The resilience of Australia’s economy is about to be tested with strong commodity prices providing some insulation as the RBA becomes increasingly hawkish. WaveStone Capital’s Portfolio Manager Catherine Allfrey joins the show to discusses the divergent paths for resources, financials and industrials and the opportunities available to investors as the interest rate cycle normalises.

 

Transcript

Paul O’Connor:

Welcome to the Netwealth Portfolio Construction podcast series. My name is Paul O'Connor and I'm the Head of Investment Management and Research. Today we welcome Catherine Allfrey from WaveStone Capital, who is a principal and portfolio manager based in Sydney. Good morning, Catherine and thanks for joining us on today's podcast.

Catherine Allfrey:

Hi, Paul. Good to be here.

Paul O’Connor:

WaveStone is a boutique Australian equities manager based in Sydney. The business was founded in 2006 and as at 31 March 2022, WaveStone manage 4.7 billion in funds under management. WaveStone is a partner in the Fidante Partners stable of investment managers. Fidante forms long-term alliances with investment teams to support and grow specialist investment management businesses. As at 31 March 2022, Fidante had 17 boutique partnerships with a combined total of 80 billion in funds under management and have since added another manager taking the stable to 18. Fidante is part of the Challenger Limited Group.

Paul O’Connor:

Catherine Allfrey is responsible for investment research analysis, dealing and investment management across all WaveStone funds. Prior to founding WaveStone, she held various roles in financial services, most recently with Colonial First State Investments, which she joined as an investment analyst in the Australian equities GDP plus team in 1998 before becoming a portfolio manager in 2002, managing a top 20 concentrated Australian fund and a sector neutral fund. Catherine commenced her career as a credit analyst for Dai Ichi Kangyo Bank in 1990, before moving across to stock broking at SBC Warburg in 1994, as an equities analyst. She holds a bachelor of economics, majoring in Japanese and a graduate diploma in applied finance and investment.

Paul O’Connor:

WaveStone manage both long-only, and long-short Australian equity strategies, and their style is best described as having a quality bias with a growth at reasonable price or GARP investment style. WaveStone invest in quality growth companies with what it refers to as a sustainable competitive advantage or SCA. SCA aims to identify businesses that have superior corporate DNA characteristics operating with favourable industry dynamics and deliver above market earnings growth over the medium to long-term. Raaz Bhuyan and Catherine are the principles and portfolio managers who previously worked together at Colonial First State and head up an investment team of eight people.

Paul O’Connor:

The WaveStone Australian Share and Dynamic Australian Equity Funds are both available on the Netwealth Super and IDPS Investment menus. Due to the recent surge in inflation, the RBA increased the cash rate to 0.85% and many are even tipping another half a percent increase at the July meeting. Not surprisingly volatility has spiked in equity markets as a result and highlighted by the ASX 200 being down around 11% year to date, although the Australian market has fared better than the MSCI World Index that is down 20% year to date.

Paul O’Connor:

The tragic Russian invasion of Ukraine has actually assisted the Australian market through increased global demand for our soft commodities, but hard commodity prices have also held up as evidenced by the ASX material sector returning a positive 1.5% year to date and energy up a staggering 31% over the same timeframe. Markets globally are really trying to digest increased geopolitical risk, the outlook for inflation and ultimately what that impact will be on global GDP growth. I'll certainly be interested in Catherine's views on inflation and whether she believes that it is more transitory and supply chain driven or whether the recent rise is structural and long-term.

Paul O’Connor:

The bond marks have reacted fiercely with longer term bond yields rising, including the 10 Year Aussie Treasury yield rising to 4.13% and US 10 Year Treasuries at 3.24%. The resilience of Australia's economy is about to be tested with strong commodity prices providing some insulation as the RBA becomes increasingly hawkish. It'll be great to discuss and get Catherine's views on the divergent paths of resources, financials, and industrials as the interest rate cycle appears to normalise, whatever normal will look going forward. I know, Catherine, you've worked as a credit analyst early in your career before transitioning to being an equities analyst, so do you think that equips you with a better understanding of inflation and the impact that it can have on capital markets and global jet growth?

