Lanyon Asset Management has been a pro bono fund manager for Future Generation Australia (ASX: FGX) since 2014, but you’ve only just come on board as a Future Generation Global (ASX: FGG) fund manager. How do you think your investment style differentiates you from your global peers?
Nick: I think Lanyon sits in quite an obscure part of the investment manager spectrum. We’re a very low-risk, conservative manager, focused on delivering absolute returns and protecting our investors capital.
There are three key points of difference. The first is that we have a very conservative investing style, so we’re looking for inexpensive businesses with excellent franchises and great balance sheets. The reason I highlight this is that over the past 10 years, the market has drifted towards more risky growth businesses, facilitated by lower discount and interest rates. Lanyon has stuck to its knitting over that decade and really hasn’t deviated in its style.
The second point of difference is that Lanyon seeks absolute returns. Most investors are focused on delivering relative performance to the index, whereas Lanyon has always been an absolute investor. That typically pushes us down the risk curve because we’re looking for low-risk, absolute returns, rather than simply beating an index. That affects the business in terms of the portfolio composition; we’re happy to hold very high levels of cash and we only invest in businesses that we think are going to deliver a reasonable absolute performance over time.
The third thing that sets us apart is that we are a concentrated equity manager. We typically only invest in 10 -15 companies and we do all of our own research on those businesses.
During the market’s love affair with high growth tech stocks, there must have been periods when you started to doubt your strategy. How difficult was it to stick to your knitting?
Nick: Incredibly difficult. You feel like a bit of an idiot when some businesses are getting rerated daily and the businesses that you are invested in are having far less exciting investment outcomes. But, as I said before, we’re focused on delivering very good, risk-adjusted, absolute returns, rather than on what certain pockets of the market are doing on a day-to-day basis. Our investor base is very patient and they understand our investing style. They know we’re focused on businesses we understand, with excellent balance sheets and excellent core franchises. And, frankly, a lot of those businesses that were growing quickly didn’t really meet any or all of that criteria. Over the past 12 months, we’ve seen a lot of questionable business models coming unstuck.
As you mentioned, one of the levers you have to protect capital is your ability to hold high levels of cash. What is your current cash level – and where does that sit in an historical context?
Nick: The Lanyon Global Value Fund’s cash has oscillated between 20% and 60% over the last couple of years. Today, it’s around 37%. I guess the question is: when do we start investing some of that cash? If you look at things at a very high level, the S&P and the NASDAQ – which are what most of the global equity markets benchmark themselves against – are still above their pre-COVID levels. By contrast, interest rates are higher than their pre-COVID levels and the earnings outlook for many businesses is in decline. So, we’re not that excited by equities at the moment and we’re not looking to draw down that cash too quickly just yet. That said, there are a lot of opportunities that are starting to emerge. Our watch list is growing by the day and there are certainly some businesses that we’re looking to make investments in for the first time.
Do you see current conditions as a short-term blip or is it more fundamental, like the Global Financial Crisis?
The short answer is that I don’t really know. To have a view on markets these days, you need to have a view on the macro, and to have a view on the macro, you need to have a view on inflation. Are we good at forecasting inflation? Probably no better than anyone else. Forecasting macro is incredibly difficult. But, like I said, I have a very simple framework for markets at the moment: valuations are still not cheap by historical standards, discount rates are higher than they’ve been for 10 years, and corporates are yet to downgrade earnings. So while we don’t forecast the macro specifically, I think it’s safe to say that volatility will continue for some time based on those three factors alone.
Also, and I hate doing this, but if you look at historical bear markets, the average drawdown is typically around 30% to 40% and it goes for many, many months. We’re only 23% to 25% down this year and that’s off a record bull market. Based on all those factors, I don’t expect the market to be off to the races anytime soon.
So, by that reckoning, how much further do you think markets have to fall?
Nick: It’s a great question. I think the consensus view is that people are still looking for reasons to buy the market and part of that is because we’ve had 10 years of uninterrupted equity market growth. But I can definitely see a scenario where the markets fall another 10% or 15%.
Are fears of a recession justified?
