The big gap between growth and value stocks

Magellan has been the funds management company that everyone's been talking about for the past few years and people have gone a little bit cold on Platinum Asset Management, who are widely regarded as probably the best international investors in Australia.

Today, I've got Clay Smolinski on the phone. He's a Portfolio Manager and has been at the company for a very long time.

I thought we'd look at a few broader issues such as the big gap between growth and value stocks, which is now the biggest gap since the tech boom in 1999, and also take a look at the number of opportunities that Platinum's recently been buying.

First of all, Clay, thanks very much for giving us your time. I heard Kerr Neilson once say part of the reason he hired you was because you were very mature at what I'm guessing, was a young age. Why was that and what were you doing before joining Platinum?

It's kind of him to say. Look, in terms of what I was doing before I joined Platinum, it was nothing particularly special. I grew up in Perth and I got interested in investing at a fairly young age, but what was apparent in Perth was there probably weren't too many roles in that vocation. Certainly, most of my friends were engineers or going off to get jobs on the mines.

Prior to joining Platinum, I was just in Perth, really just looking for roles that could somewhat get a foot in the door, so I started off as an accountant working in audit. I then moved on to work for the Home Building Society, which was a small little Perth based bank, before I got very lucky that Kerr and Platinum gave me a chance.

Look, I think one of the factors was I was just extremely lucky when I joined Platinum, both that Kerr gave me a lot of his time, and I got to benefit from spending a lot of time with him and getting his tutelage, but also I think my first years at Platinum, I spent a lot of time with the founders, so Toby Harrop, who's one of the founders of the business as well, who was running the European fund. I really worked underneath Toby for the first three years and that just taught me a lot, and so kind of saying the people you spend a lot of time with, some of their attributes maybe just rub off on you a little bit.

But certainly one thing I remember just from the early days of Kerr just coming back and doing analysis, Kerr always had this saying of he'd like you to look around corners when you're making an investment, which is really just another way of saying you don't take information at face value and you try and test your assumptions and look, I always had a pretty healthy insecurity about whether I actually had the facts straight and whether the market was wrong on any particular stock. I think Kerr probably saw that as a positive.

I think most young people that come into a value investing house are very worried about making mistakes, which tends to slow down their turnaround on stocks, which quickens up a lot once they get more experienced.

Yeah. Look, that would describe my early years to a T.

I was going to say, I certainly remember my research director telling me the same thing. A couple of years ago, Andrew Clifford started writing a macroeconomic piece at the introduce of Platinum's quarterlies. Why was that?

Yeah, no that's quite an astute observation. The answer's probably simpler than you think. Look, Platinum, one of our key duty as any fund manager, is to really communicate to your clients at all times exactly how you're managing their money and what you're doing. We always put a lot of time into writing our quarterly letters. Every fund manager wrote their own one and every fund manager had to write one.

But what we were finding that over the years, as each PM would sit down to write their letter, you would have three or four of them wanting to make some reference to the macro environment in that letter, and hence we were repeating ourselves across all of the letters. We just figured, "Look, for the benefit of investors' time and probably to make things clearer, it would just make more sense for us to do. All right, we'll do one. If we want to discuss the macro, we'll do one macro summary up the front" and that's probably better for everyone. That was the genesis of that move.

Do you think you're actually thinking more about the macro environment, just because of the changes in the Frankenstein monetary policies, if you like, that have changed the world?

I don't know if we're thinking more or less about it. I think our approach to macro at Platinum is, you've always just got to understand where you are and what's happening in the world, and I call it the Howard Marks approach. You're going to look at all of the economic data, and you look at investment sentiment, just to give you that picture of, "All right, where am I in the cycle today and what does the data and the sentiment maybe imply where we're going to in the future?"

You pay attention to macro in that way. Then really, the second aspect is we say whenever you're buying a stock, you really need to understand the perspective and the reasons of the people who are selling that stock to you, or other investors. Why are they not buying this business? What are they worried about? In today's world, often that worry is economic or macro in nature, so you really need to have a good understanding of, "All right, what's happening in the data? How are they responding to the data? What forecasts are they reacting to?"

That's how you're always bringing macro into the process. I think the difficulty with macro is it's just, it's noisy data. The world is a very, very complex system and it's difficult to predict the macro, so I think while you want to understand the macro situation and where we are, you want to be very careful that it doesn't then start driving your whole investment process, and you want to make sure it's not preventing you from buying into value and stocks when you see it.

On the flip side, have you found at all that just the markets or particularly, in regard to a specific stock, where macro concerns have actually created opportunities in the business?