Catherine Allfrey:

In some respects, Paul, it was 1990 to 1992 so that was the last recession really Australia had in terms of the recession we had to have, according to Mr. Keating. But I also think my economics degree helps in terms of understanding cycles as well. From that perspective it's definitely interesting and has led me to cover the banking sector here in Australia as well for over 20 years. Lots of experience from that perspective.

Paul O’Connor:

I tend to find investment professionals that I deal with over time have either spent their whole life in either equities or fixed income or even asset allocation, and I just think it probably equips you with a more rounded perspective if you have worked as a credit analyst, that fear of losing the capital as well.

Catherine Allfrey:

Very important.

Paul O’Connor:

Absolutely. But maybe we'll get into the questions for today. And for starters, what are your thoughts on inflation currently, and do you believe it is more supply chain driven due to COVID's impact on the global economy, or do you think it's more structural and hence higher inflation will potentially be with us over the longer term?

Catherine Allfrey:

I definitely think it's moved from being transitory to more structural. And I think every person at the moment can experience it when they go to the supermarket, or I even went to the hairdressers on the weekend and they had a lovely little sign up saying, "From 1 July our prices are going up," didn't say how much, but they're going up. And so we've let inflation out of the bottle so to speak, the genie's out of the bottle and we haven't had this environment since the 70s and so it is very concerning. And so when you look at what central banks around the world are trying to do, clearly you've got a price stability mandate, and they're trying as quickly as possible to get that inflation down. But it's really hard in an environment when you have this geopolitical tension with the Ukraine invasion, plus you have China continuing to pursue a zero COVID policy with lockdowns, which has caused major supply disruption.

Catherine Allfrey:

And so we have these peripheral issues that are driving inflation, particularly in Western countries. And so here in Australia, it continues to persist, obviously 5%, but the last reading we had was March. And we all know in the last few months that prices have gone one way. Now we've had the wage decision as well, 5% increase as well so it's going to be really hard to get back to the Reserve Bank's target band of two to 3%. And it's clearly what companies are talking about as well. And I think it's going to be hard going to the August reporting season when they give their outlook statements, particularly around costs with both wages and cost of doing business going up.

Paul O’Connor:

It is. It's a interesting debate and probably one for another podcast, but we have heard the debate, have the RBA fallen behind the curve in terms of inflation? But you also wind the clock back a couple of years, and I think most governments and central bankers were very keen to see some sort of inflation given the huge amount of debt that's been taken on by government. Only time will tell ultimately what portion of inflation is transitory and COVID induced and what is structural. But I agree with you, I think everywhere that we go today, and I think our listeners would appreciate, that we are seeing prices rise no matter what, right across the board. With the cash rate now tipped to rich 3% by the end of the year, what do you believe will be the major impact on the Australian share market?

Catherine Allfrey:

Well, it makes it very difficult for the share market to rise during a very aggressive rate rise scenario that we are now facing in terms of what the market is pricing in for cash rates, and the Reserve Bank have made it very clear they have six meetings to go, and they're looking to get that cash rate above their neutral cash rate, which is 2.5% by that time. And given that they're only at 85 BPS at the moment, that's a very aggressive rate rising scenario. And the market is clearly pricing that in and hence we've seen correction in the Australian stock market. The question is, going forward, what's going to happen in '23 as well in terms of further rate rises and how many more will be required to get inflation down?

Paul O’Connor:

Perhaps can you provide the listeners with a short explanation of what is meant by a two-speed Australian economy and why you think this will reemerge in Australia? And it's a term that has been used in the past, it's probably many years since I last heard the two-speed economy term, but could you provide the listeners with a few comments on what it actually means?

Catherine Allfrey:

The question is we've had robust GDP growth in Australia in the last year or so, with the last print at 3.3%. Clearly on the east coast is what we mean by the east coast and the west coast, so the two-speed economy. East coast is driven quite separately to what is happening in Western Australia, and so the interest rate impact in the east coast, particularly around house prices will be quite hard with some commentators calling it for it to be down 20 or 25% and retrace what we've seen in terms of the increase over the COVID years. And then the economy here could be, in terms of the east coast, hit quite hard because we are quite dependent in terms of general financial services, agriculture, small manufacturing base, but real service based economy.

