Rudi's View | Nov 06 2020
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In early August 2020, FNArena Editor Rudi Filapek-Vandyck was interviewed by LiveWire Markets co-founder James Marley.
Below is the written transcription of that verbal exchange, corrected for typical conversational aberrations and grammatical inaccuracies.
The interview took place ahead of the August 2020 reporting season, but with Rudi explaining his five-year portfolio strategy, the core basics of his analysis, and what to look for during reporting season, FNArena believes the interview has a much longer shelf-life.
Rudi, great to have you back on and thanks for joining us.
James, it's a pleasure to be here.
You recently published an article on Livewire, titled, “My Seven Secrets to Investment Success”. And it was a distillation of a number of lessons that you picked up from running your own, the 'All-Weather Portfolio', as you call it, over the past five and a half years and we might touch on some of the performance of that in a moment.
But the first thing that stood out to me, was that quality beats valuation. Could you talk me through that view that you hold that it really is quality that outperforms valuation?
James, I can illustrate this with a very simple example. We all could have bought CSL ((CSL)) shares in the IPO in 1994, and that would have cost us $3,000.
If you held those shares until earlier this year, late last year, we would have been millionaires. So, $3,000 becomes $1 million. If you are that type of investor that keeps shares for a long time, just ask yourself how much difference would it have made that in year one or year three, or even in year five of when you are holding those shares, that your shares were temporarily overvalued? And that's essentially the long and the short of my analysis.
It basically comes down to what type of investor you are. If you are the type of investor that likes to hold shares for a really long time, then you have to realise that overvaluation is a temporary thing. As long as you have the type of company that increases in value over time and continues to find growth.
I think that's the simplest example that I can put forward. On my observation, and I am going to insult a few people now and surprise the others, my observation is if you buy cheap stocks, on many occasions these stocks only bounce temporarily.
The way I compare them is: last weekend I went to the supermarket and I saw strawberries very, very cheaply priced. I've now learned from the share market that if something is priced cheaply, there's something wrong with it.
So I turned over all the punnets of strawberries and almost every single one of them had at least one strawberry inside that had a little bit of mould to it. That instantaneously made me realise: that's why they're cheap!
In the share market, you have to ask the same question. Do you want to buy cheap strawberries that you have to eat immediately and you make sure you fish out the one with the mould? If you want to stack up your pantry with food that you don't have to eat immediately, you're better off buying good stuff, great stuff.
For quality, you pay.
It doesn't mean that you never pay attention to valuation, of course, but it does mean that when you realise that you pay up for quality, that the PE ratio is not the only measurement you pay attention to.
People know I'm a big fan of CSL and I'm a long-term investor in CSL. What stood out for me is that every time investors say, "You can't buy it, it's too expensive." And every year it goes up. So obviously, there's something wrong with that narrative.
I think the problem with that narrative is that a reliable quality performer has a price attached to it. And it's not a low PE on a single digit number.
Rudi, I think there would be not many people that could hold a good argument against your CSL example. It's proven itself over a really long period of time.
I get the impression that the real frustration comes around companies with lower earnings and less proven business models. The buy now pay later is an obvious market segment to highlight, but there are others.
I'm keen to understand your distinction between a company like CSL and a company like Afterpay ((APT)), where the track records are far different and earnings profiles are not comparable.
It may be good to explain here, I'm not your typical growth investor. I'm a quality investor. But as the market evolves and, as it has transpired, because I focus on quality, I understand growth better, because I'm not looking for cheaply priced assets.
In 2015, I wrote a book titled “Change”. I thought at the time, I better be quick in getting this out, because the financial world looks forward and they are going to be all on the case in no time.
To my surprise, even today, there are hordes of investors that are paying almost no intention to the changes that are taking place in society.
The fact is when I wrote his book, five years ago, I predicted we would go through tremendous changes in society, and that those changes will have an impact on economies and on the share market.
I underestimated the changes that were going to happen. Where a lot of typical value investors have gone wrong is, they have completely ignored those tectonic changes that are taking place.
At the very least, societies are going through a transformation that is probably the biggest in hundreds of years; and even if that's not the case, it's definitely going to be the most transformative period in our lifetime.
What I discovered while doing my research is that I had to create three or four baskets of stocks in the share market.
My first basket was made up of high-quality stocks that are immune or not affected by those changes that are taking place.
Another basket are stocks that are benefiting from those changes that are taking place.
In the first basket you get the likes of CSL. In your second basket, you get the likes of Afterpay.
The third basket are reliable, solid, sustainable dividend payers. For example, you put a Waypoint REIT ((WPR)) in there, previously known as Viva Energy REIT.