Oh look, many, many times over the years. We've got concerns today, so you think about look, we've got roughly 10 per cent of our fund in the semiconductor stocks. Certainly, something that's hitting those businesses are the worries around the trade war. Semiconductors has traditionally been an economically sensitive business, and for sure, part of the reason of why those businesses are trading at book value or on single-digit P/Es are concerns around the next macro move and what happens with the trade war and what happens in China.

We can see why the short-term macro fears are keeping people away from these businesses. We say, all right, well we understand that. We can't really bring a lot of edge to that, but what we can do is say, all right, well, what do these businesses actually look like on the longer-term front? And then you're sitting back and saying, all right, well I don't know what's happening with macro, but in the longer-term, I'm pretty sure consumers will buy 5G phones, companies are going to keep moving their software to the cloud, and companies are still going to invest in artificial intelligence.

Essentially, if those three things continue to happen, it's highly likely these semiconductor businesses will be bigger in the future. That's how we pair it.

Would you put the Italian banks in that bucket as well?

Yeah. Look, the Italian banks are interesting. You can go back to macro, and I think this is a good example of why macro's so hard. Look, I managed the European fund for many years and over that period we had, during the sovereign crisis, you had people believing it was a sure thing that the Eurozone was going to break up. We had interest rates on Greek debt in the high teens. Italy had an 8 per cent interest rate.

We then, fast forward today, the yield on Greek debt is what? 2.8 per cent. The yield on Italian debt is below 2 per cent. How much do things change, right? These were unthinkable situations back in the sovereign crisis. Also, you go back 18 months ago and people were, we had rising rates in the US and people were dead certain that rates were going to be rising in Europe and in other places.

And now we've completely reversed the picture, so no one believes that we'll get rate rises ever again, and we're talking about Europe being in a Japan-style scenario, where we're going to have negative rates forever. Then, you bring it back and say, all right, well let's look at the Italian banks. The banks have de-risked, they've written off a tremendous portion of their loan book. A bank like Intesa still has a large asset management business that is generating very good earnings and growing.

The Italian banks, again, something like an Intesa is still benefiting from their credit costs falling, new NPL inflows have collapsed and you're getting a 10 per cent dividend yield while you wait, and then really the discussion is just around the sustainability of that dividend yield. But that's an example where the sentiment has gone 100 per cent negative, right? No one's thinking that the future can get any better, and we look at that and think, well, actually when you look at a lot of the data, it's not that bad.

Again, not saying interest rates are going to be high in Europe, but could they at least be zero, rather than negative 50 in some point in the future? It doesn't seem that hard. That's an example of where, if you're getting paid a large dividend yield to wait, you can have a portion of the portfolio in that kind of idea I would say.

Just switching gears for a moment, I don't believe shorting stocks is well understood by most people, particularly Australian retail investors. Can you explain Platinum's shorting strategies, the types of situations you short, and position sizing?

Yeah, absolutely. What we look for in shorting is really just the inverse of what we look for in a stock that we want to buy. When you're buying a stock, you want investors to have low expectations for the business in the future, you want to have a low price and you want to ideally be able to identify a reason why the future's going to look much better in a certain time frame. In shorting, you just want the opposite.

So we want companies where investors, they're in love, the company is surrounded by hype, so very high expectations. You want a high price that leaves no room for error, and you want to have a clear reason why the future may look worse than today. Where we can find those situations, we will go off and short, and we've found some of those situations recently in the tech space, and some of the software stocks.

For us, how is shorting different though, to essentially owning a stock? When you buy a stock, even if you are completely wrong, like it's a complete disaster, the most you can lose is 100 per cent, and even that is a pretty rare occurrence. But if you're shorting a stock, and you're wrong, you can lose a lot more than 100 per cent of your initial position. As the stock goes up, your position size continues to get bigger, so it becomes a larger part of your portfolio. Certainly, when we short, we're typically taking smaller positions than when we would go long, or own a stock. And you tend to be a bit more focused on the timing aspect, and being very clear around that catalyst of when you're going to start to see change.

Just in terms of the small sizing position, are you talking like 50 basis points, or might it be a per cent, or..?

Yeah. If you think about it, you're saying a large, one of our full-sized positions in the fund might be a 3 per cent position, and with a short, you can be thinking, again, it comes back to depending on how confident you are with that catalyst. If you're less confident around just the timing, it might be a 50 basis point position, but we have had positions in shorts where we were very confident around the timing and we had ticked all three of those factors that we want to see, and we might have a 2 per cent position. But there, the 2 per cent positions are more of the rarer breed.

