How the best-performing Aussie large-cap fund for FY22/23 achieved its results
This article was originally published by Livewire Markets, 19 July 2023
I once had a mentor explain to me that ‘boring’ is good when it comes to funds management. Yes, we all want some excitement in our lives but the stock market is not the place to seek it.
“If you want some excitement, go to the track,” he would say, “if you want to make money in the market, consistency is the key”.
He would add that the real excitement when it comes to managing money was in sticking to your process, executing your strategy, and adding value – i.e. ultimately watching your investment grow handsomely over time.
If that holds true, then the team over at Merlon has surely had its fill of excitement over the past 12 months.
The Merlon Concentrated Australian Share Fund topped the Livewire rankings for Aussie large-cap managers in FY22/23, with a 24.13% return. The fund also ranks seventh in the Livewire database for Aussie equities (both large and small cap) over a three-year period, with an annual return of 17.26% – proving this year’s result was no fluke.
Importantly, the Merlon team achieved these results by sticking to their guns, executing their truly benchmark unaware process, and not chasing rockets under rocks – rather, the performance has been spread across a number of stocks, highlighting a knack for quality stock picking.
In the following wire, the Merlon team shares a little more about their process and how they are seeing markets right now.
Could you pick two elements of your investment process and explain how they contribute to the fund’s investment returns?
One of the key elements of our process is expressing fundamental company valuations as a range rather than relying on a single, central case scenario.
Having a clear view of the bear and bull case scenarios not only helps us identify when the market has become overly pessimistic or optimistic about a company’s long-term prospects, it also limits the risk of permanent capital loss if we get things wrong.
Another key aspect of our process is constructing a truly benchmark-unaware portfolio of our best ideas rather than investing in stocks simply because they have the largest index weights. This is especially important in the Australian market which is highly concentrated in the macro-sensitive banking and iron ore sectors, and a handful of other crowded stocks.
Which investments have had the most meaningful contribution to your performance over the past year and do you still own them?
The Fund’s performance has been relatively broad-based. Investments in energy retailers AGL Energy (ASX: AGL) and Origin (ASX: ORG), coal miners Whitehaven (ASX: WHC) and New Hope (ASX: NHC), general insurers IAG (ASX: IAG) and QBE Insurance (ASX: QBE) along with Super Retail Group (ASX: SUL) and Qantas (ASX: QAN) have been the largest contributors.
We have a strict sell discipline and have exited our investments in the coal miners, Origin Energy, Super Retail and Qantas as the market shifted from being overly pessimistic to overly optimistic about their long-term prospects. We formed this view when their share prices approached our bull case valuation scenarios in recent months.
Could you talk through some of the largest investments in the fund and why they deserve a spot in your portfolio in the coming 12 months?
Our investments in the general and private health insurers have performed well over the last year, but we think are well placed going forward for a few reasons. They are high return on capital businesses, with leadership positions within strong industry structures.
The pricing environment for insurance premiums is strong, their investment earnings benefit from higher interest rates and their earnings are largely uncorrelated with the economic cycle.
AGL is another company that we own, and while we have seen it appreciate substantially from when we first invested last year, our bull case scenario remains well above the share price. It has a strong retail business with a valuable customer base that is underappreciated due to the market’s focus on the generation assets. With regard to generation, our process recognises the highly cash generative of the assets as well as the wide range of outcomes based on a range of closure/energy transition scenarios.
Which investments worked against you in FY22/23 and what have you done with them?
FY23 was a great year for our investors and builds on several good years. From an absolute return perspective, we didn’t have any investments that declined materially, so it was more of a case of opportunity cost of not investing in other stocks that also performed well.
Our returns would have been even stronger if we had invested in the iron ore miners which are benefiting from unsustainably high prices in our view. We prefer to invest in commodity stocks when prices are depressed forcing an underinvestment in new supply and this is not the case at present. A rebound in “tech” stocks that generate only modest free cash flow relative to their market value also worked against us from a relative perspective this year.
What kind of market conditions do you expect over the coming 12 months?
Forecasting is difficult and macro forecasting even more so. More relevant than our view is what is priced in, which is increasingly the “goldilocks soft landing”.
What is not priced in is persistent inflation above central bank targets or a recession to eradicate it.
These scenarios favour active management, a focus on near-dated cash-flows, conservative discount rates, and caution on leverage.
How will you be positioning your investments if your base case plays out?
We don’t build the portfolio based on a single macro view and instead concentrate our investments in undervalued companies where market participants have become too pessimistic.
Having said this, our portfolio is well positioned if inflation proves more persistent as we focus on under-appreciated cashflow rather than the potential for longer-dated growth and have consistently factored in higher real bond yields in our valuations. Our portfolio is also well positioned, in the likelihood of an economic and earnings downturn.
We are materially underweight late-cycle banks that are not pricing in a turn in the credit cycle and are now underweight commodity exposed stocks that will not be immune from the lagged global economic slowdown triggered by rapidly higher interest rates.
The Merlon Concentrated Australian Share Fund is a portfolio of what we consider to be undervalued companies constructed without regard to index weights. Learn more >>