Catherine Allfrey:

Whereas in the west, of course, they've got the huge benefit of LNG and in iron ore, they have a government which is actually in surplus, not in deficit. And the economy over there has been very, very strong and there's a lot of construction going on, both in the mining industry, but just general infrastructure as well. The Western Australian economy is expected to keep powering despite the rate rises that we foresee over the next year, whereas the east coast will pull back. That's what we mean by the two-speed economy.

Paul O’Connor:

And an outcome for the Australian market, does that make mining stocks and energy minerals look more attractive now, given that outlook?

Catherine Allfrey:

More attractive for the Australian government in terms of the coffers for the royalties, et cetera, I'm not necessarily sure, because in terms of those stocks, it's really dependent on the commodity prices and they're obviously price takers so that's really dependent on what's happening in terms of global supply and demand for the individual commodity, whether it be LNG or iron ore and so each market is quite different. Of course, we've seen very strong commodity prices over the last 12 months, and so the question now is whether or not they ill pull back?

Paul O’Connor:

What are the most important characteristics you look for in an investee company? And perhaps we can delve more into your investment process and discuss how you actually screen stocks. And maybe if you can also explain what you mean by a company having a sustainable competitive advantage that I mentioned in the introduction?

Catherine Allfrey:

Fund managers screen stocks, and we look for, obviously we have a quality filter up front and you can either do that in a quantitative way or a qualitative way. And in our case, we do it in a qualitative way. We look at 15 different factors to screen companies, and we grade those companies in terms of their quality score, whether it be low, medium, or high, and some of them they're so low we reject, or maybe we look at them in our short basket. But for those 15 factors, they actually cover the company itself, which is the superior corporate DNA, and there's seven characteristics we look at there. We then look at what the industry in which that company operates in, and we use Porter analysis, which is eight different factors, and we decide whether or not that industry is facing a headwind or a tailwind.

Catherine Allfrey:

And our view is particularly when we're buying stocks, if we have a company that has superior corporate DNA and has industry tailwinds behind it, it's clearly going to be proved to have better earnings growth, which will end up being a better investment. That's what we do upfront in terms of a quality screen.

Catherine Allfrey:

And then what we do is we model the company and we look at the PNL, the cash flow and the balance sheet and we forecast it out for five years, we come up with our valuation of the company, but we also look at things like the quality of the cash flow, and then we look at the balance sheet in terms of making sure of course that there's not too much gearing, and obviously it's got high interest cover and can withstand cycles. And then, so once we've got the quality score and the valuation, we then obviously construct the portfolio. Of course the higher the quality and the more up side there is in the company, the higher the weight will be in the portfolio.

Paul O’Connor:

And I'm assuming then the portfolio is constructed with some sort of risk overlay and maximum exposure to stocks and sectors, and just to ensure that the portfolio remains diversified?

Catherine Allfrey:

Correct, we have diversification, but we have a maximum of 10% in any one stock, but also we then put a liquidity buffer over that in terms of managing risks. For an X 100 small-cap stock, we would only have up to 2.5% of the fund in a small-cap stock. Because at the end of the day, small-caps can be lobster pots as we've even found out in the last 12 months, and you've got to be very careful in terms of liquidity around those companies.

Paul O’Connor:

Also just interesting as you are making some comments there around your screening process, effectively being a qualitative process where I think most of the managers I've come across over many years, it starts with a quantitative screening of the numbers and et cetera. It's interesting there that you're forming that view on the quality of the business first to meet your standards of whether you'll undertake the financial analysis then. I think that really stood out in the way it differentiates WaveStone and your investment process.

Catherine Allfrey:

Yes, exactly.

Paul O’Connor:

Can you provide your view on the banking sector? And we've touched on resources and the next major area of our economy is the financial services and banks so dominant in financial services. I'll be interested your view on the sector and particularly given that the amount of potential structural change and even headwinds that might be coming into that sector with the rise of the BNPL businesses and the top four Australian banks really stripping back, they're divesting of wealth management, life companies, et cetera, and going back to a more simple banking model. And also that looming rise of digital assets, although I know with the volatility and what Bitcoin has been down over the last months, there may not quite be the same appetite at this stage for digital assets.