Platinum actively manages currencies. How much of Platinum's historical returns would come from currency management?

Yeah, look, I can give you the figures over the last 10 years. If we look over the last 10 years, it works out the currency has added 2 per cent per annum to the return, but that's spreading it out. The returns tend to actually come in lumps, and if we think about that 10 year period, a lot of the money was made via shorting the Japanese Yen, when it had become very expensive. Generally, how we tend to approach the currency positions, we tend to approach it in two ways.

We want a very strong reason to essentially hedge out or go, to take a large position on currency. We just see our natural position on currency is where the stocks lie. If we own Japanese stocks, we will own Japanese Yen, as it were. But if we do it in a situation where we feel strongly, so a good example would be the Yen. A good bell ringer in currencies, so you know a currency is maybe unsustainably strong is when your exporters in that country can't make money at that level of the exchange rate.

When the Yen was down 80, you saw Toyota, these bastions of Japanese industrialisation struggling to make money. It was the same situation when the Aussie dollar was at 1.10 to the USD in this country, and basically all of the car manufacturers left. When we can see examples like that, we typically move in size. Other areas where we might use currency shorting is where it provides very cheap tail risk hedging.

Past examples, certainly something I did in the European fund days, was during the sovereign crisis, you could hedge out some of the Euro at a very cheap rate, and it was very cheap tail risk insurance of a breakup. In China today, we've chosen to hedge some of our exposure to the Renminbi, just with an understanding that look, that is a tool, so the Chinese government may wish to devalue the Renminbi in the event that the trade war continues to essentially accelerate or intensify.

Next one's a very topical question at the moment. The valuation spread between so-called value and growth stocks in the US has recently eclipsed the gap since during the tech bubble. Do you think the gap will close as it has done historically with the next downturn, or do you think the gap might be a bit more stubborn this time around given technology's ability to render businesses obsolete so quickly?

Yeah. It’s that interesting discussion around the disruption and whether this time is different. My own personal view is that it will close, and I don't think it's particularly different this time. First of all, there's a lot of talk about disruption and the pace of disruption today. I actually just don't think this is that new. Technology has been forever rendering businesses obsolete, so an example that everyone will know, we'll talk about how eCommerce is killing retail today.

The new formats in retail have always been killing the old formats of retail over the last 50 years. Whether that be the supermarkets killing the local grocery store, or the department stores getting killed by the specialty retail. So, I think the disruption is very much fitting the words to the music and is being used as an excuse to try and justify some of the valuations.

The other thing I'd point out, just in terms of what is actually driving that valuation gap and difference, look, most of the cheap stocks are actually not being disrupted at all. It's more that these stocks have some cyclicality to their businesses, and investors today are absolutely petrified of the macro environment, and are petrified of having any businesses with a bit of cyclicality. We see this just in the wild prices that are being paid for defensive businesses these days.

You've got what are fairly slow growth businesses trading upwards on 30 times earnings, and then if we look at the valuation spread, the difference between what's the value of the high P/E stocks versus... We look at it by dividing the market into five groups and it's divided by valuation. So you look at, all right, what's the average value of the top group versus the average value of the bottom group?

If you look at this over a very long time period, that valuation difference tends to stay in a band, and that actually makes sense, because investing is somewhat of a relative game. If I can go and buy a whole business on 10 times earnings, I'm getting a 10 per cent return on my purchase price. If, Nathan, you're going off and buying one of 40 times earnings, you're getting two and a half per cent on your purchase price, and your business needs to grow incredibly fast over the next years to catch up to the return I'm getting.

Eventually investors wake up to this and capital rationally moves to the higher returning opportunities. So, this has happened in the past. The simple answer was look, during the tech bubble, the internet was there to disrupt all businesses. You actually look over the ensuing 20 years, and a lot of what it was meant to do actually happened, right? It did disrupt many businesses, but that didn't stop the valuation gap closing, and people who were investing in those wildly priced companies having a pretty rough time of it. I think it will close.

Okay. Nothing new in finance?

No, no, no. We just painfully learn the old lessons again.

This is a bit more of a personal question, but can you provide some insight into how you come across some of the more obscure opportunities in China where you have to do a lot more on the ground research compared to, I guess, some other Western countries? Do you have a team on the ground, for example, or relationships with local analysts and investors?

No, no. It's interesting. We actually keep everyone in Sydney, and we do that very purposefully. We find that just having the team in one place, it really helps with communication. It's much easier to talk and engage with the different ideas the team is working on, and it's much easier to just communicate and saying, all right, well we're seeing this happen in China or, we're seeing this happen in the tech space in the US. How may that apply to other geographies and what's happening in your countries?

