The latest on Australian equities with Paul Taylor

Andrew Mellor: Good morning, everyone. And thank you for joining us. My name is Andrew Mellor from Fidelity. It's my pleasure today to welcome Paul Taylor. Welcome Paul.

Paul Taylor: Yeah, thanks Andrew. Good to be with everyone.

Andrew Mellor: As many as you know, Paul is the portfolio manager at Fidelity Australian Equities Fund, and has been for the past 19 years, delivering extremely strong returns for clients over that time period. So thank you Paul, for your time today. We're going to dive into some questions. And let's commence with the topic that's probably most front of mind for investors at present, which is inflation.

Paul Taylor: Yes.

Andrew Mellor: How are you thinking about inflation? What has worked well in the past? And how are you positioning your portfolio in this more inflationary environment?

Paul Taylor: Yeah, excellent. Straight into the heart of it.

Andrew Mellor: Straight into it.

Paul Taylor: No messing about. Yeah, it's actually an interesting way you talk about the history. Because there's a great quote from Mark Twain that says, "History doesn't repeat, but it does rhyme." I think that's exactly right. So, I think we all feel we're entering a new environment. And when you are entering that new environment of potentially higher inflation, potentially higher interest rates, what we'd like to do is to go back through history, and see, well when has that happened before? And what has likely been the events?

Now as Mark Twain highlighted, it's probably not going to be exactly the same, but it's going to give us some broad indication of the likely things that might happen through those sort of periods. I guess the first point today is where we look back through time and see when interest rates start to go up initially. Actually that's normally actually a pretty good time for equities. And the fundamental reason for that is that the market tends to focus on why interest rates are going up, rather than the fact that they are going up. And they're normally going up for positive reasons.

So, interest rates are going up because the economy is getting better. And in this case, interest rates are going up because we're coming out, or maybe not coming out of COVID-19, but we're learning to live with COVID-19. We're reopening. We're flying around the country and around the world. We're going to restaurants. So, economies are reopening, coming back to life. Things are getting better. Inflation's entering the system, and we're starting to look for higher interest rates.

Now in that environment, initially anyway, markets tend to do quite well. If you dig into that a little bit deeper though. So, when they go up steadily, that's actually a pretty good environment. When they actually go up quite quickly, and that is the environment ... The consensus is that over the next year, I think we got nine interest rate rises in the US. Even Australia, we're looking at probably up to mid 3% over the next year or so. So it's a pretty aggressive interest rate move. In those environments, they tend not to do as well as a steady interest rate increase, but still markets tend to go up.

So I guess that's the first point to note. And then what we try to do then is dig deeper and work out, "Well actually, what industries, what sectors, what companies tend to do well in that environment?" That's obviously what we are really interested in. And in that sort of environment, what tends to do well is commodities, for a start. And we're already seeing that in the marketplace. Energy, materials, they're almost a leading indicator of inflation as we start to see economy prices go up.

And the other type of businesses that tend to do quite well are effectively essentials. What, what are the essentials of life? Because you have to go out and get those. You're still got to go to Coles or Woolworth's and do your shopping, get your toilet paper. So they're all important parts of it. And those businesses have an ability to pass on higher prices because they are essentials. And if they're costs go up by 5% and they're able to pass on 5% higher prices, they'll have an ability to hold their margins. And because of that inflation, they'll actually see earnings growth. So they're in much better positions. So that's sectors like, as I said, consumer staples, supermarkets, healthcare is another area, and also potentially financials. Your mortgage is going to go up, your insurance premium is going to go up. So those sort of essentials of life, they're able to take their prices higher. And they effectively have pricing power.

So businesses that have pricing power tend to do well in this sort of environment as well. Those that do poorly, tend to be companies that don't have pricing power. So if they're contractors, building, construction companies that maybe operate in a fixed price contract, they're going to do a little bit tougher. And they're actually going to see their margin squeeze. So commodities do well, energy materials, and then essentials of life. Consumer stables, healthcare, insurance, financial services, they have the pricing power. They tend to do reasonably well in an inflationary environment. And like I said, equity markets overall tend to be in positive territory as well.

Andrew Mellor: Excellent. Thank you, Paul. And we'll dig into some of the sectors and stock stories a little bit later in the session today. You touched on living with COVID now the last couple of years during lockdowns. We saw a lot of consumer spending on goods.

Paul Taylor: Yes.