The fourth basket is the one that I've been avoiding for the past decade. And those are the laggards that have to transform, that are facing headwinds and will find it increasingly difficult to maintain their profit level, their margins, and to create value for shareholders.
Those four baskets have served me incredibly well. This is what I've been trying to communicate to investors.
Low-interest rates have created an even larger gap between these baskets. That is because low-rates have benefited the quality stocks and the beneficiaries of the changes, and not stocks in basket number four.
In addition, this year we got a pandemic, which throws some complications in the mix.
In general terms, if investors had viewed the share market through those four baskets and had acted accordingly in their portfolios, they would have done much better than most have done so far.
I'm basing this from anecdotal evidence and from the rankings I see and the updates I receive from professional investors.
Rudi, let's bring it into reporting season. On that note, a lot of people are talking about this reporting season, being a bit of a judgement day and the opportunity to recalibrate expectations.
Is this the inflexion point where bucket four starts to even, or make up some ground on buckets, one, two, and three and settle some of the score or are those frustrated value investors going to feel more pain?
I think they're going to be frustrated for much longer. The ruling narrative over the past two, three years from that part of the investment community was "the share market is crazy, investors are paying too much for success stories. You wait until the next recession arrives and we will have our day under the sun."
I have consistently been saying, "No, no, no, you wait until we have a recession and you will still not have your day under the sun."
Of course, what happens in a recession, and what we've seen with the pandemic this year, is that the weakest companies get carted out first. That's exactly what happened in the sell off this year.
The cheap stocks simply became a lot cheaper and a lot of the so-called expensive stocks deflated a little bit, but they were back up before you knew it.
And that's what you get in a time when you see tectonic changes taking place. Investors want to be part of the future and they don't want to be part of the laggards solely because they are cheap.
When we get out of this situation, and the exact “when” remains a big question mark, investors will face a situation like 2009, like the second half of 2012, or like the first half of 2019, when the laggard stocks, the value stocks in the market, will have their moment under the sun. But that's only half of the story.
The other half is these stocks bounce because they've fallen more in the first place. This is part of the economic recovery story, which always benefits the weaker ones and the laggards, but it's not a structural recovery story.
I think there's too much emphasis on what the Federal Reserve does on low-interest rates and on what governments do with stimulus.
We’re basically in a low growth environment and the weaker companies are finding it difficult to have consistency and reliability in their profit growth. And they're being punished for it, and they're being ignored for it.
It shouldn't be a surprise. Just like you pay up for a premium car or for a premium handbag or a premium jacket, you do pay up for premium companies in the share market.
Well, let's run through a couple of the observations that I've picked up from your recent reports about the upcoming reporting season.
You've said guidance has never been more important, particularly around earnings and dividends. Can you go into some detail on that point? And where are some of the areas that you're expecting certainty?
On a general level, August 2019, a year ago, was the worst profit season we had in Australia post-GFC.
I was amazed after last year that some commentators would denominate it as “not too bad”. I thought that's fairly subjective, because from FNArena’s perspective this was the worst season we've seen.
February was very difficult to judge, because we basically had the pandemic raging through markets already, but it wasn't great. We will now see a reporting season that is a lot worse than August last year. We will probably set some (negative) records.
What investors should be prepared for is the cut in dividends will be at least double the loss in profits. That is an indication of the fact that corporate Australia was not in great shape coming into this recession.
Don't forget, corporate Australia started cutting dividends already last year. Payout ratios moving into this pandemic were way too high, including for the banks; they will come down.
So, you will get this double whammy where both the payout ratios will come down and the cash-flows will be down; the impact will be severe.
Contrary to the GFC, this will not be finished in 12 months. We will have companies who cut this year, then some will have to cut next year and then maybe also the following year. Then in the year after, we will have different companies cutting their dividends.
We are creating a context where reliability and sustainability are very precious words. They are rare, so those companies that can provide us with certainty and reliability will be rewarded for it.
To my surprise, the way the situation's panning out, one of the companies that has been quite a mixed performer is Telstra ((TLS)).
Expectations are now growing that Telstra might actually crown themselves as one of the standouts this season, for that particular reason.
They might be able to guarantee shareholders that they will have a certain payout and they won't waiver from it. Because of the current situation it might actually prove sustainable. That might, for once, create a different benchmark for Telstra.
If I could have a quick look at the USA; between one fifth or one-fourth of all the companies in the USA have given guidance, which is well below what usually happens.
About a third of those guidances has been negative. We've already seen since February those companies that are able and willing to provide the market with concrete guidance will be rewarded for it. You see that in better share price performances and investors will be on the lookout for it this year.