We've experimented with the US office and we just think it doesn't work, at least for us, on the communication front. In terms of generating ideas, look I don’t think the idea generation process is that different in China. Maybe the difference is look, the rate of change in that economy is probably greater than others in the West. Whether that be the healthcare system reforming, or the cutthroat competition you see in the internet space, and of course change creates a lot of opportunities, so you're following those.

But I think what helps is Platinum's been investing in China for over 20 years now. Over that time, you build a lot of relationships, you build a lot of relationships with the corporates, and I think that helps. There's several meetings where you'll go in and you'll meet management, and you go, "Ah yes, I remember. We remember you from this company." Because people still move around. That helps, because the companies know that look, you're serious investors and you're here for the long term.

And then how do we bridge that gap of not having the office and not having someone on the ground, is simply that we just travel there extensively. We've got a six-man Asia team, they're focusing purely on Asia, and really if you think about China, we've probably got someone from the investment team on the ground travelling and meeting companies every three months.

Yeah, I think you've owned the large Chinese insurer, Ping An, for a number of years. What makes this company special other than just its huge potential as insurance coverage increases across China?

Yeah. Look, I think the interesting point about Ping An was this was a company that was always run as a private entrepreneurial business, they were primarily competing with the state-owned enterprises. You see that pattern so often, is when you pit the private, fast-moving competitor, versus the state-owned enterprises, it's generally the private company that tends to win over time.

That’s certainly always appealed to us about Ping An. But then you go a layer deeper and you think about, all right, where is the company special, or why is it succeeding? You just look for those signs of excellence, where the company's just operating a lot more efficiently than its competitors. You can look at examples of that for Ping An, so in terms of life insurance, Ping An, the old saying is that life insurance isn't bought. It is sold, right? You need to have someone to come to you, they need to explain it. It's not something you just wake up and go, “Yeah, I'll buy some life insurance today."

Your agent force is very important, and Ping An always placed a very large emphasis on training their agents. Workshops, teaching them what insurance products make sense for customers at different life stages, really teaching them how to sell, and importantly, they very much always focused on how do we sell the more profitable, longer-term, what I would call true life insurance policies? Whereas a lot of the SOE competition would get carried away selling shorter-term savings products that were much easier to sell, but would look good from basically a FUM basis, but were pretty weak profitability.

And because Ping An invested and really concentrated on the agent force, you saw the positives. Their agent force would have far less turnover, their agents would make roughly two times more income than similar agents at competitors. What that meant is just over time, one, you kept the better-quality agents, and two, you just attracted high-quality staff overtime, and that makes a big difference.

Other examples is just one of the impressive things about Ping An is the money they've spent in FinTech. This all really started with Ping An basically saying, "Look, we want to develop software and technology internally to run our insurance businesses better." You've got to remember these are insurance businesses at incredible scale, so Ping An at different stages have had over half a million agents working for them. So after building those systems they then said, "Okay, well, can we actually take this further? Can we open up our systems in terms of software business and actually sell that technology to other businesses in China?"

So, we've got a unique way to approach that and that's led them to kind of develop some pretty impressive software and technology businesses servicing the financial community in China. So it was those factors that always appealed to us, and so look, this is, again, it's a serious company who should win in the long-term.

You recently added online travel agent, Booking.com to the portfolio. This was once a market darling and probably one of the best-performing stocks I can think of since the GFC.

Yeah.

But fears about Google entering the space and hotels offering discounts to book directly have knocked valuations down across the sector. What's the case for Booking.com?

Look, I think Booking's an interesting case and we can cover those two issues directly. But, look, when I look at Booking, I don't see a big problem that's scaring the street, and also there's no amazing angle that I don't think the market particularly doesn't understand for Booking.

I think, overall, this investment is... Look, this is a very high-quality business, it meets a great need for both the hotelier who always has unsold inventory, so they want to sell those rooms, and users. You know, because hotel pricing's dynamic, it's always changing, there's a lot of value to jumping onto Booking and searching for different hotels because more often than not there'll be a hotel owner on there looking to discount rooms to fill and you'll get a good deal.

It's a high-quality business, it's serving a real need, and then I think there's enough growth tailwind. The business is growing at about 10 per cent per annum, and they've got enough growth tailwinds to really sustain this type of mid to high single growth going forward, and those growth drivers are simply in the West we're seeing, I guess there’s a trend of people wanting to spend more on experiences to go travelling, do things, rather than maybe spending their money on more material possessions or more stuff.

