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Rudi Interviewed: August Focus On Quality

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Aug 10 2022

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As has become an unofficial tradition, FNArena Editor Rudi Filapek-Vandyck was interviewed by Livewire Markets co-founder James Marlay ahead of the August results season in Australia.

A link to the video which can also be viewed via YouTube is included at the end of the edited transcript below.

James Marlay, co-founder Livewire Markets:

Last time we had a chat, a little bit of a debate erupted in the comments section [on the Livewire website] and the general context was about you holding extra cash in your portfolio, given the uncertainties you had identified in the market.

So, before we get into the reporting season, I want to hear your views on the idea of timing the market, because it always draws debate. I'd really love to hear what your views are on that particular topic.

Rudi Filapek-Vandyck, Editor FNArena:

This might actually surprise you. I've seen many statements like: it's a bit foolish to try to time the market. And I agree with that.

I also think there's a misunderstanding amongst investors about when someone like myself increases the cash level in the [All-Weather] portfolio.

That's not because I try to time the market, it’s done because I make a risk assessment.

I think investors put too much emphasis on trying to sell at the ultimate peak in the share price and to buy back in at the ultimate bottom of the share price.

There is way too much emphasis and too much effort for something that is very difficult to achieve.

But what we all can do, if we take good care of the money we have in the market, we can all assess the risks; whether they increase or decrease.

And when risks become very, very high; whereby I suspect there is an above-normal drawdown waiting to happen in the market, then I wouldn't be a cautious investor if I would not increase my level in cash.

That's basically the long and the short of it. I'm not timing the market. I'm simply adjusting the [All-Weather] portfolio in line with my assessment of the risks that lay ahead.

To put this in very simple terms: when you leave the house and you look out the window and it's raining, you take an umbrella with you. That's just the normal thing to do.

The same thing applies to the share market. When the only thing that's going to work is keeping your money in cash, why wouldn’t you do it? It is but the logical thing to do.


That conversation happened back in February. More recently, you talked about phase one being the quality recovery.

So, my question to you is: are you carrying more or less cash than when we spoke in February and can you articulate some of the thinking behind your position right now?


I think this might surprise you and some of the viewers, but I have done very little since [All-Weather Model Portfolio] raised the cash level earlier in the year.

I've basically been sitting on the stocks I've felt comfortable with and that cash was just sitting on the sidelines.

In recent times the [All-Weather] portfolio re-allocated some of that cash back in the market, but still holding more than 22% in cash at the moment.

As I always like to point out, [a bear market] is a process and effectively what has now happened is the risk is now shifting towards corporate results. There’s more than likely a recession on the horizon, so the risk is not necessarily diminishing.

Risk is descending from the macro level, which previously consisted of high valuations with very low bond yields. As those bond yields had to reset, the share market had to come down in terms of valuation, and that has now happened.

But now we're going to find out how sturdy and resilient companies are in the face of all the challenges that already have exerted themselves this year and, equally important, in the face of the challenges yet to come.

This is where the true challenge for investors lays in the upcoming reporting season.


Interesting, even in some of the early reports that are coming out, you're seeing some big moves based on the fundamentals that companies have reported.

We've seen some big surprises and we've seen a couple of big disappointments. Most recently we’re talking about Appen ((APX)) with its share price down -30% last time I checked.


And we have also the likes of United Malt Group ((UMG)), which yet again issued a profit warning. Needless to say, shareholders cannot be happy with what's happening with that share price.

We also have some smaller companies [disappointing], the likes of Nitro Software ((NTO)), for example: big reset in expectations, thus big impacts on share prices.

Then you have the likes of Bega Cheese ((BGA)); again, big drawdowns.

This is one of the reasons why I believe holding a big chunk of cash is still valuable.

Because you can't predict all these drawdowns before the season. There are many challenges out there and we can only adjust our views once we see the details that are coming out of those companies.

Not in advance, as we don't yet have all the details available.


I was reading through one of your most recent notes and against that uncertain backdrop that we've had there's been a gravitation towards resources companies, but you're not convinced?

Can you talk me through your circumspect position on resources companies?


I'm trying not to laugh too hard.

There's a fundamental misunderstanding amongst investors about how price earnings (PE) ratios work. And I've seen this throughout the whole year.

If you look at the likes of BHP Group ((BHP)), Rio Tinto ((RIO), Fortescue Metals ((FMG)), BlueScope Steel ((BSL)), Woodside Energy ((WDS)) and Santos ((STO)); they are all trading on a mid-single-digit price earnings ratio, based on the forecast 12 months out.

This is not because those companies offer great value. This is because the market is preparing for a recession.

The fear is those companies are enjoying peak-of-the-cycle product prices for crude oil, iron ore, copper, nickel, you name it.

So, you are not by definition buying a bargain because it's only trading on a PE of seven. You have to take the view that the price of iron ore or crude oil is not going to fall.

