Listen as they discuss:

• The benefits of a separately managed account (SMA) structure.
• Sectors he favours within Australian equities.
• Why a highly concentrated portfolio of 20–25 equities is ideal for SMAs.
• Positioning the portfolio for the current market environment with rising interest rates.
• His future outlook on the asset class going into 2024.

Transcript

Welcome to Relative Return. Get closer to the people, products and strategies shaping Australia's financial services industry.

Hello, and welcome to another episode of the Relative Return podcast. I'm your host, Charbel Kadib. I'm the contributing editor of financial services here at Momentum Media, and again, I'm joined by editor of money management and super review, Laura Dew. How are you going?

Hi, I'm good. Thanks, Charbel.

So, the equities market has been incredibly volatile for the past few years. Persistent inflationary pressures and the monetary policy response has really compressed returns and here to unpack some of that dynamic and talk to us about his experience in equities and his portfolio is Adam Alexander. He's the portfolio manager, Australian equities at Schroders. Thanks for joining us, Adam.

Thanks for having me. Good morning, everyone.

Good morning. And I guess, as is customary with the Relative Return podcast, we'll start by asking you a bit about your background. So, can you tell us about your experience in the industry and what led up to you currently sort of serving in your capacity at Schroders?

Yeah, sure. So, I joined Schroders about 18 months ago as a portfolio manager in charge of the Schroders Australian equity SMA. It's a similar role to what I've been doing for the majority of my career, which is analyzing listed companies, interacting with boards, management teams, basically looking at different industry structures with the whole aim of working out the value of a company and how it compares to its share price.

Awesome, man. You talk about a baptism of fire. You joined 18 months ago at the height of volatility in the share market. What was that like?

Yeah, it's interesting. I mean, over the past few years, it's been very dynamic, the market. I think interest rates going from zero virtually a couple of years ago, they've gone up faster than anyone thought over the last 18 months, and that's really put a lot of pressure around the consumer. At the same time, we've got some geopolitical events in the Middle East that's causing some real confusion, I think, for global markets, and you're seeing a bit of a disconnect between some of the commodity prices that are moving around, and we're trying to analyze how that should affect the Australian market, and is it in the same way that affects global markets?

Yeah. Could you just unpack that for us a bit more? Australian equities, as with global equities, have really suffered. We had a bit of a rebound this side of this year. There were hopes that there'd be a soft landing from inflationary heights and that the monetary policy tightening would ease off, but those hopes were crushed in March with banking volatility and signs that inflation was stickier than markets had expected. How did you assess the market? What did you do? How do you take on your new role as portfolio manager amid all that volatility?

Yeah. It has been a really tough year, I think, for Australian equities over the past 12 months, and I think in a relative return sense, that's the case. Our market has really lagged the US market, and part of the reason for that is just we don't have the same composition of our market as the US does. The US is being really held up by a lot of those big cap, large technology stocks, Apple, Microsoft, Alphabet, and stocks like that. We don't really have that in the Australian market. Definitely more dominated by banks and resources, and those two sectors of the market have lagged. If we look at banks, they are a bit dependent on what we think about the housing cycle and how the consumers and their ability to repay mortgages, and with cost of living going up, interest rates going up, there's been a lot of question marks as to whether or not the house prices would hold up. They've held up amazingly well over the past 12 months, but there's still that expectation that at some point, the consumer will crack and will be, particularly on the discretionary retail side, start to be let down, whether or not that starts to see bank delinquencies start to move up a little bit. In that regard, it's made it harder to invest in the Australian market because we just don't have a number of those big global companies that are really being driven by technology at the moment.

Okay. You mentioned that we don't have those big Googles and messes that people are aware of. What benefits do people get from investing in Australian equities rather than these big global names?