The second big driver is just that outbound wave of tourism coming from China. If you think, today, roughly 15 per cent of Chinese nationals have a passport, that compares to maybe 50-70 per cent in most other countries of the world, and really that will only grow, and I think the Chinese outbound wave will continue to grow from here.

On the concerns around Google, in terms of what Google's doing, I don't think's that different. Google for a long time has been a huge partner of Booking.com selling them travel-related keywords, and what Google's trying to do is really become a bit more of a metasearch proposition where you can go and type in your dates and it will present hotel options to you, much like you see on KAYAK or Trivago or even TripAdvisor today. But their business model is still getting that lead and then passing that lead onto the OTAs, because it's the OTAs paying for that lead.

So I don't think it's a vastly different change to the competitive landscape, and certainly the chain hotels have been doing their best to try and attract people directly to their websites to book direct. The simple reality is yes, if you're going to London and you know you want to stay at the Intercontinental London, then booking direct on that website will probably get you the best price or get you a free breakfast.

But the other side to that is, well, if you're not set on the Intercontinental, again, you can go onto Booking.com and there'll be many hoteliers who may be wishing to discount to fill a room, and hence you may get a better room at a cheaper rate by going off and searching. I think that’s one of the real reasons why the whole book direct wave has not really had a lot of impact on these businesses and I think shouldn’t have too much of a pronounced impact going forward.

Okay, last one, Clay. The oil space has been a bit of a graveyard for investors over the past few years. What’s your general view of the sector and what’s a current opportunity?

Yeah. No, look, understand that. We've taken some hits in this sector, but we're still reasonably positive. So you think about our investments in oil, so we've got to hark back that it feels a long time ago, but the oil price collapsed in October of 2014, so we're now five years on from that oil price collapse and it's been a period where industry capex has been down 50 per cent, and so we've had five years of the industry being in a fairly large recession.

In terms of how we've invested in this sector, our first wave was to buy the oil producers with just a belief that, look, oil markets will tighten over time, the price should rise and the producers will be the first to benefit from the higher oil prices. And largely that was a profitable investment. The second wave of our activity was going onto then buy some of the companies that provide the capex side of the equation, so when the oil companies start spending again. Now, this has been the painful area of investment and these haven't performed well and we’ve taken some losses here.

But why are we still positive on the capex producers? And I guess the case for oil is this. So, again, we've had industry capex in recession for five years now. The oil industry has always been about replacing a depleting resource, so if you think about the world consumes roughly a hundred million barrels of oil a day, on average, demand for oil grows at one million barrels per day, per year, and really this has been driven by China, India and Southeast Asia.

But we need to find that one million, but on top of that we also need to replace the natural decline rate of the fields, and globally the fields deplete at 3.5 to 4 per cent a year. So, just to keep round numbers, in any year we probably need to find four to five million barrels of oil to meet growing demand and to replace that decline. Now, what we can observe is that, look, oil has been getting harder to find over the years. The oil industry was not drilling shale and going and developing offshore kind of oil reserves for fun. These were the hardest and most expensive sources. They were doing this simply because the nice, cheaper conventional oil resources onshore or in shallow water, they just weren't there. We were running out of it.

So looking forward, why would oil capex pick up from here? Obviously, the story in this industry has been the effect of shale. Now, we can look at can shale meet the needs of future demand but also replace that decline rate over time? So despite the hundreds of billions of dollars thrown at the shale oil industry, the maximum amount of oil production shale has ever brought on in one year is 1.3 million barrels.

I think you can kind of say, look, shale can't do it on its own back alone. I think the other interesting factor is over the past five years, you've had offshore and conventional oil projects that were sanctioned in 2010 to 2014. These are generally projects that have a long lead time, and they were coming on from '15, '16, '17 and '18 and providing some supply to the oil markets while prices were still low as those projects were being finished.

Really, the bulk of those projects now is done, so the cupboard is starting to look bare, so if shale is going to struggle to do a lot more than 1.5 million barrels a year, we've got to ask where are the other 3.5 million going to come from, and we think that needs to come from new oil capex and will need to come from offshore development to some degree.

That's what we're starting to see the first green shoots of activity around, so you're now starting to see investment decisions around offshore resource development starting to pick up. You look at a business like FMC Technip, over the last seven months they've...new project decisions to the tune of $5-6 billion, and that's why we're still confident that you will see inactivity pick up in this space and we can still make money from here.

Brilliant. Okay, Clay, we'll let you go and let you go and find some more stock opportunities, but we really want to thank you for your time.

More than welcome. Thanks for your time, Nathan.

Thanks, Clay.

Bye bye.

That was Clay Smolinski, Portfolio Manager at Platinum.