Welcome to the April 2022 Manager Panel! Each month, where relevant, InvestNow will ask some of our fund managers some questions surrounding a topic. This month we asked Castle Point and Salt Funds Management some questions to help you understand them, their investing style and their funds better. Read the questions and their responses below.

Q1: How would you describe your investment style? And what does this mean in the type of companies you invest in?

At the heart of our investment style is being long-term investors. Typically, we will hold a position for 5 years, if not longer, and over that time we are looking for a very significant uplift in earnings and consequently a much higher share price.

The two types of companies that, in our view, offer the greatest potential increase in earnings over that timeframe are Value and Quality. With Value the big uplift in earnings is typically a recovery to more normal earnings from a low base, often termed “turnarounds”. With Quality the big earnings boost often comes from a company successfully growing into new markets or bringing new products to market. In industry speak, our portfolios tend to “bar bell” Quality and Value companies.

Q2: How many shares do you typically have within each of your funds/portfolios?

In the Ranger Fund, our high conviction benchmark-unaware fund, we will typically hold shares in 15 to 20 companies.

In the Trans-Tasman Fund that seeks to provide a return higher than the S&P/NZX 50 index, we will typically have 25 to 35 companies.

Our 5 Oceans Fund is a highly diversified balanced fund that holds investments in bonds and equities, (both local and international) and some derivatives to manage downside risk. As a consequence, that fund has exposure to several hundred different investments.

Q3: For your most popular funds, tell us about your most overweight positions in your portfolio and what you like about these companies

Currently one of our largest positions is OFX Group, a cross border payments business which falls into our Quality camp. Individuals and businesses across the globe can use OFX to convert cash into different currencies for travel or business purposes. This is a truly enormous market, even though it is already a substantial business with annual revenues of over $130m, OFX accounts for less than 0.05% of the market. In our opinion OFX has the right team and the right offering to grow their market share considerably over the next 5 years. If they can achieve that, then earnings have the potential to grow considerably which should drive significant share price gains.

Another large position is The Reject Shop which runs a chain of discount shops across Australia, think of an early Warehouse store. The Reject Shop falls into our Value camp. This business was effectively blown up by the previous CEO who attempted to convert the stores into a more upmarket offering. When that proved disastrous, a new CEO was appointed in 2019, and a “turnaround” opportunity was created. Our view is that the full benefit of the work done by the new team in repositioning the stores back to their discount roots and dramatically improved inventory management will become apparent as foot traffic returns to malls and shopping centres across Australia. At that stage The Reject Shop should deliver a big earnings boost as it returns to more normal levels of profitability.

Q4: Have you outperformed the index over a 10-year period for your most popular funds?

We are in our ninth year of running funds at Castle Point, but we are currently running ahead of performance objective for all three funds in terms of 3-year, 5-year and since inception returns.

Q5: What companies don’t you like investing in?

ESG is an important part of our research process, we don’t like companies that cause environmental or social harm.

We tend to avoid “black box” companies where the complexity of the business model leaves investors having to trust management. We prefer simple, easy to understand businesses.

We don’t like high levels of bank debt, in those situations’ decisions tend to be made that favour the banks not shareholders. Also, they can just go bust.

We tend to be wary of businesses that are operating in industries that are in structural decline or are ripe for massive disruption.

As a general rule we avoid agricultural companies, while the good times can be great the bad times are awful. There always seems to be a weather event, or a pest problem or a collapse in prices, just around the corner.

We don’t favour resource companies; their earnings are more a function of commodity cycles which doesn’t fit into our framework of Value or Quality.

Disclaimer

The following commentaries represent only the opinions of the authors. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement or inducement to invest. All material presented is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Castle Point may or may not have investments in any of the securities mentioned.

Q1: How would you describe your investment style? And what does this mean in the type of companies you invest in?

Salt is unashamedly an active fund manager. Even the median active manager has outperformed in NZ over time due to the unique characteristics of our market.

Salt focuses on free cashflow. We believe in doing the work ourselves and building our own in-house DCF valuation models. Our perfect company generates strong free cashflow, some of which can be used to pay a growing dividend to shareholders and some of which it can invest in high-returning investment opportunities. Sometimes our style leads us to “value” names and sometimes to “growth” names. The perfect outcome is when a so-called “value” name becomes a “growth” name, with great historical examples for us including Restaurant Brands (no longer owned) and Mainfreight.

Salt is valuation sensitive. Even the best companies in the world with many years of high-returning investment opportunities do not have an infinite valuation. Competitors arrive, demand and technology changes. Conversely, a company in a shrinking low-returning industry on a PE of say 6x may actually be expensive. The key is to understand the drivers of each industry and value each company accordingly.