Yeah. I think locally, we're a much higher yielding market, so probably a little bit lower growth. You do get a higher level of income in our market, particularly at the moment around the banks and resources. I think investing locally, particularly for end clients, you're really closer to the companies investing here, so you get a much better feel what drives their earnings

, what drives management teams, and ultimately, that's what drives share prices. Part of that, we're constantly meeting with management teams of companies in Australia, assessing how they're progressing versus their strategy. I think when you've got local companies, they've got local operations, a lot of the analysis can involve actually going to their sites, having a look at their operations, meeting management teams. We do a lot of that at Schroders, and that can be anything from visiting a supermarket to a lithium mine over in Perth. You certainly learn a lot. You kick the tires, and you can see how management teams bring these projects to life and then watch them create value over a period of time to benefit us as shareholders.

Yeah, and I guess looking ahead, do you see relief in sight for Australian equities? There's talk of further tightening from the Reserve Bank here in Australia, which I guess isn't good news for the share market, but do you think the worst has passed? How do you see the next six to 12 months varying?

Yeah, I think you're exactly right. Interest rates and inflation are really top of mind for investors at the moment, just from an economic standpoint. You've also got to take into account geopolitical events, but rising cost of living in Australia, it's still going up. We're still seeing inflation. The RBA, a lot of debate as to whether or not they're on hold at the moment. I think there's good reasons why we probably need to see another lift in interest rates just to get a handle on inflation and try and curb that consumer spending at the moment. It's amazing how strongly that's held up, but I think one or two more raises from the RBA will probably see us reach peak rates. And then it's a matter of how really the consumers are able to muddle through that over the next really six to 12 months. If we start to see inflation easing, and we are a little bit, I mean Woolworths and Coles reported their results recently, and they are starting to see prices come down, particularly in fresh fruit and veggies. So that's helping a little bit at the margin. If we can start to cycle over some of these higher prices, get inflation down, get the expectation of rising rates sort of out of the market, then I think we head back to sort of fundamentals and really the companies that we want to be invested in then are those that have got their future in their hands. They can continue to sort of drive revenue growth, good cashflow, good balance sheet. So over the next shorter term, I think into Christmas will be a good lead indicator on how the consumer is going. And then beyond that, if we're at peak rates, then the outlook starts to, I think, look a little bit better from where we've been.

Cool. And moving on to your portfolio, Schroders has opted to structure it as a separately managed account. Could you just explain a bit about the differences with that type of vehicle and why they opted for that over a managed fund?

Yeah, we've gone for an SMA. I think it's a great way for individuals to invest in direct equities themselves, but coupled with the advantages of a professional investment management process over the top. And what comes along with that is a team, a big team of investors. So there's 10 in our investment team, multiple years of experience in the market, and also very strong risk controls over the top of it. And so with an SMA, it's not a pooled trust where you just get units and you can't see the underlying shares. What you get within an SMA is a portfolio of stocks that you own and the transparency on all of those stocks you can see. That transparency is probably one of the key advantages. I think as the end client, you can see exactly what companies you own, how much you've got of each one, and it's all in your name. So that's unlike a unit trust where it's all pulled together and you just get sort of a one line on your statement.

Cool. Yeah. A lot of our listeners are financial advisors. So I'm sure that they'd appreciate having that full transparency available to them.

Yeah. I also wanted to say that in your sort of previous roles, you've been an analyst on areas such as commodities and consumer stocks. Are those stocks that you particularly enjoy looking into in the portfolio? And how do you divide up the stock selection with you and your co-portfolio manager?

