Ask A Fund Manager
The Motley Fool chats with fund managers so that you can get an insight into how the professionals think. In this edition, AMP Ltd (ASX: AMP) portfolio manager Dermot Ryan reveals which sector he thinks is way too overvalued and which one is ripe for a rally.
The Motley Fool: What's your fund's philosophy?
Dermot Ryan: We're a tax-aware income manager that manages money for retirees and accumulators in Australia, who can benefit from banking credits and high levels of dividends.
MF: Even though you're income-focused, do you invest in all types of shares to get that outcome — or are you purely focused on dividend stocks?
DR: We take a cyclical approach to the market. So in times where we think the market is overbought, we're in more defensive stocks — stocks with strong balance sheets and very defendable dividends.
But in downturns we will buy growth stocks if they become cheap enough and we can start to see the earnings profile. Also stocks that are able to bring through cash flow, or indeed stocks that have cut their dividends and we think, well over the mid cycle they'll re-establish their dividends.
So we do buy growth stocks, which is a bit unusual for an income manager, but it's an area where we deliver a lot of alpha relative to our peers.
The trick with being an income manager is to manage both the capital and the income. A lot of people look at a high dividend yield, but the income may be higher because it's not sustainable. And ultimately the capital value of that investment can drop over time.
COVID-19 crash
MF: How has COVID-19 affected the fund?
DR: COVID-19 has presented a lot of opportunities in the market. We were quite defensively positioned at the start of the year, because we weren't seeing a lot of earnings growth in the market.
Then we saw the lockdowns rolling through first Asia and then Europe. We recognised early that the lockdowns were going to have a very large impact on dividends, and so we were able to position out of a lot of stocks that had dividend exposure to the lockdowns.
During the end of quarter one, we were able to rotate into some cyclical positions.
Through quarter two and later in the year, we've benefited from buying a lot of reopening shares, participating in a lot of capital raisings. And positioning the funds to benefit at the cycle.
Buying and selling
MF: What do you look at closely when considering buying a stock?
DR: We look at what the future cash flow of the business was going to be, and we look at that versus our estimate of what the value of that business will be on a mid cycle basis.
MF: What triggers you to sell a share?
DR: Again, if we think a stock is about to cut its dividend, or business conditions for that stock in its industry are changing to a point where they cut its dividends, or they're indeed just too expensive.
That's the growth side of the portfolio — if the stocks become too expensive and their yield becomes too low, we'll sometimes take profits off those growth positions.
What's coming up?
MF: Where do you think the world is heading at the moment?
DR: With a vaccine, the stage is set for a very positive environment for equities in 2021 and beyond. The reason is that equities provide one of the last risk premiums that are still historically attractive — given very low interest rates have reduced the expected returns in sectors such as fixed-income and other long-duration assets.
MF: Eventually interest rates would have to go back up somewhat. Is there a risk of a bubble bursting?
DR: Yes. As interest rates rise, it will cause problems for some asset classes, like property and infrastructure. In equities, if interest rates are rising it's because growth is strong and maybe inflation is picking up. And that's often good for equities because their earnings per share and the profits will actually grow with that inflation.
It's not a level playing field across the equity market, but in general, inflation is actually good for equities.
Overrated and underrated shares
MF: What's your most underrated stock at the moment?
DR: The underrated stock sector is Australian aged care. We think there's some good opportunities in that space. The sector has gone through a very difficult year with COVID.
However, the vaccine is coming and valuations are very undemanding and there are starting to be some corporate interests around the space. But more importantly, in February next year, the government's going to announce its new funding package for that industry.
And we think that this could be a good catalyst for the industry as it positions into a new decade.
MF: What do you think is the most overrated stock at the moment?
DR: Buy-now, pay-later stock.
MF: Ha ha, so I gather your fund doesn't hold any Afterpay Ltd (ASX: APT) stocks, but can you elaborate?
DR: We think it's wonderful to have innovation and young, vibrant growing companies. However, it's important as a stock market investor not to get carried away by growth and subscriber numbers.
Margins available in this space are starting out as high, but they're being competed because there's a number of different buy-now, pay-later players in the market. And we think it's going to get more competitive.
We also think there are cryptocurrencies and blockchain solutions that can provide transactions at much lower levels than are currently being offered by the buy-now, pay-later players, or indeed the banks.
So we think longer term there's going to be deflation in the amount of charges that the sector is able to charge to retailers or indeed clients. We're bearish on the outlook for profits. We think at these levels, the sector has gone way too far.
Looking back
MF: Which stock are you most proud of from a past purchase?
DR: Mineral Resources Limited (ASX: MIN). It's a young domestic company. It's only been in existence since the early 2000s. They do mining services — produce iron ore and lithium. And we've been investing in that stock for a while. It's been a very strong performer.
It gives very good exposure not just to iron ore, which [has high] margins but volumes have kind of peaked. And there's some issues with potential exports to China, but we think it also gives good exposure to the lithium market, because they've got two very good lithium mines that happened recently, that they can deliver into the market over the next 2, 3 years.
MF: Lithium is a good area to be in at the moment, isn't it?
DR: Yes. It's a very interesting area given the amount of stimulus, and the amount of electric vehicle and industrial grid-scale batteries that are being put in place in Australia, Europe, the US, and China. It's all over the world.
It's a trend that could take off over the rest of the next decade as economies have to decarbonise. In fact, western countries for the first time in a long time have become a net importer of materials. So we're quite excited about both the growth size and immature iron ore size, which is kind of a trade that's a little bit older — maybe a last decade trade — but this stock has got a mixture of the two.
MF: Has COVID-19 changed your investment methods going forward?
DR: I think 2020 has been a microcosm of investing.
We said to our clients back at the end of March, we thought that valuations had got to a point where you had to start buying into the market with cyclicals. We use the term "Buy to the sound of cannons". That was a wonderful buying opportunity for retail investors in particular.
We think that as the confidence in the cycle builds, you'll have to be a little bit more selective, particularly given the amount of excitement in the market now. You've got to be very careful, particularly in areas like buy-now, pay-later, where stocks have overrun fundamental evaluations.
It really shows that you need to manage your emotions, you need to look at fundamental evaluations.
You need to look for where the opportunities are, sometimes in the most dire of times. It's been a volatile year. We're looking forward to more normal years in the years ahead, but we're quite confident and indeed excited about the environment offered to equities, given zero interest rates, ongoing stimulus and a global synchronised cycle.
