Expert view: how to make money from high-risk stocks in an uncertain market
With so much global uncertainty, investors can be forgiven for being wary of investing in high-risk sectors like resources.
Stockhead spoke to Patrick Hodgens – managing director and principal Founder of Firetrail Investments – who is an expert in navigating the choppy waters of the stock market.
Where are you seeing risks and opportunities?
The biggest risks are generally always macro risks and what we do at Firetrail, on the long and short side, is we try to neutralise those risks.
We never try to predict the direction of macro-economic events whether it’s interest rates, currency or an escalation of the [US] trade war. So what we try to do is move away from those.
The big risks in the market are political instability both in Australia and globally, whether the trade war escalates and just that general uncertainty that’s concerning investors.
Volatility is increasing as a result of that.
To us the opportunities both on the long and short side are always stock specific.
On the longs there’s some great opportunities in resources and cyclicals, and a number of great Australian companies that have earnings offshore for example. So Aussie companies that have most of their business in the US or UK or Europe.
(A cyclical stock is one that is affected by the ups and downs in the overall economy)
What are some of the best opportunities in resources at the moment?
There are a couple of commodities that look pretty good on a supply-demand basis.
What I think has surprised the market is Chinese steel demand this year. It’s actually growing. I think most in the market thought it would fall.
It’s growing around 3 or 4 per cent and steel production is almost at record highs again and steel prices are obviously rallying as a result of that and they are close to multi-year highs.
We believe China will stimulate late this year or early next year with another round of infrastructure spending and that should result in positive momentum going right through to 2019.
The area that we like is iron ore because there does seem to be a disconnect between the iron ore price and steel prices, with iron ore remaining quite subdued relative to a very strong steel price.
The way we’re playing that is through Fortescue Metals Group (ASX:FMG). It’s obviously the cheapest iron ore company in Australia and it has greater than 10 per cent free cash flow yield.
I think some of the initiatives the management team have implemented are increasing their value by improving the product – the West Pilbara fines premium product in particular.
I don’t think the market has really put any value on that at this point in time.
Which small caps do you like?
Three of the small caps we like are Aurelia Metals (ASX:AMI), Northern Star Resources (ASX:NST) and Evolution Mining (ASX:EVN).
They are ones that come to mind that still have valuation upside in our view.
What are the opportunities in battery metals?
There are some specific opportunities there, but they’ve all run a fair way and it’s a very volatile part of the market.
We don’t have any direct investments in lithium or battery-related commodity companies at the moment, but it is a watching brief.
There are some that have pulled back a fair way so there is quite a bit of research being done currently.
How do you identify a good investment opportunity?
For us it’s all fundamentally based. It is all about doing the research. We value companies looking out three years. We do typical profit and loss, we do balance sheets, we do cash flow analysis, but it’s all about doing that deep dive research.
It is about meeting management, competitors, distributors, suppliers, ex-employees to get a feel of the company. You need to obviously visit the assets to ensure they’re running as expected.
So it’s really doing a lot of desk-based research, but also being out of the office two to three days a week to see competitors and visit the assets.
And it’s all about focusing on the key components that will drive the majority of the earnings and hence drive the share price.
Firetrail has a high conviction investment approach. Can you explain what that is?
High conviction to Firetrail is all about being absolutely unconstrained – so looking for opportunities in all corners of the market, whether it’s value, growth, large cap, small cap, cyclicals.
It’s all about chasing opportunities wherever they are in the market.
High conviction is really all about having a small number of relatively large positions that have been deeply researched from a fundamental perspective – so we have that high confidence of being correct in the investments we go long and obviously being correct in the investments we’re shorting.
Obviously holding a small number of positions and relatively large positions can be risky so you need to do that bottom up research.
But generally high conviction managers, or concentrated managers is another way to look at it, have significantly outperformed the benchmark for a number of years as a group.
It is an approach that is getting a lot of interest in the Australian market both in retail and in the institutional market.
What are some of the key mistakes that investors make?
Number one absolutely is holding onto an investment when the investment thesis breaks down. That’s a big no-no for all equity managers.
Our view is when you get it wrong, when the investment thesis breaks down, the best time to sell is the day you understand that.
Nine out of 10 times in fact the market is right when the investment thesis breaks down. It’s a very rare day that holding on was the best strategy.
I think also people trade too often. If you do the work, if you decide on a valuation point, you should stick to it assuming the investment thesis is still robust.
Very few people do enough deep-dive analysis as well. So you need to not only do some top down macro views, but you have to have that deep-dive, fundamental analysis on the underlying stock on those two or three drivers of the underlying share price.
And you obviously need to visit the assets and talk to management and competitors.
Why should investors consider hedging/shorting in their portfolio?
The market has been strong for probably the best part of ten years both in Australia and globally and there do appear to be increasing risks out there whether it’s political or trade issues.
So we believe there is a lot more volatility on the horizon. Investors who are nervous about this should consider shorting as an option to reduce that market exposure.
What is shorting?
Shorting is the opposite to going long, so it needs a different mindset.
It’s all about selling a company on the expectation that the share price will fall in value and then at a future point in time buying it back, closing out that short, hopefully at a lower price and a profit or gain is made.
If you’re selling a company early at $1 and then you’re buying back at 80c then the profit is 20c.
So you are really, if you like, betting that that individual stock will fall in value at some point in the future.
What are the opportunities for generating returns from shorting?
It can be very lucrative, and it can significantly improve investors returns, but you do need that different mindset.
Clearly there’s added risk, so shorting is definitely not a set and forget type strategy. You need to be very active and you need to have the right systems to move very quickly.
There’s a lot of ways to short. You can short because a company looks expensive or you can short because there’s a thematic and there might be beneficiaries to that thematic or companies that will disappoint on the back of that thematic.
We don’t do any of that type of shorting because companies can remain expensive from the valuation point of view for many months if not many years.
We believe that type of shorting is quite dangerous.
Thematic shorting – like the Amazon example a few years back – is very binary in nature and I think generally the market overreacts to new competitors coming to the market. We steer clear of that.
If we’re shorting, it’s because of earnings downgrades.
Once we’ve done the fundamental research, if we’ve got a high confidence level that there will be an earnings downgrade in the upcoming earnings season, we’re happy to short that company.
All the research we’ve done over many, many years now shows share prices follow earnings.
If earnings go up, share prices go up, but most importantly on the shorting side if earnings go down then the share prices follow them down as well.
How does shorting in Australia compare to the US?
As you short companies you need to advise the broker whether you’re shorting or closing out a long position so the whole market is fully aware of the total amount of open shorts that are out there.
That works out to be around 2 per cent of the Australian market, whereas in the US it’s closer to 5-6 per cent.
So we’re relatively underdeveloped here versus the US and versus most parts of the world.
There are no liquidity issues with shorting, it just hasn’t been developed as much as it has in other parts of the developed world.
Patrick Hodgens has over three decades of industry experience, working in equity markets since 1985 and managing long and short equity funds since 2005.
Prior to establishing Firetrail Investments, Mr Hodgens spent 28 years at Macquarie Group where he was an executive director and head of listed equities.
He was responsible for a team of over 40 investment professionals based in Sydney and Hong Kong, managing in excess of $18 billion.
This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.