Yeah, that's a good question. There's two portfolio managers on the SMA strategy, but within our investment team, we've actually got 10 people looking after Australian equities. And so it's one of the largest and most experienced teams in the Australian market. And everyone from our head of equities down to our youngest analyst has stock responsibilities. I look after the consumer facing stocks for the team. And so essentially what that means is analyzing and building models for those stocks. So we have about 200 models that we look after. Each analyst has got about 20 to 25 stocks. And just that breadth of sort of knowledge and experience really helps us out in trying to select the portfolio, get the stocks that we think are going to outperform the rest of the market. And by doing that, we're relying on each of the individual analysts getting right into the detail with the companies, meeting management teams, interacting with boards over quite a period of time. So it's a fairly detailed process that we go through in trying to come up with a really diversified and strong portfolio. And how has your approach changed sort of in recent months over the past year amidst all this volatility and uncertainty? Has that prompted traders and the portfolio managers in Australian equities in particular to sort of rethink those models and tweak them and adjust? So what lessons have you learned, I guess? And then how have you responded? Yeah, so our approach is really to try and value companies on mid-cycle. So we get a lot of noise coming through on a daily basis in equities. And our job is to really try and sort the noise out and work out whether or not it will actually impact the value of a company long-term. So when we're looking at the companies, we're sort of forecasting what we think their earnings will be a couple of years out. And then as share prices move around, as they obviously have done over the past six months, both up and down, it gives us an opportunity to say, right, what's driving the share price short-term? Do we think it's going to impact our numbers? How do we need to change our numbers? But if we don't think it impacts our numbers, then it gives us an opportunity to buy that stock when others may be selling it on a short-term basis. So we think we're sort of mid-term, really medium-term investors. And I think one of the best parts about it is to try and take advantage of moves in the market when you're sure you've done the work on the models, management team, share price moves around short-term. I think that provides, volatility is not necessarily a bad thing. It does provide investors with good opportunities to enter stocks where they look good value. Speaking of opportunities and good value, what good value and opportunities are you seeing in the market at the moment? What sectors are you favoring? Yeah, so at the moment, probably ones we're staying away from is some of the discretionary retail names. We think that as a consumer really tightens up, that's going to be difficult. But what is on the other side of that is companies that offer good value to consumers in the market at the moment. As you see, consumers sort of trade down, look for value. Then companies that have a value premise will do quite well. And in that regard, names like Kmart and Bunnings, obviously both owned by West Farmers, but they're having quite a strong trading period at the moment as consumers trade down. The supermarkets also doing reasonably well, look attractive at the moment because customers are eating, consumers are eating more at home than going out. And companies like the supermarkets are consistently able to raise their prices. And that's something that we've really looked into through this inflationary period, is companies that have been able to demonstrate some really good pricing power across the market. A local company here that operates internationally is Brambles, makes pellets. They didn't basically put their price up for 10 years before COVID. And then post-COVID out of necessity, they were putting their prices up and those prices have stuck. So we've seen really good revenue growth from Brambles. We think that'll generate higher returns over a period of time. And that's a stock that we've been adding into the portfolio as the sort of industries across the world have changed coming out of the back of COVID. Awesome. And I want to learn more about, I guess, what's involved in the research. So how do you go about looking into those sectors and identifying trends? What's involved in that process? Yeah, so it usually starts with meeting management, meeting with industry consultants, industry participants, getting a real feel for the industry that that company operates in as a whole. And then from there, essentially, you're building up a financial picture of that company, how it's going to look today, how it's going to look in five years. And then looking at all the things that could impact those earnings over a period of time. So if it's a consumer-facing stock, you're obviously looking at the economic cycle. If it's a commodity stock, we're looking at where we are in commodity pricing. And then you're putting that all into your model to really create a long-term financial picture of that company. And then we get, at the end of the day, that will give us a valuation. And then we're comparing that valuation to the share price. We're always coming from a fundamental view that value is extremely important in our analysis, and we want to be investing in