Nick: Absolutely. I think it’s a very, very high likelihood that we will have a recession. Again, not wanting to be a macro economist, but we need to take a lot of heat out of the economy and to do that, we need to lower demand. Part of what raising interest rates does is contract GDP, so I think we will absolutely have a recession.
The bigger question is what kind of recession we have. Is it a hard landing? A soft landing? Is the recession focused in certain pockets of the market?
The questions that then follows is: what are the markets pricing in? I would say that the markets are already pricing in a fairly severe industrial recession in some places, less so a consumer recession.
On a more positive note, what areas of the equity market are most likely to benefit from the current macro conditions – both in Australia and globally?
Nick: Oil and gas – or energy more broadly – are going to keep doing well for the next couple of years. There are plenty of structural tailwinds there. Over the past 5-10 years, there has been massive under-investment in capacity. Events in Russia and Ukraine have highlighted that, and also suggested that countries need to be more independent and have a broad mix of energy. So investment in energy – whether that’s conventional carbon-based energy or renewable energy – is likely to continue at a fairly high pace for the next couple of years.
I suspect traditional inflation-linked assets, such as banks and commodities, are also likely to do well.
And then there are parts of the market that have been sold off considerably over the past 12 months. We like to buy idiosyncratic businesses that can grow under their own steam in different market environments. So, there are going to be a lot of companies that do reasonably well in the next couple of years, regardless of what the macro does.
Can you give us some examples?
Nick: Lamb Weston (NYSE: LW) is a relatively boring business that does very simple things: it processes potatoes into French fries. It’s no Netflix (NASDAQ: NLFX), Apple (NASDAQ: AAPL)or Amazon (NASDAQ: AMZN)! But it operates in a duopoly with McCain, there are no new competitors, they raise prices every year, and demand for French fries, surprisingly, actually grows most years. (It grew through the GFC and through COVID, despite restaurants being shut!)
When people talk about growth businesses, they tend to talk about software, but growth businesses can exist in different sectors. I would argue that Lamb Weston is a growth business that sits in an attractive market structure. It should do well in the coming years, regardless of the macro.
Another business I suspect will do well is Airbus (EPA: AIR). Airbus has the biggest backlog on record; it sits in a duopoly with Boeing (NYSE: BA), which is having all kinds of internal issues; and air travel has outgrown GDP every year since 1950.
If I were to tell the average person that I think a European industrial company is going to outperform the broader equity market, they’d look at me strangely. But, typically, when you buy a business in a growing industry with a reasonable backlog, great balance sheet, inexpensive starting valuation, that sits in a duopoly, and its main competitor is going through major internal problems, that’s a pretty good recipe for generating good returns!
David: We’ve recently initiated a small position in SkyCity Entertainment Group (ASX: SKC), a casino and gaming group. We think that Auckland casino is one of the best casinos in the world, with a very favorable tax structure and a long license term. The stock’s been sold off by 25-30% on two concerns: 1) the international high roller business, which has been impacted by border closures and COVID- induced travel restrictions, and 2) an overriding fear around potential loss of licences due to poor governance and oversight on domestic and international casinos.
We think the stock now looks like pretty good value. Despite weakening consumer sentiment, we think tourism-related businesses have a reasonably favourable outlook. People have been cooped up in their homes for many years and while they might not be spending on goods in the same way, spending on experiences and services will persist for the short-to-medium term.
How is Lanyon’s stock picking process geared to the current macro environment?
Nick: The core thing we look for is very low risk, conservative investment opportunities. We’re always focused on great balance sheets; companies that are net cash instead of having debt; companies that produce a lot of free cash flow; and, importantly, companies which return that cash flow to shareholders both through dividends and buybacks.
In an environment of rising interest rates, you need to find companies that can produce capital instead of companies that need capital.
We’re also always focused on “short duration” businesses, or businesses that will earn a lot of their market capitalisation in free cash flow in the coming years as opposed to in the outer years. When interest rates are rising and volatility is high, investors tend to swing away from growth companies towards these short duration businesses. That’s what will get rewarded in the current market and that’s typically where we have invested over the history of the firm. So I am feeling fairly good about our portfolio and investment process in the current market cycle.
