad luck. For Perpetual Ethical SRI Fund portfolio manager Nathan Hughes such dispassionate analysis is part of a continuous improvement process.
Fund managers that overestimate their own abilities are eventually found out by markets. Sometimes this is individual overconfidence but often it is simply the case that investment theses may take time to play out. And patience is a virtue in a market dominated by real-time data points that can prove to be a tremendous asset to investors. Regularly testing ourselves on whether our investment theses still hold true is a crucial part of our process at Perpetual. Such dispassionate analysis is part of continuous improvement. In this spirit, some reflections on the stocks that helped and hurt the portfolio over FY22.
Media and entertainment company Here, There & Everywhere (HT1) was the stock held by the Fund that hurt the most over the fiscal year. HT1 is one of the smaller capitalisation stocks in the portfolio, and relatively illiquid due to the presence of several large shareholders, including ourselves. Where we perceive value, we are not averse to selectively holding positions that sit outside the market indices, subject of course to sufficient liquidity at a portfolio level. This is monitored monthly.
Forced index selling can provide terrific opportunities for the patient investor, given that the computers pushing the sell button are completely valuation agnostic. So too market participants with a short-term trading focus that are seeking to pre-position for index changes. Importantly, these short-term gyrations and the reduced liquidity after index removal do nothing to alter the fundamental value of a company.
Relative illiquidity can, however, make stocks particularly vulnerable in risk off environments, and this is exactly what happened over the quarter. As the market began to fret over the prospect of a recession, media stocks were among those most impacted. Earnings are likely to slow but our view is that valuation remains incredibly attractive and even more so post recent falls, with the company set to throw off considerable cash flow and dividends. We remain believers in the company but with the benefit of perfect hindsight, I oversized the position given the relative quality of the company.
Some stocks performed well despite the tough backdrop. Global packaging manufacturer, Orora (ORA), was the largest winner for the year, with performance playing out in line with our original thesis. The Australian business remained resilient, and the US business demonstrated improved performance. Rectification of the ERP system issues and greater focus on customer cost to serve meant margins in the US improved significantly. However, while management have done a very good job remediating the US business, there was also some good fortune involved as the turnaround was turbocharged by a very hot US economy. We have used share price strength in recent months to reduce our position significantly as valuation upside diminished. The stock was up 14.5% over the course of the year, or a circa 20% outperformance against the broader market.
Genworth (GMA) was another key performer for the year even after a sharp fall in June, returning 16%. With rising rates and falling house prices, the market has moved into a ‘shoot first, ask questions later’ mood. There can be no denying that falling house prices are negative for future claims, but with meaningful excess capital over and above the target range (which is itself well above regulatory minimums) and reserving that has been persistently strengthened over many years despite a shrinking book, our view is the negativity toward the company is misplaced. We expect the company to continue to return surplus capital and a further buyback at these levels would be incredibly value accretive. Surplus capital is still conservatively one third of the current market capitalisation.
I am often asked about typical or targeted turnover levels for the fund. Turnover is simply the net result of many different variables – market volatility, availability of new opportunities, valuation of existing holdings, or changes in investment theses. We don’t trade for trading’s sake, but turnover can arise merely by sticking to a disciplined valuation process, particularly in choppy markets.
Notwithstanding the addition of some cyclically exposed smaller stocks, the largest positions in the portfolio are concentrated in larger capitalisation stocks and have remained relatively steady. These include Insurance Australia Group (IAG), National Australia Bank (NAB), Brambles (BXB), Medibank (MPL) and Wesfarmers (WES). We think fiscal year 2023 can be a better year for IAG. The headwinds are well understood by the market. These include rising reinsurance costs on aggregate covers, claims cost inflation and negative mark to markets on the investment portfolio because of rising bond yields and credit spreads.
On the positive side of the ledger, the relatively short duration nature of the investment book means rising investment yields can be captured quickly, feeding through to profitability. We also anticipate some clarity on Business Interruption, for which the company has provided, and the company has commenced renewal of existing quota share arrangements that were of concern to the market. Pricing actions are being taken that will feed through to gross written premium in FY23 that, in our view, have the potential to surprise to the upside.
Finally, with slowdown fears coming to a head, markets have begun to gravitate towards earnings certainty and defensive qualities and strangely, cash levels appear to have increased across the market. We have taken the opposite approach, putting some of our cash to work and not seeking safety, where many valuations in my mind remain incompatible with where risk-free interest rates have now moved to. I feel optimistic about how the portfolio is positioned, and confident that our investment discipline will hold us in relatively good stead if some of the bearish fears held by the market are indeed realised.