Andrew Mellor: I know there were deliveries at my home most days during lockdown.

Paul Taylor: Yeah.

Andrew Mellor: That's shifted now to services. How are you thinking about that shift across the economy?

Paul Taylor: Yeah, we're actually spending quite a bit of time thinking through this. Because I think it's a really interesting aspect. So I guess if you go back prior to COVID-19, we would've seen services structurally outgrow goods, and that was a trend pre COVID-19. COVID-19, that completely reversed. So as you already put out, we couldn't travel. We couldn't get to restaurants. We couldn't go to theme parks. Leisure activities were significantly constrained. So a lot of those ... We couldn't go to the barber. Not that's a major issue for me, but we couldn't go there. A lot of those services were seriously constrained through COVID. Now as we start to open up, people are spending on services again. So they are travelling. You can see flights are already incredibly busy. People are starting to go back overseas. Restaurants are full. Getting back into sort of leisure activities. And people, we're social animals, we want to get back out and catch up with other people. And I think the interesting thing is when you think through the maths around this as well. So just as an example, if we've got $100 in our wallet, and just for argument's sake, we spend 50 of those dollars on the essentials of life, and we spend 50 on discretionary. Now because we've got inflation, the essentials are going up, and you've still got to keep buying those essentials of life.

So maybe with inflation essentials become $60 of your $100. Discretionary now becomes 40. So there's already a bit of pressure on discretionary. But then within the discretionary part, maybe previously it was 30 goods, and 20 services. Now all of a sudden services as we start to travel again, maybe goes from 20 up to 30. And then the goods side that was 30, maybe needs to come back to 10, because we've now only got 40 on the discretionary side. So goods can potentially go from 30 back to 10. So when we look at the goods versus services argument, it just looks like there's going to be a squeeze within the good sector while services will continue to grow.

Andrew Mellor: Excellent. Thank you. The other shift across markets that has been very prevalent, is the move from growth to value.

Paul Taylor: Yes.

Andrew Mellor: How do you think about that with regards to the Australian market? And where are you seeing opportunities amongst the current volatility?

Paul Taylor: Yeah, it's definitely been a move. And I guess in the sort of market thinking, is that higher interest rates typically mean you've got a discount back. So when we do discount cash flow, net present value, on the value of businesses, the companies that have earnings out a long way or have high growth so their earnings is much more significant in the out years. When you discount back at a higher rate, and that obviously reduces the value of them in today's dollars. Whereas maybe companies that have very large today dollars, but either not growing or even declining, when you discount back, you're discounting back at a higher rate so that reduces those out years. Which means they potentially take a smaller hit in terms of net present value. So, that's definitely a key part of it.

I guess what we tend to look at, whether they're companies with high growth or low growth, we're really just looking for high-quality companies, good balance sheets, good management teams, that are going to deliver for us in the future. And at the end of the day, it's how those companies develop strategically through time that's really going to create the value. So what you'll see through these periods, if I bring it back into sort of today's dollars, the sentiment around those sort of interest rate issues will impact maybe today's price earnings ratio. So maybe a growth company that was on 30 times gets brought back to 20 times. Maybe a value company that was on 10 times gets taken up to 12 or 15 times. So, that is what happens within the valuation metrics.

But at the end of the day, if you look at the next 10 years for a company, if a company's got $1 of earnings today, and in 10 years time they're still going to have $1 of earnings. There will be movement around that PE so maybe it goes from 10 times to 15 times, but often that is just a one-off impact, right? And typically will happen, it will be cyclical around that as sentiment hits. Whereas for a company that's got $1 of earnings today, and $10 of earnings in 10 years time, you'll still see cyclicality around the price earnings ratio, but the fact that earnings are going up 10 times is going to be the key driver for the value of the company.

Now that's what continue to look out the long term. In the shorter term though, there are still really good opportunities. And like I talked about in terms of the mining space, very strong balance sheets, good management teams, good free cash flow yield, and they're actually at the value end of things. So I think there's really some great opportunities in the mining sector. Financials, the same, right? So a lot of earnings upfront, good valuations, some attractive opportunities in that as well as I talked about consumer stables healthcare.

Andrew Mellor: Excellent. Thank you, Paul. Resources clearly has been topical in the Australian market. Let's dive the middles and mining a little bit. IGO has been one of your larger positions and strongest contributors.

Paul Taylor: Yeah.

Andrew Mellor: So what is it about IGO that really stands out to you?

