This article was originally published on on March 23rd, 2021

Andrew McKie is a Founder and Portfolio Manager of Elston, which is a Brisbane-based wealth manager and they do SMAs, separately managed accounts, mainly wholesale for other financial planners and was started by a group of fellows from Wilson HTM and they are large-cap investment managers, so only in the top 100, mainly top 50. I thought it’d be a good idea to talk to him about where he’s positioning and how he’s seeing things at the moment.

Here’s Andrew McKie, one of the Founders and Portfolio Manager at Elston.

Andrew, you and Peter McVeigh and Bruce Williams, all from Wilson HTM, started the business back in 2008, which was a very interesting time to start some sort of asset management business, wasn’t it?

Yeah, a bit of a baptism of fire, I think about two weeks after Lehman Brothers collapsed. Certainly, it galvanised our thinking around how to manage portfolios pretty prudently. We came out of more of a wealth background and then extended into asset management. We have a specialist skill in managed accounts which has been around for a long time and now, flavour of the month, really, with the rollout of more of the disruptive platforms like Hub and Netwealth, so we’re seeing a lot bigger take up of SMAs. We really applied that to the external market through Elston Asset Management and that’s growing very rapidly, we have about 250 advisers using us, just over 100 financial planning firms and that’s, I think, a combination of a good long-term track record, as well as that industry push towards managed accounts so investors get the benefits of transparency and all the things that come along with that.

It says on your website that you were determined to move away from the old system that was failing to meet client and adviser needs. Tell us in what way is it failing and what are you doing differently?

I think if we look at managed accounts, ultimately that’s come down to de-unitising investment, so your traditional access, the traditional financial planning network was bank-owned, it was a product distribution model and a lot of that went into funds. A managed account is going direct to the underlying asset, bypassing the unit trust structure and there’s a lot of key benefits that flow from that to investors, the most simple one being after-tax return management. Our view is there’s not a lot of point in investing your capital in a certain structure for a certain tax outcome, but then not managing the money in accordance with that structure, so really focusing on after-fees, after-tax returns, a managed account enables that, managing a CGT for example or franking credit to ensure that your net return, not gross return, is the key driver when you’re managing money.

It sounds a bit like you’re mainly a wholesale operator, is that right?

Yeah, that’s right. It’s a growing part of the business. We have about $3 billion under management and all in managed accounts. As I said, I think it’s a little bit of that industry tailwind as well, although SMA managed accounts have been around for a long time, there’s been a few enablers recently, technology, as well as the exiting of the banks from wealth to really open up choice for advisers and we’re benefitting from that.

Can I ask what you charge?

A managed account or SMA for the Australian equities, which is a large-cap portfolio, depending on the platform, is around 44 basis points. We’ve deliberately priced very competitively because we have a large-cap focus – 80 per cent of the portfolio is ASX50. We have very large capacity. I think the Australian equities capacity is something like $7 billion, so we’ve priced accordingly and we’ve really positioned that portfolio to compete with passive, to compete with Beta. We think it’s better than Beta in that you are managing after-tax returns, you’re managing some of the inherent concentration risk in our index. We’ve always been very concentrated, whether it be the banks or the resource businesses, managing some of those concentration risks which you can’t do in a passive product, but pricing aggressively so investors aren’t paying a huge premium to get access to that.

You’re really providing an alternative to ETFs and passive investing?


It sounds like about double the fee of an ETF?

Yeah, that’s right. On average, the investor might pay another 20 basis points, 25 basis points more but they’re getting after-tax outcomes, they’re getting direct portfolio and also we’re dealing with some of those concentration risks in the index. Over a longer period of time, we have a five-year track record that’s actually now close to a ten-year track record on SMA and we’ve been able to deliver close to 2 per cent outperformance above the benchmark after fees. We think that that’s a good value equation for the end investor. The way you think of alpha – the premium above the index, it’s not typically persistent with managers, but if those managers are able to deliver that over a long period of time, usually they can continue to deliver that. I guess one of the ways of thinking of that is if you’re buying a passive asset or passive index ETF, that’s quasi-MER, in a sense, you’re paying 2 per cent because you don’t have the ability to outperform the index over the long-term.

Your long-term outperformance is 2 per cent and I presume if you’re up against ETFs, you’re only playing in the top 50 or something, is that right?

Yeah, we are dedicated large-cap managers, so ASX100 universe, but as a constraint 80 per cent of the portfolio is ASX50 and with the maximum 20 per cent in the 51 to 100. We are dedicated to large-cap and we see that as a real alternative to beta, to ETFs, you can build that as a foundation part of your Australian equities portfolio and then perhaps add a specialist manager for small to mid-caps and build a portfolio that way.

Do you have limitations on your overweight and underweight within the 50?

Yes, we have a minimum of eight industry groups, so the first constraint is we must be reasonably well-diversified across industry groups, so eight industry groups in the portfolio. In terms of maximum position size, it’s 6.5 per cent in any one business so we can’t have large positions within the portfolio as well.

Where do you get 6.5 per cent from?

Well, we looked at historically our market, for whatever reason, builds up these very large fish in a small pond – and think of CSL at the moment, in the past it’s been CBA, it’s been BHP. I think at the height of the resource boom BHP was 14.5 per cent of the index. We don’t think that that’s true diversification, one of our core investment philosophies is genuine diversity and so, if you’re so concentrated in one holding or one sector, that’s not managing risk of getting that wrong. That’s why we have a fixed weight and we have a constraint at the top as to how much we can have in any one business. Because, as a manager, you might have particular views, but you may be wrong in those views. You need to accept that and put constraints around the portfolio to manage the risk for the investor.

