Forecasting is hard

Flagship Asset Management’s Kyle Wales notes that in the US over the past year ‘we saw very strong economic growth but the markets rallied far ahead of that’.

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SIMON BROWN: I’m chatting with Kyle Wales, portfolio manager at Flagship Asset Management. Kyle, appreciate the time today. I want to kick off with an evergreen point, I suppose, which is that forecasting is hard and perhaps 2023 really taught that to us. If we go back to January last year, [there were] concerns around US recession, concerns around US GDP; both were very pessimistic, both ultimately very wrong.

KYLE WALES: Simon, I can even put numbers to it. At the beginning of 2023 people were expecting GDP growth in the US of only 0.3%, and it closed the year at 2.4%. So that was a stark, stark difference to expectation.

In addition to that we saw the US labour market far stronger than anticipated. And the Fed seems to have achieved its aim by bringing inflation down, while still keeping GDP growth robust.

SIMON BROWN: Kudos to the FOMC [Federal Open Market Committee], Jerome Powell and his team there.

Staying with that, if we look at data instead and turn to valuations, blended forward PE for the S&P 500 is 20x; the long-run average is 16.7x. The US market is expensive, certainly in places.

KYLE WALES: Certainly we think so. So even if you look at what happened last year, we saw very strong economic growth but the markets rallied far ahead of that. So the S&P 500 closed [with] the year up 24%, and the Nasdaq closed [with] the year up a blistering 54%. So an excellent performance out of markets – even more excellent than the performance out of the economy.

SIMON BROWN: Then let’s take it to stock picking. Stock picking is always a selective process, perhaps a little more selective than usual because of a bunch happening out there. We haven’t even touched on elections in 70 economies and the like.

One of those spaces you like is FMCG [fast-moving consumer goods], but you are saying that you’re being extra-selective here, perhaps. Heineken is one that comes up on your radar.

KYLE WALES: Yes, just to give you a little bit of context, in 2023 we obviously saw the magnificent [seven] stocks rally pretty hard, and actually 76% of the total return of the index was just those seven stocks. So in 2024 we are looking for more defensive positions, and FMCG are among the sectors which tick those boxes for us. Within FMCG in our view you can basically split the sector into two components, the component that we believe is fairly priced – and there are a number of stocks within that component – and then the guys who have very similar growth profiles to the rest of them but are trading on far lower multiples than they have in a couple of years. Within that bucket we are seeing stocks like Heineken and Reckitt Benkiser, for example.

SIMON BROWN: I suppose that is part of the process – I want to say always, and maybe there’s a caveat to that. But there’s always going to be opportunity in the markets. It’s your job and your colleagues’ job to go and find it.

KYLE WALES: Well, certainly I believe so. But perhaps I’m the wrong person to ask because I make stock-picking my career. But we certainly believe that within any market there will be pockets of value and in 2024 we believe it would pay to be cautious.

SIMON BROWN: One sector that I think has probably sort of been off the radar for some time is European defence. You make the point in the note you put out that Nato countries have been underspending their budgets and they’ve got a budget level they’re supposed to spend. They’ve been underspending for years. Of course they’ve got a war right on their doorstep. Suddenly European defence is looking attractive.

KYLE WALES: We think it’s looking very attractive. It fits that first criterion of being a defensive sector. In this case the government is your biggest client and less likely to be affected by fluctuations in the economy. And, as you said, the underspend by European countries on defence has been massive.

It’s interesting to point out that the US has provided as much medical aid to Ukraine, post the Russian invasion, as Europe has. But Russia sits on Europe’s border. It doesn’t sit on the border of the United States. So yes, some huge, huge additional defence spend has to be made there.

SIMON BROWN: And what are some of the listed stocks that will potentially benefit from it?

KYLE WALES: With Europe there are a number of large defence stocks. The two we like are Hensoldt, which is a German defence company, and Thales, which is a French defence company. There are others which we are less familiar with, such as BAE and Leonardo…  The reason we like Hensoldt and Thales is mainly due to valuation. They are trading on low-teen multiples and are expected to grow their earnings at low teens. We’re sitting at a price earnings to growth multiple for those two stocks of just over one time, which we think is very, very attractive.

SIMON BROWN: And then what about China? I was going to say everyone expected great stuff from China last year. Probably not everybody, but certainly a lot. Then China disappointed. But there are some valuations out there – and Alibaba stands out as cheap by almost any metric. But does one hold back with caution or is there opportunity in China?

KYLE WALES: China has been a huge disappointment for us for a number of years. It’s been at least three years since that whole Jack Ma/Alibaba controversy. We just don’t see things getting better yet. The biggest problem in our mind with China is that there is no rule of law. The regulators can make any rulings they choose to make and there’s no recourse for people who fall victim to those regulations. [For] regulators in China also there’s no coherent policy at the moment in our view.

One day they are imposing gaming restrictions and the next day they’re removing gaming restrictions, which is particularly relevant for Tencent/Naspers. One day they’re courting foreign investment and the next day they’re passing regulations like new security laws in Hong Kong, which would obviously make foreigners, expats working in Hong Kong, very nervous. So there’s no policy coherence and there’s just no way to contest regulations which are in many cases irrational or unfair.

SIMON BROWN: That’s a good point. Sometimes you might find a great stock, a great valuation, and the business is great, but in the broader environment – you mentioned the regulatory environment within China – you look at that and you think you like the stock but you would rather actually go and find something else because that environment in which it operates can have a significantly detrimental effect.

KYLE WALES: Absolutely. With shares you get your returns from two areas. The first area is obviously the dividend yield and the second area is the re-rating. So if a stock is cheap and it’s trading on an eight multiple, you’re hoping that it goes from eight times earnings to 12 times earnings. But that isn’t going to happen unless there is an improvement in sentiment, and that only happens when investors get more constructive on the economy and on the company. We’re just not seeing that happen in China for now.

SIMON BROWN: And a lot of that could be said about our own economy.

We’ll leave that there. Kyle Wales, portfolio manager at Flagship Asset Management, I appreciate the time.

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Harry Byrne

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