Portfolio construction in a rising interest rate environment

John Grace, Co-Head of Equities and Portfolio Manager of the Ausbil Australian Emerging Leaders Fund, discusses performance of the fund, favoured sectors, individual stocks and outlook.

Melissa Darmawan: Thanks for tuning in to Finance News. I’m Melissa Darmawan. Here to talk to us today is the Portfolio Manager from Ausbil’s Australian Emerging Leaders Fund, John Grace. John, nice to meet you.

John Grace: Hi, Melissa. Nice to meet you.

Melissa Darmawan: Welcome to the network.

John Grace: Thank you.

Melissa Darmawan: First up, can you give us an overview of the fund and how it’s performed?

John Grace: The Ausbil Emerging Leaders Fund is largely a midcap strategy, with some exposure to the small caps in the domestic market. The fund’s had a relatively strong last 12 months, up about 21.7 per cent net of fees, against the benchmark of about 15.5 per cent. So, a relatively strong performance given the underlying circumstances.

Melissa Darmawan: We’re moving into a period where there’s higher inflation, let’s say sustained commodity prices and an imminent interest rate hiking cycle. Can I get your point of view in terms of those factors, what it means from an investment allocation point of view and also portfolio construction?

John Grace: Yeah, some great questions there. For us, our focus on top-down, bottom-up investment process leads us to be positioned for growth, but there’s some moderation in that growth given the headwinds that you’ve just mentioned, particularly higher rates. So, the sectors we are mainly favouring continue to be the resource sector, where we see strong pricing fundamentals and strong supply and demand fundamentals as well, and that leads us to be overweight that sector. And in the midcaps in particular, I’ve got some really good stocks I can get my teeth into, and give me good exposure across the commodities suite, from lithium, to nickel, to copper, and to iron ore in particular. So, therefore, the fund has remained overweight those sectors, and I’ve been adding to those type of stocks in the pullback of recent times, given the pullback in some of those resource-related names as there’s fears of growth, potential slowdown in China, etc and that’s always a good buying opportunity when the underlying supply and demand fundamentals remain robust. So, we’ve remained overweight resources for largely the last 12 months, and that’s helped returns in the fund.

Melissa Darmawan: Given that landscape, have you made any changes to the actual fund itself in terms of a sector move or potentially added or removed any other stocks?

John Grace: Yeah, the fund is always active. But, on balance, the fund has remained overweight a growth tilt, and that’s largely reflected in the materials space, which is quite a wide sector in the domestic market. But, within that materials space, overweight resources, which I’ve just touched on, overweight fertilisers and chemicals, and increasingly overweight some gold exposure, given the outlook for gold as a potential safe haven. And those gold stocks have really pulled back quite hard, and I’m finding some terrific value there. So, I’ve added some gold into the portfolio in the last 12 months.

Melissa Darmawan: Talking about these individual stocks as such, are there any actual positions that you’re excited about?

John Grace: Yeah, of course. I’m excited about stocks such as Lynas (ASX:LYC), which has been a core part of the portfolio for a number of years now. The fundamentals continue to improve for that stock. You’ve got a supportive commodity price, you’ve got nearly $700 million in the bank, and prospects for growth in rare earths, not only in Malaysia, but also increasingly in Australia as they start to produce in due course after they’ve built the plant. And then increasingly in the US as well they’ve got some plant exposure over there. So, we really like the outlook for Lynas (ASX:LYC) in particular.

Melissa Darmawan: Are there any other stocks?

John Grace: Sure, Melissa. There’s always opportunities in the domestic market. Another stock that I’m keen on and I’ve had in the portfolio for a while is Allkem (ASX:AKE). It’s the former Galaxy Resources which merged with Orocobre. And it’s got some very good exposure to the surging lithium market, and it has operations in Argentina, Australia and Canada. So, it provides some interesting angles going forward for increased production over time, and very well tied into the EV story.

Melissa Darmawan: Are there any risks that investors should be aware of?

John Grace: Yes, there’s always risks, but always opportunities. One thing you mentioned earlier was rising interest rates. We’ve seen market rates already rise, and now we’re starting to see central banks raise the official cash rates. So, that puts a bit of a headwind into equity valuations in particular. We’ve already seen the impact on the Australian tech market, where a lot of stocks have pulled back quite materially. And that does interest me actually, because some have pulled back a little bit too much, and we’re starting to do a lot more work in that tech space. And I think there’s some opportunities there going forward, and the team is quite excited about some of those opportunities.

Melissa Darmawan: Can you give us some more colour as to what you mean by that?

John Grace: Yeah. Some of the midcap tech stocks offer some really interesting opportunities post that pullback now. There’s some really good global leaders in that space. And I’m referring specifically to WiseTech (ASX:WTC), Carsales (ASX:CAR), REA (ASX:REA), which is a domestic stock — it does have some offshore exposure — and Domain (ASX:DHG) as well. And all of those stocks have pricing power, which really starts to make things interesting on that pullback. Yes, they’ve had some PE compression, but their underlying earnings remain very robust and they’re providing some opportunities for us as investors.

Melissa Darmawan: I can see that you do have financials as one of your top three sectors in the fund. What does it mean in this environment, then?

John Grace: Yeah, we’re looking for financials that will benefit from higher rates and therefore better cash margins, and improving earnings and earnings revisions. So, I’ve got Bank of Queensland (ASX:BOQ) in the portfolio. That is a beneficiary of rising interest rates. I’ve been very active in Challenger (ASX:CGF), which is also a beneficiary of rising rates. And increasingly over the last few months, I’ve been doing a lot more work on AMP (ASX:AMP), which is going through a demerger, which has just been cancelled actually, because there’ve been some very significant interest in their Collimate, or the old AMP Capital. And that’s proving to be very attractive for investors. And we’re expecting a decent return for investors and shareholders over time as AMP starts to give some of that excess capital back following the sale of some of those assets. So, that’s been a key part of the portfolio for the last six months or so.

Melissa Darmawan: Last question for me. What’s your outlook for this year?

John Grace: I think equities may struggle a little bit given the rising interest rate environment, but that doesn’t mean there’s a lack of opportunities in the market, and I’m finding opportunities all the time in the midcaps and the smalls, and the team is very active researching these opportunities, to then populate the portfolio and generate excess returns.

Melissa Darmawan: John, that was really insightful, and I look forward to speaking with you again.

John Grace: Thanks, Melissa. Thanks for those questions.

Ends