Paul O’Connor:

Just be interested in your views more broadly on the banking sector.

Catherine Allfrey:

In terms of the Australian banking sector, we're at a interesting point in the cycle in that what happens with banks is as the cycle is strong and credit growth's strong, which it has been in the last couple of years and they survived the COVID years because there was so much government payments, too small business in terms of Job Keeper, but also in terms of the Reserve Bank cutting interest rates to all time lows, and house prices through the roof. The banks actually survived very, very well through that period and they've ended up with surplus provisions, surplus capital so they could buy back their stocks, so everything was pretty rosy.

Catherine Allfrey:

I think right now, what happens is when you move from a positive environment, people are quite happy to bid up the stocks and the P’s get re-rated. There is a view of course, that they can recover some of their margins as interest rate rises. That has all been quite beneficial, but the interesting thing of course now is because we're on such an aggressive rate rise picture for the next year there is concern that that could tip us into recession. And so as soon as you mention the R word, when it comes to banking, you see a dramatic de-rate. And so what we've seen is about a 10% fall across the board in the sector, just talking the banks. The small regional banks have fallen further, and then anything that's newly listed IPOs, whether it be Latitude or Judo or any of those new names, tech names that have been totally trashed. By now pay later has been absolutely smashed, so the sector has really pulled back over the last few months.

Catherine Allfrey:

And what happens of course, is investors are at this point where they're saying, are we going to see another bad debt cycle? Is the economy going to slow? In which case we go from looking at the banks at a PE level to looking at them from a price-to-book level, and investors quickly change their tune because they're then very concerned about how much provisioning is on the balance sheet and we're back in the sand, the bad debt toll that will come if there is a recession in Australia. They're very well provided for, they have a lot of capital because their APRA under the guise of [inaudible 00:18:46] has actually increased the capital weightings of all the banks, so they're actually very well provided for and very well capitalised. There's no concern around that.

Catherine Allfrey:

And of course there's always the Australian equity market to fund them in terms of capital raisings, as we saw through the COVID period as well. We're actually at a really interesting turning point, I think in terms of what's happened with the banks is something that we are watching really, really carefully as to see whether or not the sector does fall further on the back of recession risk.

Paul O’Connor:

It sounds to me there, Catherine, that it's very much, as you say, going to be an outcome of the broader Australian and probably global economy, than the outlook for the banks there. How are your portfolios then exposed to the banking sector at the moment in the top four?

Catherine Allfrey:

We are underweight overall in terms of the sector, we do own three of the four banks, CBA, NAB and ANZ. We don't own any of the regionals, we don't own any the by now payload sector. We've had a very negative view on that sector in our long-short portfolio, we've actually shorted the by now pay later names and done very well out of that in the last 12 months. And then we don't own any of those new listings that have occurred in the last 12 months either. You can imagine we're reasonably underweight, the financials.

Paul O’Connor:

Sounds like more of a conservative approach to the exposure, just holding an underweight to three of the four majors, that certainly makes sense given your broader views about the risks of recession. Which sectors or stocks should investors consider rotating into, given the current market backdrop, the potential for recession? Have you got any thoughts or comments on sectors or stocks, and given your earlier comments about the potential risks, it'd be something that would be a more conservative exposure?

Catherine Allfrey:

I think really the last six months you've seen it where initially it started with NASDAQ and Bitcoin that you mentioned in terms of the high risk assets got completely sold off. And then of course it went into industrials and anything that was high PE with the increase in discount rates in line with the view on rising interest rates, we've seen a real de-rating in the industrial sector. And then of course, more recently we've seen both the financials as well as now the resources sector sell off on the risk of global recession. If you put them into those four buckets, it's hard when your long portfolios you've got to be 90% invested. The best thing you can do in this environment is do your bottom up analysis, stick to your quality, be well diversified.

