BlackRock's take on Australian equities

The Australian stock market has lost substantial ground over recent months in line with other markets.

For Charlie Lanchester, who heads up the Australian Fundamental Active Equities division of the $US6 trillion global fund manager BlackRock, the likelihood of increased markets volatility presents a sound opportunity for him and all investors.

In the interview below, he says the value opportunities on companies with sound fundamentals, especially those generating earnings offshore, are "quite compelling".

Lanchester doesn't believe there will be a Christmas markets rally, and points to more volatility ahead, but he says it is not a time for investors to be fearful. Rather, he says, investors should hold their nerve, at least until the next reporting season in February.   

Listen to the podcast, or read the full transcript below.

Tony Kaye: Hello I'm Tony Kaye, I'm the Editor of InvestSMART. Today I'm talking with Charlie Lanchester who's the Head of Fundamental Active Equities for Australia. Hi Charlie, how are you?

Charlie Lanchester: Yes, good morning. I'm very well, thanks.

Tony Kaye: Great. Charlie, we're catching up at a time of great volatility in the markets. Every day there's something else to look at in terms of markets going down at the moment. But talking generally, in this period we've seen quite a bit of volatility. Just want to really talk to you about what the drivers are behind all of that, and where you see things are heading into the new year?

Charlie Lanchester: Look, you know, you've asked a lot of questions there Tony, and I'll do my best to sort of break it down. Certainly we are seeing much higher levels of volatility than we've seen, particularly over the last couple of years, and I think it's been a bit of a shock to many investors who got used to those very low levels of volatility, that we're coming back to something that perhaps is actually more normal when you look back in history. That said, I think that volatility has been amplified in the last six weeks or so, and a lot of it obviously is around geopolitical tensions and events. Whether it's Brexit or US-China relations, or sort of the wash-up in Australia more directly around the Royal Commission and some of the effects that that's having and some of the announcements that are coming out.

Tony Kaye: Yeah. We're not likely to see much change in that though are we? It's going to continue for the foreseeable future.

Charlie Lanchester: Yeah, look, the market's perception of it can change. I think we are in quite a period of negativity at the moment. The markets oscillate between fear and greed, and we're certainly in the fear aspect. You can actually point to some quite positive aspects of economic growth around the world, and the US economy is still going well despite what market are perhaps predicting. The Australian economy still actually is growing and there's reasonably good employment. The federal budget is in good shape and the Aussie dollar has weakened, which is a good thing and sort of shields our economy somewhat, but obviously the market's looking to predict some of the things that are coming around the corner and there are some things to worry about. I think there's no doubt that the relationship between the US and China has changed over the last 12 months. It's sort of been a gradual process but there is clearly a step up in aggression from the US, particularly around the theft of intellectual property, and I think that is cause for concern over the medium term.

Brexit is very topical. Theresa May has just delayed the vote around Brexit, and clearly there is a lot of uncertainty about how that actually plays out in Europe. That doesn't affect a lot of Australian companies directly but does cause that sort of heightened risk awareness around the world. So look, a lot of these things will be around for a while. We're not maybe going to see a Christmas rally, which everyone has been hoping for, but the proof really from my point of view as a bottom-up stock picker will be in results season. I'm actually looking forward to getting through this period and getting into February where most companies will report their half-year results, and I think at that stage we will see much more clearly what's going on in the world, how those companies are doing, and which ones are more shielded than others.

Tony Kaye: Yeah, it will be very interesting to see how they've fared over this period of time where it's been quite interesting. Now on an operational level for those companies, whether they've been heavily impacted or not by the various factors, including perhaps the fall in the Aussie dollar, may have helped them, hindered them.

Charlie Lanchester: Yeah, look, all of these and above are interesting. When the sell-off in the market started in sort of October, I think initially it was because we were seeing rising interest rates in the US, and global evaluations are very much based off that 10-year bond yield in the US, and as it tracks well above 3, up in Tokyo I think up to 3, 3.18 at one point in time, that some of those high valuation stocks, high P/E stocks started to sell off. But then what subsequently happened towards the end of October and November is some of the cyclical value started to really sell off, and you're already seeing the US housing stocks come off, for example.

The market went from selling off the valuation names to predicting something more sinister, almost a global slowdown into 2019 and 2020, and that's really gathered pace. So that bond yield actually has come back down now to well below 3, and I think as we as investors look to the medium term to long term, we're talking three to five years plus here, we don't think that interest rates are going to go up significantly from where they are right now, so that 3 per cent discount rate is something you should factor into your valuations, and that's how we look at things.

Tony Kaye: We're heading into an interesting period. Of course, we've got an election coming up next year, most likely in the first half of next year, so that's going to throw up all sorts of interesting situations for companies. Have you factored that into your investing strategy?

