At Sage, you have two funds: the equity plus fund and the absolute returns fund. The former is the one that Future Generation Australia (ASX: FGX) is invested in, so can you explain its investment style?
The Sage Capital investment strategies provide investors with two neutral portfolio solutions that follow the same investment process and style, built over 20 years through my experience as a long-short investor. They use the same stock selection process, but are structured differently to provide investors with different outcomes. The Absolute Return Fund balances long and short positions to provide returns above cash, driven by our stock selection. The Equity Plus Fund layers long and short positions on top of the S&P/ASX 200 Index to improve its returns. Our approach is to utilise a long-short structure as a framework to run broad diversified portfolios, take a lot of different stock positions, and control risk at the same time.
There are two components to our investment process. The foundation is a broad, structured quantitative approach, where we’re ranking stocks across the S&P/ASX 200 Index using a range of stock selection factors, such as momentum, value and quality. In doing so, we’re trying to exploit the behavioural biases that exist in the market, the way people process information and make decisions.
The second component is then to leverage the investment experience of our team, with our four portfolio managers undertaking more thorough, fundamental research. This goes into a lot more detail than a structured quantitative approach can, and really looks at company earnings and what’s driving them. We look at the broad, top-down drivers – like industry growth rates, competitive dynamics, barriers to entry, or environmental, social and governance issues – as well as the company-specific drivers, like management quality, incentive structures, the financial operating leverage of the business, whether they’re pursuing organic growth or acquisitive roll ups and so on. Then we look at what’s priced into the market from a valuation perspective.
This combination of quantitative and fundamental stock selection approaches enables us to run broad, active portfolios. We rank the S&P/ASX 200 Index companies and take overweight positions in the top 50 and short positions in the bottom 50. We then employ a suite of risk management tools to ensure the portfolio is tightly risk controlled.
You structure your portfolio into eight groupings or clusters. Can you explain the strategy behind this and give me some examples of what those groupings are?
Yes, we split the market into what we call Sage Groups and this is key to our process. So rather than use GICS (Global Industry Classification Standards), we use eight broad classifications of stocks that are more tailored to our investment process. These are:
- Defensives, which include supermarkets, telcos and hospitals;
- Domestic Cyclicals, such as building materials or retailers;
- Global Cyclicals, which include broader businesses like Brambles (ASX: BXB) or Amcor (ASX: AMC), mining services, agriculture and chemicals;
- Growth, which is basically any company with above-market earnings Traditionally that’s been healthcare companies like CSL (ASX: CSL) or ResMed (ASX: RMD), technology companies like WiseTech (ASX: WTC), materials companies like James Hardie (ASX: JHX), or consumer discretionary businesses like Aristocrat (ASX: ALL) or Breville (ASX: BRG). This is a very important category that insulates us from big value and growth rotations in the market;
- REITS, or real estate investment trusts which include companies that own, operate or finance income-producing real estate
- Resources, which are all the commodities except for gold, which we strip out due to its volatility;
- Yield, which includes banks, insurers and diversified financials like Challenger or Computershare; and
- Gold, which is companies involved in the gold mining industry.
We select long and short positions across those eight groups, which means the portfolio is very style-neutral and insulated against broad macroeconomic swings that often occur in the market. We’re really relying on our idiosyncratic views of the companies and the factors that are driving their earnings and valuations to get that genuine alpha into the portfolio.
What is your outlook for equity markets over the next 1, 3 and 5 years?
Bad, worse and terrible. [Laughs]. Seriously, it’s an extraordinarily tough period for markets. Until recently, we’ve been through this golden age of low inflation, falling interest rates and easy monetary policy, where central bankers have been able to ride to the rescue every time things have looked a little bit wobbly. In the background, we’ve had the impact of globalisation and China, which has produced low-cost manufactured goods that have really anchored inflation all around the world. Other than the GFC, we’ve had a long period of constant growth, shallow recessions, and low unemployment around the world.
We’re in a different period now. The pandemic has really exposed the fault lines on the supply side and suddenly people are looking to onshore and move supply chains away from China. The Russia-Ukraine conflict is driving inflation, and low unemployment is also pushing up wage expectations. One thing I have noticed over the last couple of years is a major shift in psychology around inflation from businesses and consumers. Businesses were once too worried to pass on price rises in the case that a competitor would start undercutting on price in order to take market share. As consumers, we have become accustomed to buying goods cheaply, on sale or at a discount. Suddenly the pandemic came along and disrupted supply chains across the globe. It became apparent that consumers were prepared to pay up for convenience and access and businesses realised that they too could pass on price rises. And we’ve just been through the latest reporting season, where pretty much every company has said, “Costs of labour and raw materials are through the roof, but it’s okay. We will pass on the price, recapture that money and maybe even expand our margins a little bit.” So that dynamic between businesses and consumers has really shifted and central banks are aware of it. Central Banks are determined to retain credibility on inflation, and they’re going to keep tightening to anchor inflation. If that means we have to trade off growth, then so be it. The reason I said the three-year outlook might be worse than the one-year outlook is that behind the scenes, we have had this massive energy shock. It’s starting to look more and more like the 1970s, when the Yom Kippur War and the OPEC embargo led not only to major inflationary impacts, but also hit capacity and growth. At the moment, we’re seeing the same kind of thing. We’ve got an energy transition going on, where we are trying to switch to renewables, but the pace at which that’s happening hasn’t been well planned. We under-invested in traditional sources of energy faster than we scaled up our ability to produce renewables. So fossil fuel prices are driving up energy costs, which has just been massively exacerbated by the Russia-Ukraine conflict. What you’re seeing now in terms of European gas and electricity prices is truly horrifying. They’re shutting down industries.