Salt totally embeds ESG factors into our valuation work. In recent years, companies with strong ESG characteristics have tended to outperform due to both the weight of investor money and due to shortening profit horizons for companies that fail to measure up. This will continue.

Q2: How many shares do you typically have within each of your funds/portfolios?

We are pleased to have three very different funds with InvestNow and the number of holdings varies markedly. When we have high conviction, we tend to have a 4-8% position relative to index and scale it down from there.

The Enhanced Property Fund has 25-30 holdings, with half being a range of Australian exposures. The NZ Dividend Appreciation Fund has 25-35 holdings, with these being NZ-only. The Long-Short Fund is more diversified, with 60-80 names, of which around two-thirds are currently Australian.

Q3: For your most popular funds, tell us about your most overweight positions in your portfolio and what you like about these companies

The Enhanced Property Fund runs off a strict relative valuation process. Our two largest overweights are in Australia. GDI Property is chiefly exposed to Perth, which has by far the strongest outlook of all cities across Australia/NZ due to the resources boom, little being built since pre-GFC and rents having halved from their pre-GFC highs. It is internally managed, has high internal ownership, is at a 15% discount to a conservative NTA and you get an attractive fund management business for free. It pays a gross yield of 7.8% to a NZ investor. The second is Elanor Commercial Office, which is a well-run owner of B-grade office properties that dominate their local catchments. The gross yield to a NZ investor of 10.0% is simply too high relative to the risks.

The Long Short Fund’s largest holding is the general insurer, Tower Limited. It is cheap, has a high yield, a successful new IT system is lowering costs and giving them an advantage versus competitors and it is a rare beneficiary of rising interest rates from their float. They have had a bad run of natural disasters but the market prices them as though they will pay their full reinsurance deductible every year, which will absolutely not be the case. This is really material. Bain owns 20%.

A second key name is Dalrymple Bay Infrastructure. It is primarily a major coking coal export port but long term is designated as a renewables development zone. Nearer term, there is expansion potential given growing capacity constraints and upside as they move from heavy-handed to light-handed regulation. The cash dividend yield of 8.2% is highly attractive given NZ’s unusual FDR tax regime which taxes stapled securities on an assumed return of 5%.

The NZ Dividend Appreciation Fund’s key current overweights are Turners and Tower. Turners has had its cyclical ups and downs but has been a very successful holding for the Fund going back a number of years. They have top-notch management, generate strong free cashflow from their businesses throughout the automotive value chain and have many years of growth ahead as they reinvest in what is a huge but very fragmented industry. Many of their competitors are capital-constrained and gradually exiting.

Q4: Have you outperformed the index over a 10-year period for your most popular funds?

From inception (14 years), the NZ Dividend Appreciation Fund has returned 12.01% p.a. post-fees to end- March 2022 versus the benchmark’s 10.65%. It tends to lag a little during a strong bull market, do quite well in normal market conditions and strongly outperform in negative market conditions.

The Enhanced Property Fund has returned 11.27% p.a post-fees since its November 2014 inception, comfortably outperforming the benchmark return of 10.20%. A highly correlated wholesale property strategy has similarly outperformed since its 2008 inception.

The Long Short Fund aims to perform similarly to equities over the long term but with far lower volatility and with no correlation to them. This is why it has a benchmark of OCR + 5%, which is the risk-free rate plus an equity risk premium. Since inception, it has returned 10.38% p.a. after all fees versus 6.66% for its benchmark and an almost identical 10.44% for a 50/50 mix of NZ and Australian long-only equities. The Fund has done this with no correlation and approximately half the volatility. These attributes will be really important if markets continue to be choppy as interest rates rise. We are seeing investors look for alternative sources of returns given the more difficult backdrop for equity and bond markets as central banks tighten. This Fund is very much an “alternative” to equities within a diversified portfolio.

Q5: What companies don’t you like investing in?

Those that go down! More seriously, poor ESG ratings are a complete no-no as they mean the company’s cashflows may not even exist in a few years’ time. We shy away from industries in structural decline as they tend to have no value-adding reinvestment opportunities. Having been an investor since the 1980’s, I am also acutely aware of the risks posed by “vapourware” companies – we tend to shy away from “growth at any price” and try to find growth at the right price. High returns and strongly growing markets have a funny way of attracting competitors (eg, just look at Netflix this year) and this competitive decay has to be understood and modelled when coming up with a fair value. Everything has a price.