If we have an economic recession coming up, that is a big call to make [that those prices won’t fall].

My favourite response when I am confronted with such views is I try to turn it into a little bit of a joke.

I say to people: let me check the last time that commodity prices held up in an economic recession.

I then run through my papers, do an extra check of history and then go:… the last time this happened… oh, that’s right, it has never happened before!

So basically, if you put all your money in commodities, you are hoping that this time is different, and that this time, prices will hold up in the face of a recession, which has never happened before.

Let’s go back to your first question: I said successful investing is all about managing risk. It doesn't seem to me that betting hard on commodities equals managing your risk very well.

When I manage risks, I'm definitely not going to be taking a large leverage to a forecast that if it proves wrong, I might lose my shirt and my trousers.

I think it is most important as an investor to realise investing is not about making forecasts. It’s about making sure that if the forecasts you’re making are wrong, that you don’t end up going down by -30%, by -40%, or by -50%.


Alrighty, the flip side is that you are interested in looking at some of the technology companies and some of the smaller cap stocks; companies that have really borne the brunt of the selling.

Is that because you like that area, or because you think a lot of the bad news is already in the price?


There are two sides to that. One: I have been waiting until I could feel comfortable with where bond yields are, because bond yields ultimately are the master of everything.

I think bond yields have peaked, for now, which probably is a fair assumption to make. Unless we are all reading inflation in the wrong way.

That means the higher multiple growth companies no longer have to fall on the basis of bond yields rising. So now it becomes an individual story.

Now it's about picking the quality in the sectors you like. And quality, in this case, means you should have an eye on how resilient are businesses going to be in a recession?

As I explained earlier, that is the main question investors should now be asking.

Even if we somehow, by miracle, escape an economic recession next year, the question will still be asked by markets.

That's how I look at the share market right now.

In summary, I think an era of quality is opening up and it's no coincidence that, for example, CSL ((CSL)) is back at almost $300, TechnologyOne ((TNE)) is at $12 and Goodman Group ((GMG)) is back above $20.

You’re seeing the quality companies in each sector taking the lead in the recovery. And that is basically happening on that same philosophy I just explained. Other people are thinking the same way.


You named three companies. They're not exactly what I call small caps.

Are there similar areas, outside of the well-established names, that you think have the potential to be quality leaders across a few sectors?


One of the small cap stocks that I've held on to throughout this year’s turbulence is IDP education ((IEL)).

[The All-Weather Portfolio] halved its position in that company and recently it was topped up again.

I believe this company is excellently positioned for the post-covid era; it should do well, including in case of a recession.

Obviously, we're gonna find out the answers in August.

The mega trends that existed before we saw a resurgence in inflation and higher bond yields, those mega trends will still continue.

But not every company that can claim to be supported by long term mega trends is necessarily well-run in the short term, is not necessarily profitable, and not necessarily well-managed enough to weather an economic recession.

Hence, it's still a field full of landmines [out there]. I believe that putting an emphasis on quality in each sector that you're looking at will pay dividends.


Let's get on to reporting season because that is the catalyst for us to have a chat.

Before we get into it, is there a chart or a statistic that you can draw on that you think is really important for investors as we head into reporting season?


I am assuming most people know what we’re doing at FNArena. For those who don’t: we also collect data on stockbrokers.

This might surprise a few people, but the total percentage of Buy ratings in Australia is still 59% – near a decade high.

On that basis, you have to conclude two things: this is still a bear market, plus a lot of corrections still need to happen in terms of forecasts and in valuation modelling for companies.

August is not going to give us all the answers. It’ll probably happen in August and February next year. But forecasts are probably too high.

Another statistic I find very interesting is that the average savings rate in the United States is declining, and quite rapidly so.

I can pick up on that because my impression from surveys done in Australia is that the Australian consumer and Australian house owner has been quite resilient but also quite ignorant about what is basically laying ahead.

I think the consumer in general wants to keep doing what he/she's been doing in past years but, ultimately, he or she will have to be forced into changing habits.

That's one of the reasons why I think the changes that will come through on the back of higher interest rates are very slow-paced; we all have to wait until the true effects show up.

I do think investors are realising this and they will be very hesitant to pile in into housing-related companies in Australia and in retailers etc.

It is also becoming clear in the United States that the divergence between new orders and inventories is widening almost every month now and that is not good news either.

This in itself will prove deflationary. It also increases the chances significantly that companies will be left with too [large] inventories.

You can see the bad news building if you have an eye for it.


I noted in your most recent article to FNArena subscribers, you said on face value the Australian market “looks” like a bargain hunters paradise, with the key word there being “on face value”.


There are two elements to that statement. First of all, if you take the average price earnings ratio for the ASX200, it's now 13x-something and it was as low as 12x-something a little while ago.

Historically, that looks like very, very cheap. The problem with that is, of course, the numbers behind the average tell a different story.

