Fidelity Future Leaders Fund

Andrew Dowling: Good morning and welcome to the Fidelity Future Leaders Webinar. My name is Andrew Dowling, I’m part of Fidelity’s Wholesale Distribution Team and joining me today is James Abela, Portfolio Manager of the Fidelity Future Leaders Fund and Co-Portfolio Manager of Fidelity Global Future Leaders Fund.

The Future Leaders Fund was established in July 2013 and over the last 10 years to the end of May of this year, has delivered 10.33% p.a. net of fees, versus the S&P/ASX Mid Small Index of 8.95% p.a. an active return of 1.38% p.a., also net of fees.

In addition to being one of the best performing ex-50 strategies over the long term, it is also worth noting that the Future Leaders Fund has also outperformed the S&P/ASX 200 Accumulation Index by 2.55% p.a. over the last 10 years, adding significant alpha to investors’ Australian equities portfolios. 

Now, James, welcome and thank you for joining us this morning. I think probably a good place to kick off is just a brief recap on the strategy and just right across the board with your approach, and the role that the portfolio plays in an Australian investor’s portfolio.

James Abela: Great. Thank you, Andrew. I've been a Fidelity for 20 years; as an analyst for 10 years, and then as a PM, pretty much 10 years each. I've been in different roles, but always analysing stocks and working across different sectors. My Fund looks at Aussie small-caps and holds 40 to 70 names, using the S&P/ASX Mid Small Index. All the awards are really awards for the performance, which is a function of the process. But it's really accolades, that recognition of a process that has been, and ultimately aims to be, a smoother ride for clients. It's not trying to be an extreme quality or extreme momentum fund. It tries to be very balanced, and therefore is delivered a smoother, consistent outcome for clients.

If you look at where that blue dot is, as Andrew mentioned all the statistics, 2 and a half above large caps, 2 above my Index, and about 5 or 6 per cent above smalls. Now, that's a decent outcome in performance. But the reality is, I'm also focused on risk. And that dark blue dot left of the risk metrics of my Index, and also left of the risk metrics of the small cap Index. So that is really important for me.

The QMTV process is a very balanced process and is all about risk control. And that risk control you can see. It has delivered good returns and solid returns, but with less risk than the indexes that I'm in the universe of.

AD: What's your thoughts on macroeconomic views at the moment? I mean, there's the constant debate around inflation, interest rates, growth. How do you navigate that within your universe?

JA: It's been a good market. It’s certainly more positive. In the second half of last year the market moved its headspace to peak inflation, peak fear about recession, and peak interest rates. Once that happened, the markets had begun to rally, and we saw that globally since about October of this year. What's really been working is quality and momentum. So quality stocks with high ROEs and good growth, those multiples have now expanded because the headspace of the markets have gone out of quality and fear into quality and duration. Those companies that are quality and growth have been allowed to get higher multiples because the duration mindset of investors is now extended.

When you're in a fee mindset as we were in the first half last year, it's very value, but it's also very short duration focus. So those multiples tend to tend to shrink, whereas now things are definitely going out. The themes are really that structural growth stocks done well in terms of earnings and multiples. This includes technology, healthcare, consumer, and technology including educational and financial.

You've also got cyclical strength in industrials, construction, consumer, and financials as conditions and confidence have improved. Tech rallies and the green theme have definitely slowed down.

The macro backdrop has seen the recession fears gone. ‘No landing’ is more the thought process. Inflation has come down and expected to come down further. All of that is positive and constructive for a market to continue to move forward. As I mentioned, peak rights, peak inflation, peak recession fears are now behind us.

When you think about my process, and how I think about stocks quality and value has really come up in valuation. So very high pays now for tech stocks, such as Altium which obviously got taken over. But it was still a hot PE then over the forties. Pro-Medicus in the 100 Times PE club; Hub, Netwealth in the 30 40 times; Car Group in the high 30. So, these multiples have really expanded. As I mentioned, it's because the mindset of investors has gone from short duration to now long duration and the confidence levels and comfort levels have really improved.

Anything with real cash flow improvements in momentum things, like Megaport, Siteminder, Life360, Audinate, where they're going from low margin or low profits into profitability or high returns, have received quite significant multiple increases but also momentum, as I mentioned in construction and industrials. That's also being positive for multiples and earnings.

Expansions are in transition and value have been weaker, and we have certainly been making Alpha from being underweight a lot of these: real estate, materials, energy, and utilities. They haven't really been doing well in this current market, which is much more looking at growth and earnings, and looking a lot more positive.