Catherine Allfrey:

We have an overweight to healthcare because during a recessionary environment, those stocks continue to perform well on previous cycles. And usually their earnings are quite resilient because of the fact that we've got this demographic tailwind and you've got those earnings holding up nicely despite recessionary conditions. And so we also have a reasonable position in Transurban, which again has performed reasonably well recently because, again, people are more concerned about recession risk. And then you've got to go for things like Woolworths or things that are more staple rather than any cyclical type stocks and then have a good weighting of cash so that you can take advantage of sell off opportunities where you think there is long-term value. Make sure you look out three to five years, which is what we do, and make sure the balance sheet's in really good stead. And if you can find some nice dividend yielding stocks too, to add to your portfolio, that is good as well, but be patient, be patient, there's going to be plenty of opportunities, I think, over the next few months to get set.

Paul O’Connor:

Be patient and just have a more broadly diversified and probably slightly conservative approach to the portfolio today. And certainly your comments around healthcare and other sectors, trying to think, obviously supermarkets as well, that tend to be less aligned or their earnings are less aligned to the economic cycle. Certainly makes sense to me. Have you got a favourite amongst the supermarkets, the big two bad boys there, Kohl's or...

Catherine Allfrey:

Will I prefer Woolworths and that's predominantly because they've got now about a 70% share in online. They've done exceptionally well on the online side and a very strong approach to capital allocation, and so that's why we prefer Woolworths.

Paul O’Connor:

Now to a sector that has been beaten up somewhat of late, the tech sector. What are your thoughts on the sector now? And it's still not a large part of the Australian economy, certainly not compared to the US, but what parts of the sector do you like, what parts are you cautious on, and is now the time to jump in or do you think there'll be a further de-rating of tech stocks?

Catherine Allfrey:

Okay. When I talk the technology sector, I'm talking the Australian technology sector, as opposed to the NASDAQ and the US. And our market is down about 40%, and it did get totally ridiculous in terms of the multiples that these stocks are trading at and some of the focus on TAMs and revenue multiples and unprofitable tech has being absolutely smashed. The question is, whether some of those businesses survive and they've got to go into cash conservatory mode. It was part those, because we don't like to invest in anything that's unprofitable.

Catherine Allfrey:

And then that leaves really the big four that you talked about in terms of WiseTech and Xero, Afterpay, Upen. The only one that we've maintained an investment in which we bought at the bottom of the COVID cycle was Xero. And we've written that up, we sold some and then it's fallen all the way back down again. Over a three to five year view, we still think that that business can continue to grow both its customers, its different geographic jurisdictions, it's just going into Canada now. It also is a very under priced product, but well valued by its customers so we still think that it's got pricing power and ability to increase its prices. We still like Xero, that's one that we do like. The rest of the sector we're passing at the moment.

Paul O’Connor:

Maybe to an area of more opportunity for WaveStone in specifically your long-short or your dynamic Australian equity strategy. How do you identify stocks that represent a good shorting opportunity? And I guess you're seeing more opportunities in the face of heightened volatility that's come into markets over recent months?

Catherine Allfrey:

I think particularly the last 12 months have been very, very good for shorting. Our fund in terms of the short siders book has really delivered compared to the long book's been okay, but nothing in comparison to the short book. First up, it was more the unprofitable technology names that we shorted. The best short we had over that time was Zip Money, which we shorted at $12 and we did cover it a dollar, but it's fallen obviously down towards 50 cents now. That stock, in terms of buy now pay later sector, clearly under pressure, and I think people forgot how much of a COVID winner it was and now it's got that zero bad debt cycle, so that will be interesting for that company.

Catherine Allfrey:

Then in terms of the consumer discretionary names, because as interest rates rise, of course households are going to have less money to spend. And so therefore you'll see discretionary items which did particularly well through the COVID years with all the government handouts and low interest rates will come under a lot of pressure. And so we think that the earnings numbers are just too high in the market for consumer discretionary names. There is a number of companies there that we shorted.

Catherine Allfrey:

Then there's some specific scenarios like a NanoSonics that we've been short for some time and that's formed well. Overall it's done exceptionally well for the dynamic fund over the last 12 months.

Paul O’Connor:

In terms of identifying the opportunities, are they all stock specific or does it start with a view that a sector might be on such a high multiple, and doesn't have a lot of room for error, and then you start to look through that sector into the different business models?