What do you think is reasonable to expect from equity returns going forward over the next five years?
Something much lower. If it’s positive, that would be fantastic. We’re moving into a recessionary environment where earnings are going to fall and a soft landing is going to be very difficult to engineer. Earnings recessions lead to job losses and higher unemployment, which impacts consumer demand. But that’s what central banks have said they’re prepared to accept to get inflation under control. They are prepared to have a recession, and potentially a hard one, to get inflation out of the system, anchor it and then rebuild from there. The alternative is the scenario of the 1970s, where Central Banks never managed to get inflation under control – and what followed was a decade or more of lost productivity and growth.
Given the market is being driven so heavily by the macro, is it still a stock picker’s market?
Every market is a stock picker’s market but when you get uncertainty and volatility, it becomes more so. When things are stable, it tends to be less of a stock picker’s market. The money just follows trends and thematics, or flows to passive index funds and ETFs. When you are in times of stress and volatility, there’s more variability. Active stock picking can add more value by identifying which companies are most exposed, who’s handling the environment better and who’s positioned themselves best. There are more winners and losers.
It seems that there is a very different skill set and mindset required when you’re a long only investor, versus a long-short investor. How easy is it to be good at both?
Philosophically, it shouldn’t be a different mindset, but I find that a lot of long-only investors approach investing from a different perspective. They tend to approach investing from an absolute return perspective, so they look for the stocks they like the best, which could be high growth stocks with great return on capital or stocks that have really cheap price-to-book value. This seems like a reasonable way to invest, until you consider that most professional investors are mandated to beat the index. By contrast, a long-short investor is always looking for the best stocks and the worst stocks in a particular sector so that they can then go long and short, with the objective of beating the broad benchmark. They don’t have to worry about high growth stocks halving if the US Federal Reserve takes rates from 25 basis points to 425 basis points because they effectively have a bet each way. I think long-short is the way people should think about investing from a professional point of view − but many people don’t.
What themes are you currently looking for in your short selling?
Across the portfolio we have about 50 long positions and about 50 short positions and these are spread reasonably evenly amongst the eight Sage Groups. For instance, in the Defensives group we like Telstra and Sonic Healthcare, but we’ve been short on stocks that have looked more expensive, like ASX. Across Growth, we are long on healthcare, short on software and technology. In Resources, we’re long on new energy, lithium and transition metals, but a lot more bearish on iron ore stocks due to issues with the Chinese property market and global demand for steel. In Yield, we like insurers more than banks. We see more positive pricing power on the insurance side, with premium rate rises and a bit more leverage to increase in yields. With banks, we see a lot of competition coming through next year’s fixed mortgages cycle which can outweigh any benefits the banks get from risking cash rates. Plus, credit risk increases for the banks as the economy deteriorates. The key to our short positioning is identifying stocks that are likely to underperform their peers with similar growth and risk characteristics, rather than trying to find stocks that will necessarily fall in absolute value or are inherently broken.
It’s obviously been a tough year for investors. How do you feel you have fared and what have you taken out of this period?
We’ve fared very well, with both our funds performing well above benchmark, so we’re very pleased with the outcomes we have delivered for our investors. I think it comes down to the flexibility of our investment process and our structure. A lot of long-only managers, who don’t have any particular investment style, have really been caught out by the macro issues, as the world has moved dramatically in different directions. Our approach of stripping out that risk and relying on stock fundamentals has worked well, and has been proven to work over time.
How do you incorporate ESG into your investment strategy?
We’re integrating ESG into our evaluation and analysis of individual stocks. So, when we look at a company in terms of industry growth, competitive dynamics, or the stability of earnings, ESG also factors in there. We definitely score stocks on ESG concerns as well as excluding stocks in firearms and tobacco.
What are the two main lessons you have learned over more than 25 years in the markets?
Number one: Psychology
Investing is just as much about psychology as it is about fundamentals. It’s not only about what’s happening, it’s also about people’s perceptions of what’s happening. So, you need to spend as much time understanding people and how they make decisions and how that influences markets, as you do understanding the dynamics of a company’s earnings.
Number two: Diversification
Acknowledge that the future is always far less certain than you think and your ability to predict it is a lot worse than you think. The only way to deal with that is through diversification. You should never limit yourself to just one possible future; you should always be thinking about a range of different possible futures and have balance and diversification in your portfolio to deal with any of those.
Which bring us neatly to Future Generation. Why is managing Future Generation Australia’s money important to you?
As professional investors, we recognise that we live very privileged lives, so we welcome avenues that allow us to make a difference by giving back and showing our support for worthwhile charities and causes. Future Generation is a way that we can do that effectively and we’re proud to be part of this initiative that aims to make a difference to the lives of the generations to come.