Lastly, what you should be thinking about right now is really earnings, earnings, earnings. As Peter Lynch, a famous Fidelity portfolio manager once said, ‘If you're going to focus on one thing, focus on earnings.’ That is definitely where I'm focused right now, because that's where the market is paying up a lot for the expectation the earnings are going to improve.

You’ve got to be careful not to become a quality-momentum cheerleader and get FOMO: this frenzy or fear of missing out. Because that's what happens in this marketplace, which will continue for a while. But if there's any shocks or any individual companies that do disappoint, those movements will be quite dramatic, because the confidence and evaluations are certainly at a high level at the index level.

AD: James when we look over the last 12 months, a lot of the strong performance has, in a positive and absolute sense, come through in the last 6 months. You've mentioned some of those strength, those themes playing out. How does how does that continue to support the outcome for the strategy?

You can see that the 1-year number up 16%. There’s a lot of that's happened last 6 months, like I mentioned since October, the market has been quite strong. This has been led by technology: software technology, health technology, financial technology, consumer technology, and also a financial market recovery. When you look at the individual stocks, they're the major things that fit into that performance.

The market is also being very positive, like, I said, on valuation. The market is now 18 times PE but also the earnings have now come up, especially in mids and smalls, with large-cap earnings, growth profiles on as strong. The growth has improved and the growth expectations have improved so that's allowed the multiple to expand. They're really the key. I think it's really been quality growth but also cyclical growth that has really been driving the performance.

In terms of sustaining Australian equity market at current levels, you've mentioned some of the macroeconomic challenges. Earnings will be critical. But you know, there's obviously pockets where you've got to be risk aware, which is a critical factor for managing the strategy. Where does that leave you currently?

JA: The EPS of large groups, as I mentioned, is only a few percent. It's only 3 or 4 percent, whereas mids and smalls are more around the 8-9 level percent. So growth is going to need to come through. But is it is expected to come through.

Secondly, interest rates are expected to fall to the end of the year; whether they do or not. Is not that critical. I think housing is going alright, and business lending is really driven by confidence, and both of those are moving quite well. So, we really need inflation to slow, which is happening, but needs to continue.

The other real thing is the macro setting. People point to New Zealand, which had a lot of economic challenges in the first half of the year. It was like the canary in the coal line. It reduced the impetus on housing and rates were held quite high. Conversely was the US, which was very strong all the way through.

Australia fell in between, we're still a bit cautious as a country, and too on earnings, growth, and expectations. We are still quite positive when you look globally, and because our country as a universe points quite globally. Besides resources and the China concerns, we are still quite positive, because we're pointing more towards the US and global markets. Overall, the economy is still trending quite well and that confidence needs to hold to the end of the year, especially and through reporting season because of that multiple expansion that's occurred in the market. Getting to 18 times at the index level is pretty high but if the earnings do come through at 10, that'll drop down going into next year. So that that'll be okay. But we need these macro factor environments to sit there with inflation rates and confidence. I think if those three tenants are in place, and then the growth comes through, the market will likely continue towards the end of the year.

AD: You've mentioned technology, healthcare, industrials, financials - these are all sectors that operate in the in the global marketplace and are well placed in the current environment. How, particularly from an Australian equities / Fund point of view, does the work you undertake on the on the Fidelity Global Future Leaders Fund support this strategy? We're seeing interconnections between Australian companies and earnings, revenues offshore.

JA: Absolutely. So, 70% of the companies in Australia meeting really operate in a global marketplace. When you think about that, technology, healthcare, financial industrials, consumer, energy, and materials, all of those operating global marketplaces, it's only really where there's heavy local regulations, such as real estate and utilities, which tend to be more localised. But they are really yield businesses that still get led by the global marketplace.

Themes, opportunities, challenges, products, innovations. They are all global in nature. There are no borders when it comes to those things. So for me, there is a significant opportunity and benefit in running both Funds.

From a cycle viewpoint - in the last 12 months, August 2023, came through quite confidently, but I could see that from April. In the US, results from March and April kept confidence at a very high level. You could see that didn't really come through until August in Australia. So we're positioning from March, April, May, June, July for the Fidelity Future Leaders Fund, for good, positive August results which delivered obviously very good outcome for August 22, and through other record performances for the Fund. But you can see that lead from the US which was strong.

The US is where the trends get established and market leadership gets established. When you look at the attribution, you can see that we are positioned for it early and that's why we've got the benefit. Technology, healthcare, financials, consumer, which is really consumer technology. For me, I can see that we're positioned well here.

