Fund Managers’ Favourites: Recovery Investing

Transcript:

Alanna Petroff: Being a contrarian investor can sometimes be difficult. You need guts of steel to really invest when everyone else is running away scared, and that's why I'm joined today by Alistair Mundy. He is a very successful contrarian investor from Investec and we're going to talk about contrarian investing, but not just about investing when companies are hitting their lows. We're going to talk about once companies have hit their lows and now they are in recovery phase.

So, Alistair, thank you very much for coming in today.

Alistair Mundy: Thank you very much

Petroff: Now let's talk a little bit about your overall strategy. You take that contrarian stance, but tell me a little bit more?

Mundy: Yes contrarian is a very popular word. Everyone seems to call themselves contrarian these days.

Petroff: Yeah.

Mundy: What do we mean by it? We mean that we're look in other people's dust bins for our ideas. The stocks that other people have lost hope in ever recovering. And to put that in numerical terms, it means we don't look at buying anything or going overweight in any stock unless it's fallen at least 50% relative to its peak. So, it's really had to go through a lot of pain before it even comes up on our screens.

Petroff: And you often focus on mid- and large-cap companies, right?

Mundy: That's right. We found over the years we’re not very successful in small caps so we don't really bother with them anymore. We love information so if -- what we really want to do is understand why the company is underperforming. If there is lots of information out in the market about it, we find it easier to analyse those opportunities.

Petroff: Okay. Now let's talk about your top three picks right now, which are more in the mid-recovery phase. They're not in the low points right now.

Mundy: That's right.

Petroff: So we have Signet Jewelers, Grafton Group and HSBC Holdings. Now let's talk about Signet Jewelers: over the last five years they seem to have done quite well and you see them continuing to recover.

Mundy: That's right, I thought I'd focus on the stocks that are recovering because we're not finding a particularly exciting market for new opportunities at the moment and as Signet is a classic example of a stock that was on its knees, the market didn't want to know about it, but it's helped itself through. Really, what we call self-help opportunities: the company being managed better. And it's a lovely company. It's the largest jewellery company in the world. It competes against many other jewellery retailers obviously, but a lot of them have found difficulties in the recession and have never really bounced back, they've had lots of balance sheet problems. So, as the largest player, Signet's got advantages in its brands. It can sell exclusive brands. It can get better places in shopping malls. It can spend more money on advertising. Those advantages are really helping it to drive sales faster than all its competitors at the moment. So, it's 80% US, 20% UK; it's really the US where we think the exciting growth prospects are and will continue to be. And we think that all that's available at a very cheap rating on an EBIT of just 0.7 times.

Petroff: Okay. Now let's move on to Grafton Group. Tell me a little bit about Grafton Group.

Mundy: Grafton Group is a builders' merchant: 70% of its revenue roughly is in the UK, 30% of it is in Ireland. So, it's the stuff your own builder will go down and reappear within your house an hour later. So, they've got a very, very fragmented customer base and that is really fantastic for them, because what it means is that they've got local monopolies. If the builder just wants to go to the closest builders’ merchant, time is of the essence for him and he hasn't really got any great pricing power. So, it's a very consolidated market. There are a very small number of large builders merchants who control the market really and you don't really see many new entrants, because it's very hard to get the economies of scale in that market.

Grafton, obviously, had a tough couple of years because of Ireland in particular and it's very reliant on repair and maintenance and improvement in the building market, not necessarily on new homes and not really in the big commercial jobs. And that really has been a tough market, both in the UK and Ireland for the last few years.

One statistic though that’s interesting is the average house in UK is 61 years old, so it constantly needs updating and more building work. So, we think Grafton's got a lot of opportunities to increase its margins relative to its competitors like Travis Perkins, but we think the whole of the builders’ merchants as an industry can see better times through more work being done on people's houses as economic growth eventually comes back over the next few years.

Petroff: Okay. Now, HSBC didn't do so well earlier, and they seem to be in that mid-recovery phase.

Mundy: Yes.

Petroff: Why do you like HSBC? Are you still buying in as well?

Mundy: Yeah, it's interesting. HSBC, rather like Grafton and Signet, I've chosen three companies who we describe as having good recessions, by which I mean, their competitors had even worse recessions and went out of business and have allowed these companies to gain market share in the last few years. And HSBC we have stopped buying recently because it's had a good run, but we love the fact it's a very strong bank financially, it's got a good balance sheet, it's got a lot of deposits, which means it can continue to grow its loan book. And what it's found over the last few years is banks that started competing against it in Asian markets in particular have gone back to their core markets. Particularly European banks now really aren't seen in Asian trade finance, for example, and that's really helped HSBC grow their loan book, but also grow at an attractive price and attractive margins.

Alanna: Okay. Now for key risks, because there are risks for every company, what would you say is the key risk for Signet Jewelers?

Mundy: I think, Signet Jewelers, it's key risk has got to be the strength of consumer spending, the average expenditure in one of their shops in the US is about $300 a head, 75% of their turnover is diamonds, and half of it’s for essentials like weddings, which of course you can never get away from, the other half is gift-giving, which is more discretionary.

Alanna: Okay.

Mundy: So, if there is a significant consumer downturn that will undoubtedly hit Signet, but as I said before, we think it will affect the other retailers who are weaker, rather than Signet.

Alanna: Okay. It will be worse for their competitors.

Mundy: Absolutely. So, once again it could work out as a long-term positive for them, but it will probably have negative short-term effects.

Alanna: Okay. Grafton, what's the key risk there?

Mundy: Well, it's hard to really imagine the building numbers can get any worse particularly in Ireland. But I guess there is that risk that, once again, we have a triple-dip recession in the UK and Ireland and numbers I guess can always get worse. Perhaps, if turnover gets worse, you can get a bit of pricing problems. The competitive builders’ merchants do start competing against each other. And finally, you could get bad debts: builders go to builders’ merchants because they can get goods on credit and perhaps if they can't pay up when the builders’ merchants comes and asks for their money that could also be a negative for these companies.

Alanna: And what do you think would be the key risk at HSBC?

Mundy: I think all banks have been affected more and more by regulation and we can always see the current regulation and try and work out how much that's going to affect banks. But we never know about future regulation. And if you're in charge of banks at the moment, your major interest is not going bust and therefore why wouldn't you want to keep on asking them for more and more capital behind their business. And as they put more capital behind their business, that will undoubtedly lead to lower returns on equity. So, I think the unknown is when central banks will start to take their hands off their throat and say ‘we've asked you to put enough capital behind your business, feel free to grow now’. So we've got to constantly look at that.

Alanna: Alastair, thank you very much for coming in today.

Mundy: Thank you very much.

Alanna: That was Alastair Mundy from Investec. I'm Alanna Petroff and thank you very much for watching Morningstar.