ARCO fund manager George Colman says he is cautious on the Australian economy and is warning of a “slow-motion property market crash”.
“Broadly speaking, we think that the game has changed in terms of consumer behaviour,” he says. “Bank credit is creating a step change.”
Credit is getting harder to access after last year’s regulatory crackdown. while the ongoing royal commission into the financial services sector is taking a deep dive into system practices and uncovering tales of banking woe.
Property borrowers moving from interest-only to more expensive fixed-rate mortgages are also likely to be another source of market stress, Mr Colman says.
He argues that those factors are likely to add up to increased consumer nervousness, which would be bad news for the economy.
National house prices fell 0.8 per cent over the year ended June 30, Corelogic reports, and auction numbers have also dwindled in key markets including Sydney. The latest auction numbers were a touch stronger, however, with clearances improving from recent dismal readings.
“Housing is partly related to our short positioning. We are cautious on anything to do with housing or credit and that takes a large chunk of the Australian market out of consideration,” he says.
A long property boom is at the centre of a stunning record of prosperity for Australia, with the economy recession-free for more than 26 years. But Colman believes the economy now suffers from declining breadth after a years-long narrowing of focus on housing and related sectors.
“We might limp along, but we would like to concentrate on other areas of the market,” he says. He prefers companies that are undervalued by the market, or are actively engaged in trying to improve their businesses or capital positions.
“They aren’t dependent on the Australian economy, of which we’re quite sceptical,” he said.
Height of the global crisis
Arco was formed in 2008 at the height of the global financial crisis by Mr Colman and Peter Whiting and the Melbourne-based investment management firm had $147 million of assets under management in its long-short Absolute Trust at the end of June.
The fund returned 6.5 per cent over the 2018 financial year, and Mr Colman admits that short positioning was a drag on returns in June, as the market rallied 13 per cent over the year.
Banks have rallied since June, with the sector taking back some of the losses made since the start of the year. The gains in the banks accompanied a strong push higher for the broader market.
That development, Mr Colman says, occurred “in a time where many strange things are going on” in the market. “There have been tremendous capital flows over the past six weeks into the Australian market.”
A drop in the Australian dollar and global investors buying Australian shares to escape turmoil in emerging markets are some of the factors behind the recent gains, he believes.
But Mr Colman expressed scepticism that those gains will last and says that ARCO is trying to keep its net market exposure to low levels in the current market.
“While it looks great from an index point of view, I think those flows tend to be typically transient and value insensitive. Often this money is just buying the index,” Mr Colman asserts.
Valuation is important
One development from the gains for the market is that it’s exceptionally difficult to find stocks to take up fresh long positions, Mr Colman says.
“Valuations keep going up and up,” he says, while earnings growth estimates haven’t seen a lot of change.
“Valuation is important to us. We’re finding it easier to identify potential short selling positions” in the current market than long ones, he says.
The ASX 200 is up 3.6 per cent year-to-date at 6065 and has repeatedly moved back to fresh decade highs over the past couple of months.
One bank stock that has been of interest to the fund manager is CYBG, the company formed from several smaller UK regional banking operations.
“We made some really good money in CYBG,” the fund manager says. “It was a classic orphan stock. It was ignored in the UK because it was seen as a small cap.”
“In our mind, it had a credible path and we viewed it as making the same progress as the big Australian banks without the credit cycle risks.”
CYBG CDI’s are up 1.7 per cent over the past year in the Australian market, after rallying hard since the start of June. It’s listed in the UK as well.
ARCO also likes agricultural chemicals maker Nufarm, which has seen its share price struggle since the start of the year, trading down 3.8 per cent at $8.41.
“Management have done a great job of cleaning up the company, driving ROIC and pushing for growth in Europe,” Mr Colman says.
The consolidation of global agri-chemical players after the merger of DuPont and Dow Chemical was competed last September has thrown up opportunities for other firms in the space, he says.
While new long positions may be hard to come by in the current market, Mr Colman argues that long/short funds have more flexibility to juggle market cycles than other types of funds.
“It’s a style of fund that doesn’t use a tremendous amount of market exposure. When we are bullish, we are a net 30 per cent long. We don’t like volatility, we are looking for smooth returns.”
“It’s all about finding opportunities that make sense,” he says, rather than investing in areas of the market that are opaque or inconsistent with the fund’s strategy.
“Our objective is to dampen down the volatility and get some sleep at night.”