Charlie Lanchester: Yeah, look, I think, as I said, the market's very forward-looking. It is clear that Labor is well ahead in the polls, and really everything is pointing towards a Labor victory. Labor has actually been quite clear in terms of its policy in opposition, which is somewhat unusual, so we sort of know where things are heading, and for some of the stocks that we're investing in. For our particular fund, we don't invest in the banks, so we don't have to worry as much as maybe other Australian long-only investors about the effects of the Royal Commission, the effects on housing of removing negative gearing. But obviously other industries like private health insurance, for example, Labor have been very clear about what they're going to do in that industry. I think that actually affects the whole health industry here in Australia. So, we are thinking about it, positioned for it, and certainly probably our biggest concern is that there's a whole confluence of factors, particularly around the housing market, which could lead to a period of perhaps weakness in the Australian economy.

Tony Kaye: So, we're really seeing a return of value in many companies, that for various reasons have been sold down at this particular point in time. That's obviously presenting opportunities for you?

Charlie Lanchester: Yes, look, we do see when we look across our portfolio, some, we think, exceptionally well-priced names. I think markets have had a good run over a little while, and pull-backs do happen. I think you have to accept that they're quite hard to predict, but they do happen. But when we look at some of the companies that are still generating growth, and some of them in particular have offshore earnings which will be positively impacted by the lower Aussie dollar, we think that some of the valuations out there in the market now are quite compelling.

Tony Kaye: Do you look at stocks on a sectoral basis, or you're looking at them individually? How do you go about your strategy in terms of finding stocks?

Charlie Lanchester: Yeah, as I've alluded to, we've deliberately excluded the four banks, as some of the huge positions within the index here in Australia, and we believe retail investors in particular who we are aiming our fund at have significant exposure to those four banks, either directly or through other funds that they may own. So we've taken that out of our fund. We also exclude resource stocks, the mining companies. Mainly because it's very hard to predict commodity prices, and as such we think we can add more value investing in the industrial side of the market. I ran for a decade the Perpetual Industrial Share Fund, and really the fund I started here is sort of a new and improved version of that. So yeah, once we take those things out, we then have a very much diversified portfolio of individual stock names. We don't have any particularly large sector overweight bets. It's a balanced portfolio. It's a concentrated portfolio, the top 10 stocks make up about half of the fund. Yeah, we're actively seeking to run the money really as I would choose to run my own money, and all the team are invested in the fund.

Tony Kaye: Are you looking at stocks below, all in the ASX 200 or are some below that?

Charlie Lanchester: Look, some of them below, so we have a mix of small cap, mid cap and the large cap names. Ideally what we're really looking to do, the strategy of the fund, is to try and find companies in the reasonably early stage of their development. Maybe when they're a $300, $400, $500-million market cap range, we might buy a small position initially. Get to know the company, get to know the management, the board, how they are reinvesting capital. Ideally paying some dividends but then taking the rest of the money and putting it back into their business. If you find people and management teams that are doing that well, we want to stick with them for many years. And then ideally they become mid cap and then mid cap stocks over time. So we will ride these companies right through the market cap spectrum.

Tony Kaye: Let's just summarise here. For the retail investor, what are some of the things they should be taking on board from the current conditions, and perhaps how should they be looking at their asset allocation at the moment.

Charlie Lanchester: Look, I think it's a time not to be too fearful. I think it's a time to hold your nerve. That's very difficult from my own position when you're looking at these prices on a daily basis, but the reality is particularly at this time of year coming into Christmas, liquidity has really dried up in many parts of the market. It's quite hard to trade smaller mid cap stocks. So I think it's a real time to focus on valuation methods. Companies that you really understand and believe in, companies with strong balance sheets are absolutely key. Don't want to move into times of dislocation with too much debt. But then really hold your nerve. Don't be panicked out of stocks just because they've fallen 20 per cent on a relatively small percentage of the register changing hands. Hold your nerve and then wait to see how the companies actually report their results in February.

Tony Kaye: So it's obviously a long-term gain. Stay in, try and switch off from the market noise, I suppose, as best as you can.

Charlie Lanchester: Yeah. Look, it's very hard to do, Tony, but exactly, it's time in the market rather than timing the market. I think the long-term prospects for Australia, even with the concerns we have around the property market, are still very good. We have population growth, we have a very good education system, rule of law. We're close to the growing Asia-Pacific region. This is an environment over five and 10 years, which is how you should think about investing in equities, that Australia will continue to do well.

Tony Kaye: Alright, Charlie. We'll leave it there for today. Thanks very much for your time.

Charlie Lanchester: Thanks Tony. Thanks for coming in.