David: One of the disciplines that the investment team has had over the last few years is that we haven’t incorporated artificially low discount rates into the way that we think about valuations. By contrast, many investors have made the mistake of placing aggressive values on stocks because they’ve assumed that the current level of discount rates, the 10-year bond yield, is likely to persist forever. As rates have started to normalise and go up, that discipline has certainly assisted us by not impairing our valuations enormously.
What is your current outlook for markets?
David: Interest rates are to markets what gravity is to matter. At the moment, there are really two things impacting global stock markets. The first is the interest rate cycle. Interest rates have been held artificially low for a long period of time and we’re now in an environment where they are clearly going up. That’s having an impact on asset prices and stock markets and we’re right in the eye of that storm. The second factor weighing on markets is the broader economic environment and the potential for a global recession.
The quicker we get to a period where interest rates return to normal levels and the economy starts to improve, the quicker markets will recover. But that’ not going to happen any time soon.
We’re in an environment where there are a lot of moving parts, so it’s not going to be plain sailing in equity markets for quite some time. But, quite often, market volatility, fear and some blood on the streets provides a really good environment for stock pickers. For value investors like Lanyon, it’s a time to try to find some outstanding investment opportunities.
What is the top investment lesson you’ve learned over your time in the market?
David: To do your own work and not rely on the opinions and forecasts of others. If I think about the mistakes that I’ve made in my investing career, they’ve often occurred when I’ve relied on the opinions or thoughts of others.
Nick: Mine would be the concept of “margin of safety”. Our job, first and foremost, is to protect our investors’ capital. We have no way of knowing what’s going to happen tomorrow – with interest rates or in Ukraine or with oil prices – so our job is to find businesses that have a sufficient valuation buffer. To preserve your investors’ capital in the long run, you need to have businesses where there is a margin of safety.
How do you incorporate ESG factors into your investment strategy?
David: We’ve spent a lot of time over the past two years refining and enhancing our approach to ESG. That’s been less about ESG issues with the companies in which we invest, and more about the way we capture and report on those ESG issues to our clients.
The reality is that Lanyon is an actively engaged investor, so we are constantly thinking about all the components of ESG.
I’ll start with the “G” first. We spend a great deal of time understanding the businesses in which we invest and that involves getting to know the management teams and the boards that ultimately drive these organisations. We have strong views around effective governance, effective board composition and what we think is appropriate for companies in the listed space. So governance is critical to the way we think about investing.
The “E” and the “S” components also dovetail strongly with the way we think about the sustainability of cash flows that companies generate. Nick has spoken about our valuation process – this concept of “margin of safety” and how value is always determined by a discounting of cash flows. If we don’t believe that companies have the appropriate environmental and social considerations in the way they operate their businesses, we won’t be able to get comfortable with the future sustainability of free cash flow.
Nick: ESG is the acronym du jour. Everyone’s always talking about ESG but, really, companies that look after their stakeholders have always tended to do well over time. That’s not a new concept; it’s something investors have been thinking about for many decades. Sure, there is now a more explicit, formal framework for ESG – but it’s something that Lanyon has taken seriously since inception.
We’re incredibly grateful for your support as one of the founding pro bono fund managers of Future Generation Australia, and even more grateful that you’ve now come on board for Future Generation Global. Why is managing the funds important to you both?
David: We’ve had a long, successful relationship with FGX and it’s important to us for two key reasons. The first is that it’s an opportunity for us to partner with some truly outstanding fund managers to deliver exceptional investment returns to investors. That’s something that we’re passionate about and grateful to be involved in. I’m looking forward to seeing what we might be able to achieve over many years.
The second, more important, reason is that as fund managers, we’ve got a specific skill set – yet there is little opportunity for us to use our professional skills to give back. Future Generation is a phenomenal opportunity for us to donate some of our expertise and skill for the betterment of some outstanding charitable and philanthropic organisations. So we’re really thrilled to be involved.
Nick: David and I have eight kids between the two of us, so not-for-profits that focus on children really resonate with us. Personally, in my household, there are health issues with one of my children. We’ve been incredibly well-supported and we feel very blessed to have that support, but it’s nice to be part of an organisation that helps kids who perhaps don’t have that support network. So from my personal standpoint, I think it’s great.