We have, for example, BHP making up 11% of the index. We have to go back two decades before we had another example of one company [News Corp] representing such a big chunk of the index.

Long story short: after the banks and the financials in general, the energy sector and the mining sector in Australia are the second largest contingent in the index.

Combine the banks and financials with the miners and energy companies; they're all trading on below market average PE ratios.

That’s more than half of the index trading below the average which shows you the other half is trading well above 20x.

I just mentioned CSL. That stock is trading on 36x.

But as I explained earlier, the fact the banks are trading on PEs of 11-12x, with exception of Commonwealth Bank ((CBA)), plus the fact that BHP, Rio, Woodside, etc are trading on a PE of six or seven, that's not a cheap market.

That shows you the fear for a big recession coming. Those low PEs give investors the wrong impression.

The other big question mark is: are we in a down-cycle for profit forecasts? If forecasts have to be cut, this means PE ratios automatically rise, assuming the share price stays the same.

You could call this a head fake because the 13x-something might in reality be more like 14x-something and if you accept that the long-term average in Australia is about 14.5x -14.7x then the share market is actually bang on valued in line with the long-term average, not cheap thus.


In context of those comments, to what extent do you think the market has priced in potential earnings downgrades, which, as I keep reading, are going to continue to flow through?


This is one of the answers we are going to find out in August.

The market previously sold down the retailers and anything related to the housing market, but both have bounced hard recently.

It may well be that we're finding out in August that it’s still early in this cycle.  Don't underestimate we just had a fantastic July. It means a lot of share prices have rallied quite hard already.

I also believe because we are looking towards a recession that hasn't arrived yet, that in particular the institutional investors will be very reluctant to join a rising share price if they don't believe that that share price will prove resilient in light of the recession that is yet to come.

History shows that if a company surprises on the upside in reporting season, that share price usually outperforms by up to four months, in a relative sense.

This time might be different, I suspect, and I think there will be disappointment in that regard.

To put it very simple: people always say the share market is all about company profits and dividends. That is factually incorrect. The share market is about forecasts of profits and dividends.

Those forecasts are going through a down-cycle and the downgrades might well last into next year.

This by definition will act as a headwind so we are looking at a share market that, as I call it, is a bit of Dr. Jekyll and of Mr. Hyde; not everything will be functioning in the same way as it has done in the past.

There will be lots of curve balls and surprises, both to the upside and to the downside.


I'd like to finish our chat on a positive note because I was telling our team today there's been too much bearishness. July was a good month. The sun's shining.

So, to finish off on a positive note, could you share a couple of companies that you think have the potential to provide an upside surprise or, if that's too much to ask, perhaps you can point to the ones that are just unlikely to be disappointing?


I actually don't think my story is that negative. Sometimes, as an investor, we have to accept that risks are elevated during certain times. This is one of those periods.

It doesn't mean that the share market can only go down by definition.

I have for years been poking fun at people who held shares in Telstra ((TLS)), for the dividend and then held on and held on while their capital eroded and eroded away, over two long decades.

Today, I believe Telstra is making a recovery and shareholders might well be positively surprised over the next three, four years.

They should see share buybacks, bonus dividends and higher dividends. The latter hasn't happened for a very long time.

Irrespective of what happens in August, whether Telstra surprises or not, I think a new trend has been set in motion.

I've been very fortunate that in early 2021, when I was looking for a replacement in dividend allocations [for the All-Weather Model Portfolio], that I chose Telstra at that point in time.

It has been a very beneficial ride since. You could say I'm talking my own book, but I truly believe what I just said.

Otherwise, I'm predominantly focused on market leaders and on quality companies. So, what I just said about Telstra also applies to CSL.

I think CSL is making a come-back. You can already see this in the share price response prior to August.

It is not about what CSL might release in August, as that might still be slightly negative. We know the pandemic has had an impact.

I think the future looks increasingly better for CSL which, again, all else being equal, should prove very, very resilient in a recessionary environment.

[The All-Weather Portfolio] also held on to Goodman Group. Obviously, if you look down from the peak, the share price has fallen a lot.

But, again, I do believe that investors who simply treat Goodman Group as a bond proxy and little else will be proven wrong.

The share price is now back above $20. This company should, above everything else, continue to be carried by a mega trend, and that mega trend is not going to disappear anytime soon.

One of the stocks [the All-Weather Model Portfolio] said goodbye to earlier in the year, because I was afraid of how far it might fall, is NextDC ((NXT)).

While reducing [the All-Weather Portfolio’s] level of cash, we bought back in recently. Again, those who are worried about data becoming a commodity are way too early in their predictions.

NextDC is, all else equal, another quality operator in yet another sector that is carried by mega trends.

Also, don’t forget that if one’s worried about energy costs and the like, this company has contracts to pass on those increases to customers.

There will be no shortage in demand for data.


The video of the interview (28 minutes):

The most recent update on the All-Weather Model Portfolio:


(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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