Also, the connection through Asia that we have through China indicated the weakness was going to come. A lot of those lithium names started to fall and resources were a bit weaker. You can see that the lead from the US. In terms of tech: health tech, fin tech, consumer tech, the advantage and position was put in place, and that benefit has come through to the Fund in the last 12 months.

AD: They're sort of more globally led leads than locally led leads as far as some of these themes?

JA: Yes, that's the theme. National and international - they're very, very correlated.

AD: One thing I know that you look at very closely and consistently is the portfolio characteristics that have been a real staple. The way that you assess the portfolio for the Fund. You appear more cautious at the moment and it appears it’s how you're managing any concerns you've got. Can you talk to this?

JA: Firstly, I’ll look at the performance of the rolling 3 year, is that orange line. We have consistently, with the process, delivered alpha except for that post Covid period when it was ‘the free money period’, a real momentum rally/junk rally that followed by value. During that time, the Fund wasn't able to deliver a 3% positive alpha for an approximate 12-month period. But now we've got back to there, which is great. One-year numbers are obviously positive, heading towards 10, and then the 3 year alpha is now fully recovered from that.

If you go back to 2016, the lessons learned was the cyclicals were very underweight. Energy and resources were nearly 20% of the Index which went up nearly 100% at the same time that quality came down. It became a very much a value, cyclical trade and quality really came off. That 18-month period was quite negative.

Covid has a number of cycles through it. We did quite well early on, because it was quality and fear. Meant quality was good, so that 3-year number held on right up until November 2021, when the 1-year number of the big negative from the free money cycle came through and really hit us hard and took that 3-year average down. Then you had a value phase because the market went into recession fears and the duration, as I mentioned, went very short. Then, as you got to the end of that cycle, towards the end of 2022, the market started to move away from junk, away from momentum and towards quality, and you can see that. Then, trending up very sharply from November 2022 and it's just continued ever since then. That's why the 3-year number is now quite positive.

The growth is what you've got to look out for, which is there in mids and smalls. Now, the mids and smalls are the 20% of the market, 80% of the market is large-caps which is running at that 2-3% EPS level. That carry of the market up to that 4% EPS growth is because those mids and  smalls are growing to between 9 and 10%, but it's only the 20% of the market. So that's where the growth is and we're following that.

This one is what you know, what your question was, and this is where you need to look at all those things. I make sure the Fund is not too far skewed towards quality, not too far skewed to high valuations and not too far skew towards growth. Now, what I call the safe zone is around 1.5 times. I look at a number of factors here.

So, the PE, 27-18 is around that 1.5 level, that is reasonable in the context of where the EPS growth is. The EPS growth historically is 21-17, but the forward looking is 15-9. So that's around 1.5. If you look at the ROA, 10-6, that's above 1.5. Then 13-10 is around 1.4. So, it's all around 1.4 to 1.5 with ROA above, because there's more efficient companies delivering high returns.

But that is all making sense now.

If the Fund was a lot more leaning about following quality or really going harder into momentum, those PEs will be probably 2x the Index, so I'd be at a 36x PE. The ROE may or may not be high depending if you go into quality or momentum. But the risk, if that changes, or if there's another kind valuation check on the market or the Index, or if the duration of the market starts to move inwards or gets worried about valuations, that risk exposure would be quite significant, and we would maybe go through another under performance phase, which is what we're trying to guard against.

So, we're keeping quite balanced. What I call that safe range in the 1.5x range. When we're getting up to 1.6 to 1.7, that is what I call amber territory and danger zone is 2x the Index. We’re not in the danger zone yet. The ROE and the growth all looks fine. The only one I'm really watching, being very careful of right now, is the price to cash flow; the Index is already 2x, that's already in danger zone. So, I've been trimming momentum. A lot of those momentum stocks have done incredibly well where there's weak cash flows all the innovations.

The market has been very generous on evaluations. We've taken a bit of taking off the top of those stocks but held onto those quality names where there is good cash flow generation, and it's still not excessively valued in our view.

AD: As we approach reporting season, are there any signals, at a company or sector level, where you see opportunity or risks?

The Index is on 18x and as mentioned, the EPS growth for our world in mid and small-caps is around that 8, 9, 10% level. So that's what needs to be delivered in August this year and that is really what needs to hold.

Earnings trends are following very closely right now: confidence and management. I need to be investing and need to be innovating. Dispersion of expectation in terms of returns needs to be tracked, because if dispersion starts to grows out, because if the uncertainties are rising then the risks are rising. They're all quite narrow right now, which is good, and it tells you confidence is quite high and managing has been quite clear in their guide. But if that starts to change, that's a bit of a signal that risks are starting to rise again.