Catherine Allfrey:

Well, the first thing you do is look at the balance sheet, because if a company's over geared or high gearing and then they hit an earnings vacuum, then that business is going to clearly be in trouble. A lot of companies though don't have that issue anymore so it'll be interesting as interest rates rise to see if that does cause some, but because of rates being so low and most companies have been low over the year, there hasn't been that opportunity.

Catherine Allfrey:

Then you have to look at things like the change in competitive nature of the market in which a company operates in. But the biggest thing that you do need is an earnings miss on shorting, evaluation. It's not that it doesn't matter, if it's a really high PE and an earnings miss you're going to go even a bigger fall, but we've seen short companies that have had low multiples and then their earnings have fallen away 20 or 30% and you can still make good money out of short that way.

Catherine Allfrey:

And so it's really trying to look at balance sheets, it's looking at the quality of the company's earnings, when the earnings trigger is going to happen. And what we've seen of course is a lot of companies benefited from those government payments, COVID beneficiaries as we call them. And then that's all normalising and the problem is the stock market or the analysts out there haven't forecast the normalisation processes properly and so that's providing the earnings missed opportunity. And so therefore we have seen quite a few companies come out and have to warn analysts about their earnings or their outlook and so the share prices have [inaudible 00:27:58] dramatically.

Paul O’Connor:

How about older energy style companies? Are they an area for shorting or are they a gradual decline?

Catherine Allfrey:

Yes. A bit like a Kodak or a melting ice cube, you can have industries over time continue to degenerate. That sector has actually, obviously, attracted some takeover type activity as well so you have to be really wary when you're shorting a takeover bid coming through. And structurally too, that industry now has got government intervention in it as well so you have to be very careful around some sort of government intervention when you're shorting as well.

Paul O’Connor:

I can imagine, and particularly with the rise of energy security becoming more forefront of mind, given the Russian invasion of Ukraine in the opening there, that you can never be sure how governments will react But maybe just perhaps a final comment on AGL and the recent speaking of Cannon-Brookes and the activism there to change the direction of the company.

Catherine Allfrey:

Look, I really think it's interesting covering the banking sector and then listening to politicians as well, and then I'm married to a greeny and so we can have very interesting debates. But I think it's really important that we go through an energy transition phase that is quite controlled because otherwise we're going to face a blackout type scenario. And so I think we've got to encourage the transition as fast as possible, but we have to do it as orderly as possible. And so AGLs not a company that we own on the long-side or the short-side at the moment, but it's obviously going through a very difficult time with its coal plants down and then clearly tried a demerger, which failed. And now Mr. Cannon-Brookes is obviously active on the register to hasten the change, so good luck to him. And it's for the long-term interest of the country that this energy transition happens as orderly as possible.

Paul O’Connor:

And I think that I absolutely fully agree with your comments there about the transition to clean energy, that it must be done in an orderly manner, it must be done ensuring that there are no significant interruptions to energy supply. And I think at times that has been lost in the debate and the push to cleaner energy. It's a challenge that we've all just got to keep our heads down and move forward, I think, over the next probably 20 to 30 years, at least.

Paul O’Connor:

On that note, thank you very much for joining us Catherine, for the Portfolio Construction podcast. Been interesting just getting your thoughts, your insights onto the state of the economy at the moment. I think it's certainly prudent words that you've made about just some level of conservatism over where we're at in the economic cycle with still some significant potential risks on the horizon there. It certainly would not pay to stick your neck out as an equity investor at the moment just to ensure you've got a good base anyway in your portfolio. And certainly interesting too, those comments that you've made around shorting. And I guess it also highlights the value that pending the investors' objectives and needs in their overall portfolio to consider including a manager that can include some level of shorting in their equity portfolio there. Thanks for joining us there, Catherine.

Catherine Allfrey:

Thanks very much, Paul, it's been really interesting.

Paul O’Connor:

To the listener, thank you very much for joining us again on the Netwealth Portfolio Construction podcast. I hope you've enjoyed the discussion we've had today with Catherine Allfrey from WaveStone Capital. And I look forward to you joining us on the next instalment of the podcast series.