Paul Taylor: IGO is a really interesting company. It's fundamentally set themselves up as a EV metals play. So they're effectively buying nickel, copper, lithium are their key metals. And they're all key metals that go into electric vehicles and the batteries in electric vehicles. Now, I actually think the really interesting thing is decarbonization. And we are definitely on that path to decarbonization, potentially getting to net zero by 50/50, or even earlier, if we can. I think it'll be a key part of where we are heading.

The process of decarbonization is an incredibly metal intensive phase. So the interesting thing to me is, actually a lot of these metals are required in that decarbonization. And particularly, a company like IGO that is focused on those EV metals will play a key part of it. Now, they're also positioning themselves from an ESG perspective, even internally within their policies in terms of their operations. But also they're setting themselves up as employer of choice.

So we're seeing less and less people come out, and looking for employment within the mining industry. But those that want to be a mining engineer or a geologist are increasingly looking to companies that are solving the problems of the world, not causing the problems to the world. And the IGO is really setting itself up as that employer of choice as well. So, a good quality company, great assets, and some of the best assets within that space. And, those metals are going to be required as we continue to decarbonize.

Andrew Mellor: Excellent. Let's move across to technology sector. WiseTech has been your strongest contributor over the past five years.

Paul Taylor: Right.

Andrew Mellor: By performance and has done exceptionally well as a stock, and I've been told that since IPO. But how are you viewing that now? It's done very well. How do you view Wisetech current come across?

Paul Taylor: It has been a great stock, and it's actually one we've owned pre-IPO as well as you know. So it's been a great stock for us for a long period of time. And really well placed as well. I guess we still own it. We still own WiseTech. We did take the opportunity because it had an incredibly strong performance through COVID. We took the opportunity through 2021 to trim the position. So it's a much smaller position than what it was. It is the software behind eCommerce, effectively. So when you order something on Amazon, it's potentially using WiseTech software to get from the supplier to you.

But now once again, if you look at the trend of eCommerce, that incredible growth was happening pre-COVID. Accelerated through COVID. Now while as we come out of COVID, we might see it come back a little bit, I think. But the penetration trend is still there. We're still going to head to more eCommerce. I think people have got very comfortable. They've got into the habit of ... I think there's a few people at work who've they were telling me they've ordered so much stuff that they can't remember what's actually coming to their front door. And I think that's where we've all been in some way. Maybe we're going to buy more in bricks and mortar in the short term, but the longer term penetration is still very much there. So yep. Trimmed it through the strength of 2021, but still own some. And think, they're very well placed, I guess, for the longer term opportunities.

Andrew Mellor: Yeah. Excellent. Moving across the healthcare. Now trying to get across some of the sectors across the market, Ramsay Health Care, very topical, has received a multi-billion dollar public bid recently.

Paul Taylor: Yeah.

Andrew Mellor: What are your views on that? Is it a good deal for shareholders and will it go through?

Paul Taylor: Yeah. I think Ramsay's great. They're some of the best hospitals in the country and around the world. Private hospitals are an interesting one. Because they did get ... To me it was the ultimate COVID-19 recovery play. Because they got negatively impacted by COVID-19. And a lot of private hospitals were either closed down or stopped elective surgeries. Now that demand for elective surgeries. It can't go away. Now you can maybe delay that you've got to have a knee operation or shoulder operation. You can potentially delay that for 6 months, 12 months or even a little bit longer, but it's got to happen at some point. And actually the interesting thing on that side is that the demand never goes away. So that demand is going to come back. So I think we're going to see private hospitals incredibly busy for the next few years as that demand comes back online as surgeries are completely opened up.

And the share price of Ramsay Health Care kind of got hit through COVID, came back. So to me it was the ultimate COVID recovery play. I think KKR had obviously tried to time this perfectly. So they've seen, "Okay, we are now starting to bottom out. We're learning to live with COVID-19, and we're going to resume that demand in the private hospital." So they put the bid right at the bottom of the market, $88. So obviously that's driven up the Ramsay share price. And I actually still think there's potentially more to go. I think maybe to get it over the line, they might need to pay a little bit more, but we'll see through time.

But yeah, I mean, to me, that's the perfect example. And it also shows you when it's a really good asset and the demand's going to come back, people will be looking at it for M&A opportunities as well. And potentially there's other bidders that could come in on that as well.