companies where we think there's a great deal of cashflow coming through, great management team, strong balance sheet, and that the earnings are durable over a period of time, so durability, sustainability of earnings are probably two of the highest factors that we have going into our models, and that means when we're investing in companies every six months, we're reviewing their performance, we're checking what the company has delivered versus what we expected, adjusting those models and valuation, and then making sure that it all fits within the portfolio. And has that changed since COVID? I'm thinking in terms of, are you doing this research and speaking to managers remotely, or are you, now the travel restrictions are over, are you going to the factories, to the manufacturing plants, are you going to see them in person? Yeah, so for a period of time, it was obviously all on Zoom and all remotely, but that certainly has opened up now. So my co-portfolio manager, Ben, has just come back from a two-week long trip around the US, where he was meeting with, so he covers the industrial companies, Brambles and Amcor, companies with some of their operations in the US. So he went around there meeting their management teams locally on the ground, having a look at how their operations were going, and it's been a big period that we weren't able to go and do that through COVID. And so getting out there, re-engaging with these management teams, getting back and looking at the plants and operations is a big part of the investment process. And so being able to do that again and travel has been really good. And then the companies recognise this and the companies are starting to really organise a lot more of these site visits for investors to get out and do it. It would have been maybe say three months ago, I was over in WA looking at West Farmer's new lithium mine that they're bringing on. That'll start production at the end of this year and start selling into the beginning of this year, but all the companies are doing it. And I think it's invaluable to get out, kick the tyres with management and have a look at some of the projects and where your shareholder capital is going. Yeah, great. So you've done the research and then you've done the visits, then you've narrowed it down to which ones you want to hold, and you only have about 18 to 25 stocks. So that's quite highly concentrated. How do you decide which ones you like best and what are the benefits of being more concentrated than others? Yeah, I think your concentration works really well in an SMA because all the stocks are held in the client's name. And so if you've got say a 70 stock portfolio, that can be very hard to keep track of. Even for a professional investment manager, 70 stocks is a lot. So we find that concentration and that 20 to 25 stock level gives us a great deal of conviction in the companies that we invest in. So we've got to be very selective, I suppose, in trying to narrow that universe. So we look at the ASX 200 and we're trying to get that down to 25 stocks in the portfolio. And that really is going through that investment process, narrowing down the companies where we see value and upside in our valuation versus where the share price is, but also creating a degree of diversification across the portfolio. So we're really designing this portfolio so that it performs well through different economic cycles. And in that regard, we're generally going to have an exposure to most sectors in the market. And so what you're doing from a conviction point of view is really looking for probably the two best companies in each of the 11 sectors of the market. And if you're getting the best two in 11 sectors, that's giving you basically just over 20 stocks. And then one or two, three, either side of that where you think the industry's changed post COVID. So airlines at the moment, Qantas is making much more money than it did pre-COVID. And that's an industry that looks a lot more attractive now than it did pre-COVID. And so there's elements like that where industries are changing, companies have changed, and those companies sort of come in and out of the portfolio. And then when you go to sell something, is it one in one out or are you quite happy to sit in cash for a while until you find a better opportunity? Generally, it's one in one out. So we like to be fully invested in the Australian market all the time. We've got a limit on the amount of cash we can hold and that's 10%. Typically, we don't get anywhere near that. So generally, we're holding 2% to 3% of the portfolio in cash. That gives us a little bit of flexibility in case we want to buy something one day, but we haven't got a stock to sell it at that moment. And so that gives us that little bit of flexibility, but essentially we're almost one in one out when we make the investment decisions. And how do you reconcile differences of opinion between your analysts? Is there an objective standard that you follow before making sort of your ultimate determination? Yes. So what we do as a team, so before everyone's got about 20, 25 stocks that they cover, before that valuation goes into our system, we sit down as a team, all 10 of us and work through that model. So the analyst will write a 10 to 15 page report. They'll present that report to the team and basically run through from the start how the company makes money, essentially how it sells, whatever it's selling. And then we go through the P&L, the forecasts from today and then what the forecasts are