It all makes sense; it's about reducing your risk. The Australian share market has some standout dividend payers. Apart from Waypoint, mentioned earlier, you also have the likes of APA Group ((APA)) and APN Convenience Retail REIT ((AQR)), but also industrials like Aurizon Holdings ((AZJ)) and Amcor ((AMC)).
These are all dividends payers that are expected to continue increasing their dividend payout for not just this year, but through the years ahead.
You've also got companies like a CSL, ResMed ((RMD)), and a few others. These companies do not necessarily feature on investors’ radar because they trade on higher multiples and then the yield is not high enough for your typical income investors to go for those shares.
Rudi, you also said that the market has developed a stomach for bad news, which means that bad news that you read in your report might not necessarily translate through to weak share price performance.
Put some more context around how people should be gearing themselves for bad news and trying to sort of correlate that with market reactions.
Nothing is as easy as calling a share market or a share price overvalued. We've all been doing it as a community for four years now. And every time we call a ResMed or CSL overvalued, the impact seems to be quite temporary.
The big lesson I've learnt over the years is that companies on high multiples that move on results are not usually the ones that come crashing down. It might happen temporarily, but there's not a correlation between high valuations, lower valuations and share price movements in reporting season.
You either disappoint or you don't.
Given the context at the moment, there is a general sense that, maybe, the share market has risen a little bit too far given what's coming. It's possible that investors will be on tenterhooks and become nervous. But I also think this is macro-picture related.
My observation is that for 80% or so, prior to results, the share market gets it correct. So, where ResMed is trading at is probably correct. And where GUD Holdings ((GUD)) is trading at is probably correct as well. There's quite a divergence between the two.
Too many people are calling the share market overvalued, because they actually underestimate how the share market works and the best way to illustrate this is by going back to the GFC.
Back in 2009, there was no indication whatsoever that we were going to have a quick economic recovery, yet share markets rallied from the lows in March. And they kept on rallying until early 2010.
By then they had done their dough. The share market now is trying to look forward. I think investors are largely ignoring 2020 numbers, unless the indication is that things are not quite right internally with a company. If that’s the observation, you have to revise your view.
We are dealing with two types of companies. The ones that have done well and are a beneficiary of what has been happening, like ResMed, Fisher & Paykel Healthcare ((FPH)), Afterpay, Zip Co ((Z1P)), and Carsales ((CAR)), for example.
These companies will be judged on normal metrics as per always. We put the share price at a certain level, and ask the question: how are you performing? Can we trust you that the years ahead will be okay?
The larger group of companies is trading on lower multiples. We know their numbers won't be good. But now we’re about to find out what we don't know.
These companies will have to convince us that in the year ahead, maybe in two years, profits will be back at pre-pandemic levels, hopefully.
As long as these companies can convince us, we will probably push their share price a little bit higher than where they are now. If they can't convince us, then again, these companies will become a value trap for the time being.
We can stomach bad news at this point, as long as we can keep the confidence that next year, at least in two years’ time, those companies will be in better shape.
This is also why the balance sheet and cashflow will be now very, very important. We don't care that a Qantas ((QAN)) is only having a few planes in the air, we don't care that at Sydney Airport ((SYD)), there's nothing happening.
What we do care about is: can these guys weather it out? Do they have enough cash so they can start operating normally again when things normalise?
That's another element that investors will have to pay attention to. It's not about the bad news. It's about: will they survive? Can they get back to normal?
Rudi, when I looked back at our article or our interview from February, one of the things that you said, "Well, you should never be afraid to sell, and it's never too late to sell."
That was before the pandemic ripped through the global economy. So, my question to you is have you had to sell anything? Have you forced yourself, have you changed your view on anything? Is there anything in there that wasn't all-weather?
Unfortunately, there are a few I regret selling, and there are a few I'm very happy I sold. One of the reasons why my all-weather concept works so well is that we are not living through normal economic circumstances.
If you go back to late 2018, the second half of 2015 or early 2016, and before that 2011-the first half 2012, and before that 2007 until early 2009; we seem to have limited time when we have normal economic circumstances before we have these mini-crises that come along on a regular basis.
What I learned from these crises is every time you check out what hasn't performed in your portfolio, and you go through a cleansing operation. It improves the portfolio. Now, that's the theory. That's what I do every single time we go through those phases.
What I do is I chuck out, for example, a Jumbo Interactive ((JIN)), which I owned. I wasn't that confident anymore. At the moment, I'm glad I don't own it anymore. I've lots of other stocks that have done very, very well.