Andrew Mellor: So just on that point across the market, I mean, what's the market appetite currently for IPOs? And also for M&A? Is there less likely that deals will occur, or you think there'll be some of those opportunistic players that private equity might take on?

Paul Taylor: Yeah, I think it's a little bit different for both. So I think the IPO market is pretty much dormant at the moment. I think we could come back to life maybe later the year, maybe Q4. Maybe. I think that just given the volatility in the market so far this year, I think that the ECM and IPO market is probably closed for a little while. Think M&A might be a little bit different though. With M&A normally, you need some sort of certainty. I think companies look for more certainty before they take action.

I think that's why what happened with Ramsay Health Care is that as we start to see that we're bottoming out and we're opening up, that's when companies will take action. There's more certainty. We feel comfortable now that we're learning to live with COVID, so action is taken. So I think with M&A, I could potentially see some more of that as we learn to live with COVID, and we start to understand the environment. And also from an interest rate perspective, as we start to understand where interest rates are going. And we get more and more information as becomes more certainty around that, I think corporates are more willing to act on M&A.

Andrew Mellor: Sure. Okay. Domino's pizza, Paul. One of your favourite stocks. I know your regular Friday night dinner at your place is Domino's. You've held it a long time, it's been one of the strongest contributors to clients over the history of the fund.

Paul Taylor: Yeah.

Andrew Mellor: But we have seen a price decline over the last six months. So how are you currently thinking about Domino's?

Paul Taylor: Yeah, so Domino's, I look at it in a similar vein to the way we talked about WiseTech. So obviously very strong. So the whole digital delivery of food and beverage that was growing pre-COVID, accelerated through COVID, and will also likely continue to grow post-COVID. But there's probably a normalisation initially as we learn to live with COVID as well. So very similar vein to WiseTech. So once again, in the long term, I think they're incredibly well positioned as they roll out stores.

And people I think have got into the habit now of they still want to eat out, but they don't necessarily want to go into expensive restaurants. So I think they're in a really positive space for the long term. We did take the opportunity through once again, like WiseTech, took the opportunity through 2021 to trim the position, just given the very highest share price. So we trimmed the position, we still own it, and believe in the long term, but 2021 just gave us the opportunity to trim the position back a bit.

Andrew Mellor: Yeah. Thank you on that one. The Aussie market more broadly has been pretty resilient compared to many parts of the world.

Paul Taylor: Yeah.

Andrew Mellor: And it's now attractive for offshore investors looking at Australia. So what's your medium term outlook for the Aussie market?

Paul Taylor: Yeah. Look, I'd agree with that. It's interesting, isn't it? It puts it in perspective. And as Andrew said, we've got a lot of investors from overseas that invest into Australia. I've definitely seen an increase in a number of inbound questions I'm getting, or people wanting to talk about the Australian market. There's obviously a lot of issues around the world. Russia-Ukraine conflict, inflation, interest rates, lockdowns in parts of China. So lots of things to be concerned about around the world. But if you look at that environment commodity rate, a quarter of the Australian market is commodities. We've got another 15, 20% that's financial. So we are sort of wealthy. From a market perspective, we actually got the right companies for this environment. And as people get more and more interested in commodities, and businesses that have pricing power, I think they're looking to Australia.

So there's actually a lot of interest in Australia at the moment. And we're a long way away from the conflict around the world. So I mean, Australia is well positioned. They're a very attractive market, well-managed market. Corporate balance sheets are incredibly strong. So we are seeing a lot of interest in the Australian market. In my investment horizon, I always look out five to seven years. And from my perspective, I think this sort of volatility in the first few months of this year ... You can look out that five to seven years and think, "Actually, this is a really good period to look to investment in the market."

I think the other thing is, and I've talked a little bit about this in other forums. But, there's a common saying in the market that, "You sell in May and go away." And the concept behind that saying is that, we start every year on a very positive, with a high. We were very optimistic, and we would look at everything through rose tinted glass. But then as the year progresses, in normally about May, reality starts to set in and then, maybe you get the downgrades from May, as reality starts to set in.

I think this year is almost the complete reverse of that. Which is we started the year incredibly depressed. Worried about the lockdowns in China. We hadn't quite learned to live with COVID-19 yet. Inflation, interest rates, a lot of things to be ... Logistics. Supply constraints. A lot of things to worry about. And we've been pretty depressed until May. And now I think all of those things, whether it's interest rate, they're starting to get factored into markets.

