An edited transcript of an interview between Australian Ethical's Head of Domestic Equities, Mike Murray, and his colleague, Maria Loyez.
Maria Loyez: In our asset allocation and particularly our multi-asset funds, Australian Ethical factors in inflation and what's happening in the macroeconomic environment, but from a domestic equities' perspective, you think about that a little bit differently. How are you thinking about inflationary pressures?
Mike Murray: Inflation matters a lot to long-term returns, but just because we're in a higher inflationary environment that's had consequences for, for example, resources companies, oil companies, we're not actually changing what we do. Just because the oil price is higher, we're not going to start investing in fossil fuel companies. We're a true-to-label ethical investor. We spend a lot of time explaining to people what we stand for and we don't intend to change.
But I think the difference between running a multi-asset portfolio and running a bottom-up equities fundamental portfolio is that we're spending less of our time trying to understand what the next inflation number might be and more time with the individual companies, understanding their business models, making sure they're resilient to a higher inflation environment. For example, do they have pricing power? Do they have too much debt, which they're going to have to pay a higher rate of interest on? Or in the case of some smaller capitalization companies, do they need to pivot their business model from growth to free cash flow generation? We're focused on identifying resilient and sustainable business models than we are about trying to pick macro trends.
Loyez: A lot of ESG funds are not invested in fossil fuel companies. What's the difference between ESG integration and what we do as an ethical fund?
Murray: It's important to distinguish between ethical investing, which often involves negative screens and aligning portfolios with an ethical charter in our case, which we hope represents our customers' values and a sort of light touch strict ESG integration approach. And I'd characterize light-touch ESG integration as being prepared to invest in most companies as long as you've integrated a particular ESG risk or concern into your valuation. And so, you may invest in a fossil fuel company if you're comfortable that on a risk-reward basis, the returns exceed the risks of investing in that company. So, we're different. We wouldn't invest in fossil fuel-oriented companies really under any circumstances.
Loyez: Which sectors or ASX companies have outperformed or surprised you this year?
Murray: One area that we do invest in in resources is lithium. And we came across Pilbara Minerals [ASX:PLS] several years ago, and we put money into it at around about $0.70, and it promptly fell the $0.15. So, we're no strangers to volatility. It's currently trading over $4. So, that's been an example of a company that's really outperformed our expectations.
I'll give you another example. It's a little bit more normal. Insurance companies are a bit more boring. General insurance companies, you would have expected them perhaps to do poorly, given we've had such severe weather events around the country. They've actually held up quite well, and I think it's an example of companies like Insurance Australia Group [ASX:IAG] and Suncorp [ASX:SUN] that have very strong business models with strong degree of pricing power. And what those companies have found is actually as interest rates have risen, they're getting more return or high yield on their investments. So, we've found those companies quite a defensive place to invest in this environment.
Loyez: Are there any themes in the ASX at the moment that you're particularly excited about?
Murray: Yes, and I think that's a really good question, because even though markets have bounced, we're still finding companies and opportunities that we like. One of the companies we think that hasn't benefited to the extent it should have from higher energy prices is Contact Energy [ASX:CEN] based in New Zealand. We've just had two of our analysts actually visiting Contact Energy. And the reason we like it is because New Zealand is about 85% renewable power and it will probably go to sort of 90% or 95% renewable power, and they are a major player in geothermal hydroelectric power over there, and they've actually got a major new geothermal project coming online. And you can buy that company today for about 12 times EBITDA, which we think is very reasonable for that sort of asset. It's quite defensive. It gives you a dividend yield of about 4.5%, and we think that dividend will grow at about 5%, giving you a total return of probably somewhere around 10% for an asset we think is sort of below average market risk. So, that's an example of the kind of thing that we're excited about at the moment.
There are also other things we're excited about. I'll give you a different example. Capitol Health [ASX:CAJ] is a Victorian community radiology player. We got involved in that some time ago as a turnaround situation. They've been improving their margin. Their earnings are improving as they come out of a COVID lockdown period. They're conservatively geared. And we think those earnings being radiology-based are quite defensive to a higher interest rate environment. So, they are two examples of things that we like at the moment.
Loyez: Looking forward to, again, to 2023, are there any themes or opportunities – we talked about renewable energy, we talked about healthcare – what are you seeing as the opportunities in those or other sectors for 2023?
Murray: Look, one of the things that we've seen quite recently is we've seen small cap software technology companies, and in fact small cap companies in general sold off quite aggressively in an environment of higher interest rates. And I gave you the numbers before that actually that's been where we've found some of our best long-term opportunities through time.
So, to give you an example, we're very early investors in Pilbara Minerals at around about $0.70. Another company CogState [ASX:CGS], which is a global cognition, a digital cognition company providing services on big pharmaceutical clinical trials. It's another example of a company we identified very early and has grown very significantly in valuation and earnings terms for us. So, we do think that the environment for small caps recently has been challenging, but that's likely to throw up opportunities.
What we're seeing at the moment, and particularly in small cap software companies, is those valuation multiples have come back to what we think are very, very attractive levels, and that's bringing corporate activity into the sector. So, we've got a company in that space at the moment called Nitro Software [ASX:NTO] that's under takeover and that plays against some of the big boys, Adobe and productivity-oriented enterprise software.
Another company we really liked that upgraded – it's a smaller cap company – its earnings recently is called Gentrack [ASX:GTK]. It's a billing software company. It's positive free cash flow. It's got no debt, and it trades sub 2 times EV to revenues, which is, again, we think a very attractive level for that style of company.
Maria Loyez is Chief Customer Officer and Michael Murray is Head of Domestic Equities at Australian Ethical, a sponsor of Firstlinks. This information is of a general nature and is not intended to provide you with financial advice or take into account your personal objectives, financial situation or needs.
This is an edited transcript of Maria and John's interview published 1 February 2023. View the original interview here.
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