Emma Wall: Hello, and welcome to the Morningstar series, "3 Stock Picks." I'm Emma Wall and I'm joined today by James Clunie, manager of the Jupiter Absolute Return Fund.
Hi, James.
James Clunie: Good morning, Emma.
Wall: So, a bit of a different flavour with you this Morningstar and that's because as an absolute return manager you do have the power to short stocks as well as hold long positions. So, with your three stock picks in mind, what's the first position you'd like to tell us about?
Clunie: Sure. First of all, I think, let's go short glamour. So, glamour stocks, there's lots of evidence that these stocks can get bid up to overpricing. And if something is glamourous and yet has some kind of fragility or problem that it can go down an awful lot. And a key example of the stock in that space that we're short of is Netflix (NFLX).
Netflix is definitely a glamour stock. It has a huge market capitalisation, but actually it appears to be losing money with cash flow issues and a balance sheet that's not particularly strong at all. They've recently had a growth warning in the sense that expectations are not being met and that looks like the catalyst to get what we think is a heavily-priced stock to fall.
They may do well in the long run, but at the same time, there's lots of competition coming into their space of internet broadcasting and we feel that the balance of probability is that this stock will disappoint heavily. So, Netflix is the first short idea and that characterizes overpriced glamour with a reason for going down.
Wall: And what's the second position today?
Clunie: The second – let's keep on the negative track – the second actually is maybe a little bit more controversial and it's to short a number of very low volatility, low-risk, quality decent firms where the share prices are just too high and where growth expectations are probably too high. In other words, they are slow growing and expensive. And the catalyst effectively is the realisation from investors that these are not growing at the rates they're used; they've got headwinds.
And this might include stocks like Campbell Soup (CBS) in the States, for example, or even McDonald's (MCD), where the valuations are very rich, expectations are for margins to improve yet further in the long run and yet sales growth is disappointing, not the old sort of 5% to 10% per annum that people used to see, more of the flats to 2% to 3%. And as people factor that in, they will realise these stocks are probably overpriced. And actually, recent results from both of those firms have been somewhat disappointing. That could be the start of a reset towards lower share prices.
Wall: And this is an interesting point, isn't it, because you're saying these firms are quality, they have good fundamentals, they're just priced wrongly?
Clunie: That's right. So, it's a case of good firm but potentially bad stock. And that feels unusual because you might think, oh, you short sell bad firms and you go long with good firms. But actually, here is an example. It's a case of what you're actually buying is the share, the stock, and the firm is simply something that's sort of underneath that and it's the price you pay that matters. So, it is controversial. It isn't a popular trade, but I think it could become one that could actually make a bit of money for investors.
Wall: And then a long position to finish?
Clunie: I think let's again stick with a little bit controversy. Let's go long of an ugly sector which is some of the integrated oil stocks, so the likes of BP (BP.) and Statoil, for example. These stocks have disappointed investors for many years. But when we look at the firms, we actually find balance sheets that are okay, cash flow statements that are improving from a weak base and quality that looks sort of okay to average relative to other firms in the spectrum. So, they are decent but not exciting firms, but the stock seems cheap.
And the way we come to that idea is, if you look at return on invested capital over history, they seem to trend down for many years during high or low oil prices. Sell-side analysts expect another few years of bad returns and if we then flat line that and then work out from the share price, what's implied for the long run, the perpetuity, we find something like a 10% return on capital. That's roughly the cost of capital for these oil firms.
So, in other words, the market is saying that these firms will almost never again choose another good project to invest in. That's almost definitely wrong. I bet anything that gets a sort of pass-through the vetting process of these firms, any new project, probably is being risk-tested and stress-tested to death and probably will prove to be a very good project.
So, I suspect the market thinks nothing good will ever come from these firms. In reality, every decision being made now will probably be very rigorous and in two or three years' time we'll actually see that actually these firms were not as bad as we thought. The shares should begin to drift upwards.
Wall: James, thank you very much.
Clunie: Great. Thanks Emma.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