So valuations have come back, but those negative issues have now being factored into markets. So it could be a case of "Buy in May go away," in this sort of year. So look, I think Australian market's well positioned against the rest of the world. I still fundamentally think investing in businesses is your best way to protect against inflation. A lot is factored into markets. And you've got to put your money somewhere. It's pretty hard to beat equity. So in this sort of environment.

Andrew Mellor: Yeah. And I'm sure you'd argue for all those points as well, that it's a very good environment for active investors as well.

Paul Taylor: Absolutely. Well, that's a really interesting thing is that with volatility comes opportunity. So I know with volatility, you get worried and concerned. But actually that presents the best opportunities. And I'm sure not everyone thinks this way, but sometimes there's always a company that you've been wanting to own, you think is a fantastic quality company, you've always wanted to own it. Sometimes these periods of volatility present you with that opportunity to buy that company you've always wanted to own.

Andrew Mellor: And what about payout ratios? For any credits, how people should think about the ability of Aussie companies continue to be paying strong dividends for clients?

Paul Taylor: Yeah. Look, I think so. So balance sheets are strong. Cash flow is still there. So I think we'll continue to see reasonable dividends come out of the market as well. Think as people know, while government debt has gone up, it's still relatively low by global standards. Corporates actually have repaired their balance sheet through these difficult periods. So actually ... And they want to put themselves in the best possible position given any volatility or negative impacts, or any closures at different markets.

So corporate debt's quite low. Debt in Australia anyway, is mainly in the consumer household area. And a lot of it is very productive debt. But debt's mainly in that sort of consumer ... But yet dividends in income and franking credits, I think Australian companies are well positioned in that space.

Andrew Mellor: Yeah. And for meeting with management, obviously a key part of your process, how is that evolving? You're obviously doing a hybrid now of in-person meetings, virtual meetings. How will that sort of play out, do you think, the rest of the year and beyond?

Paul Taylor: I think, yeah. Zoom has been incredible through this period. So through COVID, we just met with corporates through Zoom, and it worked. We didn't really skip a beat. And in fact, in a lot of ways, it was easier to talk to management. And it's also been easier to talk around ... Fidelity's obviously a global company, we've got analysts all over the world. It's been, almost much easier through Zoom to talk with the analysts and the portfolio managers around the world.

We're starting to open up now. So we've actually restarted meeting with companies face-to-face, which I think is a positive. We really need to get back to that. That is the best way to maintain the relationships. But yeah, I actually think hybrids are going to work. So we'll go back to meeting with them face-to-face, but to maintain that contact, maybe catching up with them four or five times a year, maybe two or three or in person, two are via Zoom.

But to me, that's actually an improvement. That's actually a better, much more efficient way. And we can still maintain our really close contact with analyst and portfolio managers around the world, or even other companies around the world. Because we look at the Australian market and Australian companies, but often their competitors, suppliers, distributors, customers are in other parts of the world. And maintaining those contacts are just as important.

Andrew Mellor: Yeah. We're getting close to time. We got a couple minutes go. We're want to ask you, Paul, what are you concerned about in the Australian market? What does worry you? You've spoken about the many positives, but is there something that does concern you or that could be a risk?

Paul Taylor: Yeah, I guess the things I think about ... Obviously costs are an issue. And companies are reporting much higher costs. And that is obviously part of the inflation. That is part of the inflation argument. Now, sometimes there can be maybe a slight mismatch for when costs go up, to when revenues go up. So companies can be caught in that squeeze. Like I talked about certain sectors or industries may be a bit more exposed to fixed price contracts. Think the thing in Australia as well is, we're an immigrant nation. We've had reasonably strong population growth, what, for a hundred odd years.

So we've gone through a couple of years of really no ... We've had some population growth, but it's been very low. And demographics are still good in Australia, but I think it'll be important to reopen to immigration. You can obviously see it. Some markets are incredibly tight. The hospitality industry continues to run short on people. So it'd be good to see immigration open back up. And I think the country can get back on that growth trajectory as we return to normal immigration.

Andrew Mellor: Excellent. And one final question I'm reluctant to ask, who will win State of Origin? Will the Blues continue their domination of the Origin Series?

Paul Taylor: Look, you should be reluctant to ask that question. Because I am going to be on Queensland, again. Yeah.

Andrew Mellor: No surprises there for Paul. Thank you all for joining us.