I've sold out of Atlas Arteria ((ALX)), for example, because I quickly established that they were not going to pay dividends and I had them in the portfolio for the dividends. So, the reason I owned them fell away.
Unfortunately, I also sold out of Macquarie ((MQG)) and that I came to regret. I thought they were in trouble. They have a lot of investments in infrastructure, including airports and the likes. I'm just as surprised as everyone else that the situation resolved quite quickly, and this quickly resulted in the share price recovering.
I can only blame myself. Macquarie would still have been a buy last week, but you get that mental barrier that builds up.
Investing is like golf. It's not about having a perfect game. It's about having a game that's good enough for your score.
Investing is the same. You will make mistakes. There will always be stocks that you would have liked in your portfolio, or that you should have sold earlier. But at the end of the day, with the stocks I own in the portfolio, I feel I could absolutely not complain in 2020 or in the years prior.
Rudi, I'm going to ask you for one or two stocks in a moment that you think can deliver this reporting season. Before we do, I'm keen to hear your view on gold equities, given the level of interest that there is right now.
It's something that seems to be proving a bit of a bright spot and a good all-weather style part of the market at the moment, but doesn't seem to fit the traditional buckets that you've put in on there.
Well, I've got a surprise for you then. I approach gold as an investor and not so much as a trader or as a short-term investor. The largest holding in my portfolio this year was gold. And I'm quite happy with how that's performed.
Was that directly in the commodity?
I bought an ETF. I go for gold and not for gold equities. The reason for that is I already have complications, because I'm buying gold in US dollars, so I already have the complication of the Australian dollar.
I do not need even more complications where I get individual company risk as well. Some gold stocks have performed absolutely fantastically this year and some have not. And that's the risk that I don't want in my portfolio.
You will go through times when having exposure through the share market relies on different dynamics than simply having exposure to the commodity itself.
I'm a lower risk investor. I just wanted to own gold, because of all the other stuff that was happening in the world. So early in the year, I made gold the largest holding in the portfolio. I'm not trading in and out, and I'm not seeking exposure to the share market either.
And I'm keeping my holding, by the way.
Can you explain to our viewers why you've chosen to have that position denominated in US dollars?
Well, it doesn't matter whether you buy in US dollars or in Aussie dollars, because ultimately you always get the conversion risk.
It’s just my preference, ultimately, we have to buy in and sell out at some point, and conversion is always there.
I think that the major decision you have to make is do you buy gold, pure gold, or do you buy gold producers?
With the gold producers, you are taking on a different type of risk. I'm just after simple, straightforward and uncomplicated.
Righty. Finishing up. Last question. Outside of CSL, which we know is your bellwether go to stock for reporting season. What are a couple of stocks that you're looking forward to reporting?
You can tell from that group already, that the portfolio has performed well this year. So, I'll definitely be paying attention to how well they are performing and whether I maybe should take a little bit off, or add a little bit more to those stocks.
I'm convinced that all of those I just mentioned still have a long runway of growth in front of them. It's just that I have to pay attention a little bit to the short-term dynamics.
I have other stocks, which have not necessarily shot the lights out. They're a little bit in that laggard camp, although not at extremely cheap levels. If they were, that would make me worried that something nasty might be coming up.
There are stocks which I believe are still representing good entry points, good operational prospects, et cetera. It just hasn't been priced in so far.
I also have Orora ((ORA)), by the way, and they are definitely going through a challenging time in the United States, but they are, for the time being, going to pay more to shareholders. And that's probably going to keep their share price supported.
I also have stocks like a Ramsay Health Care ((RHC)), for example, and they're holding up quite well. And I suspect that once we're opening up in Victoria and in other regions, that they should do well.
Basically, I pay attention to all of them, because I own them and I have to make a decision whether I still want to own them post reporting season.
Again, most of those companies I own I tend to own for a longer time. The assessment I have to make is: whatever they come out with in August, is that going to be enough to keep those prospects alive for years to come?
All right, Rudi, well listen, thanks for sharing your views and opening up on some of the stocks that you're holding and some of the ones that you're watching out for.
If I'm to summarise your view on reporting season, you're telling people don't expect to get too many bargains for the good stocks. You're probably going to have to pay a little bit up for those earnings.
The market is already expecting bad news, so don't be surprised if bad news doesn't see a big downside reaction. And the other thing that you're looking for is certainty.
Those companies that can provide concrete guidance about their earnings and their dividends are likely to be rewarded handsomely. Is that correct?
I think that's very correct. I think you summarised it quite nicely. Don't assume automatically that a stock that has performed well, that the only way next is down. Often there's more to come.
Okay, great. Rudi, thanks for jumping on the call.
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)
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