Trying to invest based on fundamentals has been termed the “widow maker” and it has even been suggested that we should give up trying to identify stocks which we believe are fundamentally good value because that is considered to be too old fashioned. We completely disagree with this view and despite the criticism from some quarters and scoreboard pressure (underperformance) we continue to stay true to our style.
While it goes without saying that we would love to buy the highest growth company with the best management team exposed to a squillion dollar Total Addressable Market (TAM) if we were able to do so at the right valuation, we tend to gravitate to areas where we believe there is a fundamentally attractive risk/return investment opportunity. Our analysts are happy to sift through sectors and companies, which may not be fashionable, in order to identify good opportunities even if there is no immediate catalyst.
Central to our investment philosophy is finding good companies at wonderful prices instead of wonderful companies at any price. There is no doubt that this process has resulted in us missing some good opportunities, which in hindsight were good value when we dismissed them. However, we believe that this discipline will hold us in good stead over the long term. November was the first sign in a long time that the market has started to consider value as again being a factor rather than pure momentum.
When it comes to value investing, the best opportunities generally come from sectors which are either being ignored or are not popular. We like finding situations where the share price factors in a lot of the bad news and does not consider any positive surprises (even if these positive surprises are unlikely). Generally, there is no obvious positive catalyst which can be very frustrating for non-value investors but, conversely, if there were an obvious positive catalyst, there would unlikely be an opportunity.
What we are generally taking advantage of is several flaws in human psychology. The first flaw is wanting to look smart. When asked for a stock tip in early October, most people would talk glowingly about the latest buy now, pay later IPO which had gone up 2000% as being their best idea. It would not be fashionable to talk about the fact that National Australia Bank or Incitec Pivot looked great value at the time. The second flaw is confirmation bias. Buying eCommerce companies in the middle of the pandemic and shorting shopping malls was a brilliant trade. However, our view was that at some point - either through increased competition, ridiculous valuation or a reversion to more normal conditions - this trade would no longer work. Early on, despite some obvious improving trends in some of the shopping malls and decelerating growth in eCommerce, these trends were brushed over because the share prices didn’t react – until they did.
Winners and losers
As we wrote in a September market update: “We believe that in the event the economy responds positively to the fiscal stimulus and vaccine that we could see a massive rotation out of these growth at any price stocks (GAAP) into some more beaten up cyclicals which from a mid-cycle perspective are looking cheap. While we are not predicting the macroeconomic outcome, the relative risk return on banks, travel stocks like Qantas or Flight Centre, energy stocks or building materials looks pretty good at this point in time. We feel the risk/return on long-duration and COVID-19 beneficiary companies looks extremely poor.”
Both the long and short sides of the portfolio reflected this view leading into November. Outside of our core positions, we had established new long positions in economically sensitive cyclicals with a strong balance sheet, competitive position and trading at material discounts to our mid-cycle valuations. We spent considerable time analysing these names to ensure we were getting the most attractive risk-adjusted exposure.
On the short book, we had spent a lot of time analysing some of the “COVID winners” to isolate opportunities where we believed the earnings benefit from the pandemic and associated business disruption was unsustainable and where we had a fundamental view that the company had no real competitive advantage. Some of the valuations of these names were, and remain, extreme which provided the potential for outsized returns.
Clearly this scenario then played out in November with vaccine developments forcing the market to focus on what companies' earnings will be in a post-vaccine world. There was a sharp rotation out of COVID winners towards cyclical names and the increased optimism around an economic recovery saw bond yields rise and a rotation towards value. The fund benefitted strongly from this with outperformance on both the long and short book.
Find out more about the performance, strategy and holdings of the Perpetual SHARE-PLUS Long Short Fund.