at five years and how the analyst gets there. Through the team, we then pick apart the assumptions in quite a detailed way. So these meetings generally go for an hour and a half, two hours as we go through line by line, each of the analysts model. And then at the end of the day, as a team, we come to a valuation that we're happy to lock into our database. And then once that goes into the database, the Thresholder's global portfolio management systems will give us an indication as to how much of that stock we should be buying or selling across the different portfolios that the team manages. So we've got, I think it's quite a detailed process. We're doing those stock discussions two to three times a week. And so the numbers in the database are extremely fresh. We can pull up models anytime we need to assess the individual stocks. And I guess on the human side, when returns aren't as strong as sort of previous cycles, investors do get a bit jittery, clients do get a bit jittery. So how do you go about sort of managing client expectations and what would you say to investors who are still quite reluctant to opt into Australian equities or at least sort of put in a fair bit of capital into that asset class? Yeah, it's interesting at the moment because given where interest rates are, you're getting paid reasonably well to do not much at the moment by having your money in the bank. And so what we're really looking to do is invest in companies that can grow their sales and grow their profits, plus pay a dividend that will give you a higher return than just what you're getting in the bank. And there is, in the Australian market, and we've seen this sort of coming out of COVID, there's a lot of companies out there that have pretty good pricing power and ability to control costs. And so we are seeing some pretty strong profit growth out of a number of the blue chip companies. And we expect that to continue over the next couple of years. If you can get that out of some of the blue chip companies growing sales at 5% plus, that drops down to maybe 10% growth at EBIT, plus a dividend yield, then you would expect returns coming back in that 8%, 9% range, which is sort of what we're targeting year in, year out over a diversified portfolio in the Australian market. I think the long-term average is around about 7%. And so with Australian equities, you need that diversification. So you're getting decent dividend yield and cashflow out of your financials exposure, resource exposure at the moment, given where commodity prices are is also paying quite good dividends. And then on the blue chip industrial side, you're really looking for that sales and earnings growth over a period of, into those mid-cycle numbers. And I guess finally, how confident are you that you'll beat the benchmark moving forward over the next 12 months? Of course, the performance has been subdued across Australian equities over the past year. So for those investors who need some encouragement, sort of how confident are you in your sort of performance over the medium term, I guess? I'd love to be very confident, I would. And I think what helps me and our team be confident is the process that we go through. And I think markets will go up and down and there'll be sectors that are in favour, driving performance, there'll be sectors that are out of favour. But I think given our process, that sort of focus on the mid-cycle, we tend to look at performance over a two to three year window. And I think being invested in the market for that medium term is what investors really need to think about. Moving in and out on six monthly basis and seeing the news flow sort of throw markets around and create volatility. I think you've got to take a bit of a long-term view, look through that, look at the companies and their earnings, the cash flows that they can generate over a period of time and the excess returns that some of these companies have been able to do over a long period of time has generated good returns for investors that have stayed invested in the Australian market. So on a six month view in terms of performance, that could go anywhere, but on a two to three year view, we're confident that Schroder's investment process will stand the test of time and do well in a variety of market conditions. Absolutely. Fortune always favours the brave and sticking it out always usually delivers positive results, as you said, over the long term. And for investors and advisors who want to learn more about Schroder's and its Australian equities portfolio, where can they find you? The best way to go is through the website at schroders.com.au. And if you navigate from there to the Schroder's Australian equity SMA, there's a lot of detail on there, particularly for advisors on the advantages of an SMA, how it helps advisors and sort of a bit more on our investment process and the depth and detail we go into there. So that's probably the best place that both advisors and end clients can have a look at that SMA products in a bit more detail.

Awesome. Thanks so much for your time, Adam. It's been great chatting with you.

Thanks for having me. Good to chat. Cheers. And Laura, thanks for your time for the second Relative Return podcast running.

Yeah. Thanks for having me. And to, I guess, keep in touch with what's happening in the market. Make sure you follow moneymanagement.com.au, ifa.com.au, superreview.com.au, and investordaily.com.au.

And until next time, thanks for joining us. And until next time, thanks for joining us. Bye.