Also the structure of the earnings I'm following very closely. I just did a whole big printout for my all of my holdings. If you look at the earnings outlook (2024, 2025, 2026), you want to make sure that's structurally upward. But then, also you want to make sure that the trend lines are upward as well. So, 2024 is moving up, 2025 moving up, 2026 moving up = the trends are positive, but also the structure is positive.

Also, the sustainability of the business is very important. So obviously, we look at ESG metrics: quality management and overall view on the company. For me, that's also really important. So there is a whole group of factors that we're looking at right now, and those are the things we need to hold in our minds right up through the result season.

AD: The last 11 years you've had variations in your weightings for QMTV. How does that sit historically with where you're at the moment? What's the key themes there that stand out.

QMTV is at quality maximum; we've been here before. We tilted, towards it. As I mentioned early late last year. We've been in that 49-50% level since September 2023 which has been good for the attribution, and momentum has come up. But we've now been trimming up, as I mentioned. Borol’s been taken over, CSRs being taken over. I’ve been trimming those very high multiple stocks like Live360, which has got a big benefit from confidence levels. So, momentum is being trimmed in technology, but also in industrials and financials, because insurance has had a very good run as well.

You can see, quality is being held up. That is software tech, health tech, consumer tech, and education tech.

Transition is still a number of stocks in retail for me. Things like a JB Hi-Fi is in transition and value is mainly resources or real estate. They're the two sectors that are in that value group. So, value we want to hold a little longer.

There's still some idiosyncratic stories where there's turnaround available. Transition and momentum is still quite low, that range is very low. 22 is almost at the bottom of the range for me in terms of the strategic asset allocation, whereas quality is still right at the top, and we probably hold that all the way through to the end of 2024.

AD: Can you discuss 2 or 3 companies you own at the moment, and just a brief thesis around why you like them?

CAR Group: very high return profile, has a about a 45% cash-flow return investment, according to UBS Invest Holt. Australia’s averages around 9%. So that's safe. ROI is 4x the country average. PEs, you know, are quite good. It's in the thirties, but the growth is there. It's very persistent and consistent. That's what we want to see in those sort of quality businesses.

HUB24 and Net Wealth: two businesses that advisers know very well. I've owned them for a long time. They've been delivering growth. They're growing between 10 and 30% over the next few years. Consistently taking market share, high return businesses, a huge level of trust. You can't just wake up or develop an app or have an idea that you can penetrate and compete against these businesses that have got decades of history and decades of data and processes and code.

They're the kind of business that I really like to have in the top 10, that are very hard to compete against and have a really big moat because it's either time or trust to build these things.

AD: Can you provide an oversight on the Australian equities team you work alongside, and how you tap in more broadly into the whole Fidelity global network to support the strategy?

JA: Small and mid-caps is very dynamic, there's lots of innovation and there's lots of change. Sentiment and ideas can come and go quickly. So, for me, it's very important to have analysts who are on the ground all the time talking to customers, company suppliers, buyers, competitors of all the stocks that I own, and the stocks that they cover.

There are 7 analysts sitting in Sydney that cover all the stocks that are in my universe. I talk to them every day. Every week we have a committee meeting, and we talk about all about portfolios. We have a very broad discussion about what analysts are thinking, what they're doing whether more positive, more negative, concerns. innovations that are happening in Australia or the world.

There's the global network as well that feed into these analysts. I find Australia is a window to the world. We do see the world through the Australian eyes, but they're seeing on the ground, you through the eyes and ears of these 7 analysts.

AD: When you do have those periods of underperformance, it's challenging. How do work through that in terms of psychology around portfolio management?

You come back to the numbers, the risks, and ultimately the CFROI and ROE about businesses in this country is going to be where your total return comes from. You buy a small part of a business, and what you're buying is a return on capital and a return on growth.

For me, that is what you must rely on. There are times when junk-like things, like Afterpay, went up enormously, didn't make money, didn't make sense for me to own it. I've been damaged by that. I just had to have a strong stomach and go back to the numbers. It was incredibly innovative and had really good time. These big things that come through are very significant that are very dominant for a short period of time. But ultimately, you need companies that are quality companies and deliver returns and growth and return on capital. That's ultimately what we are investing in what we are buying and what is going to drive returns for clients and portfolios.

For me, I just go back to the numbers, and that's the reality. It's economics, mathematical reality, and finance reality. That is ultimately what will play out over time. You can have themes and junk, or free money, or fees of inflation and recession happen over 1-2 years, but on a 3-year basis, those fundamentals will ultimately win out. On all those short-term trends.

AD: Thank you very much, James.