How do you make your decisions about overweight and underweight?

We convert our investment philosophy via a process. The investment process starts with screening our universe, we screen on various growth and value criteria. That really is about our idea generation as well as some top-down macro sector positioning. Then, when we look at a particular business, we then do a three-year valuation which we predominantly use EBIT as the basis for valuing your business. We have four portfolio managers, two analysts that do that work on large cap. We all go away and do our work on that business and work out what we think EBIT will be in three years’ time and then what we think a reasonable EBIT multiple is for that business. That gives us our total return. Our job really, we see ourselves as just glorified valuers.

Our business is to value businesses and identify gaps between intrinsic value and the current market price. That really gives us our return expectation and the return expectation drives a lot of the weightings. It makes sense too if you’ve got a business that you believe has the highest expected return, that it would be close to your highest weighting in your portfolio.

You value businesses three years out, is that right?

That’s right.

And then what, apply a PE to that value?

That’s correct, yeah. We look at the operating earnings of that business, look at the drivers of sales and expenses. We get a sense of what we think margins will do over that period of time and that gives us an EBIT number. Then we use an EBIT multiple to value that business, which usually is driven through growth rates and also comparative multiples for the sector. We find that that three to five-year timeframe is a bit of a sweet spot, we call it ‘timeframe arbitrage’. You’ve got a lot of the market is sell-side, sell-side broker activity, and usually, that’s fairly short-term, that’s 6 to 12 months and so, we find there’s a bit of a gap there in the outlook and for us, that’s a sweet spot where we’re looking not ultra-long-term. What you might do, a growth manager might look at 10-year timeframes, within that three to five years there are always opportunities presented to us in large-caps.

So you’re not a value investor or a growth investor, right? Would that be fair to say? Or are you more value than growth, perhaps?

Well, at times the composition will change in the portfolio. All we do is look at relative value, Alan. If you’re looking at a business, we don’t really put them in certain buckets, it’s about how much are you paying for that business relative to the earnings growth of that business. That composition may change through time depending on how the market is pricing those businesses. For example, last year where we had growth do really well, they weren’t screening all that well for us because the market was paying a premium for them, so on a relative basis, although maybe growth’s there, if you overpay for that growth, it’s still going to be a bad investment.

Equally, if you buy a value business with no pathway to earnings growth, it’ll be a bad investment as well. The composition will change through time and that’s why we are style neutral, we think that gives the investor a smoother ride through time. It might mean that at a time when growth does well, we will slightly underperform, but not as badly as, say, a pure value manager. That’s what we’ve found is the consistency of our company through time.

What do you think is a decent EBIT multiple for a three-year sense, what’s the upper limit of what you pay?

We don’t really have an upper limit, we have some constraints. Around 25 times EBIT is a slight constraint where we’d look at it but it really comes down to the growth. A good ratio that we might look at is a PE to growth rate, what are you paying relative to the growth of that business? You can justify paying a much higher multiple if the earnings are going to grow over that period of time at a high rate. For us, that’s a two-sided equation when you’re looking at PEs or multiple, you can’t answer the question unless you know both sides of that coin which is the multiple and the earnings growth, that gives you the full picture.

Afterpay is in the top 50, does that mean you have to be in it or are you in Afterpay because you want to be or not?

No, we don’t own Afterpay. We don’t have to build a portfolio around the index, we are a pure active manager. We don’t build the portfolio with regards to index weightings, we build it based on the portfolio construction constraints as well as those ETRs. But something like Afterpay, our investment philosophy really excludes something like in that it’s currently not profitable and so one of our core investment philosophies is preservation of capital and for us, that’s downside protection and earnings as a basis for that. We’ve certainly looked at that business given it’s our universe, but it’s something that we, at this point in time, wouldn’t be comfortable owning.

Is that just simply because it’s losing money?

Not simply because of that. One of the things when looking at the business is really about sustainability of business models and that’s about balancing up the various stakeholders of a business, whether it be the customer, whether it be employees, whether it be shareholders, but balancing those often competing requirements is all about building a sustainable business model. If we look at Afterpay, we think that it’s a receivables factoring business, it’s very good for the retailer in that the retailer is able to get the sales upfront, the cash up front, and then Afterpay funds those sales and collects the money, the receivables in.

But, the pitch to retailers that they’ll increase the basket size, they’ll increase the frequency of sales, more traffic and so on, and so from a sustainability point of view we wonder where the consumer sits in that equation. If we’re driving increased sales, largely driving sales from money that they don’t have at the moment, or that the basket size is larger, that means that they’re spending more than potentially they should be, we question how sustainable that business is.

The trouble is that not owning Afterpay in the past 12 months means that you’re underperforming the top 50 index quite a lot, I imagine.

Yeah, that’s right. It’s been a huge contributor and we find that’s what happens, we go through a period of underperformance and usually, that’s followed through as those circumstances reverse through a period of outperformance as well. But if you have an investment philosophy it’s about discipline, it’s about not chasing your tail and not getting caught up in some of those things. We will always accept some form of underperformance in the short-term if we’re doing the right thing for investors longer-term and we’ve been able to deliver that, and that is about having an investment philosophy that you believe in, it’s a genuine belief and you implement that consistently through time.

What about Xero, which does make money but it’s on a colossal PE?

If you look at that whole sector, so if we look at a macro view and we convert that down to a sector positioning – say, if we look at the IT sector at the moment which will encapsulate a lot of those businesses that you’re talking about…

Well, there’s not many of them in the top 50.

In the 100, that’s right.

I suppose, there’s more in the 100 though, yeah.

Yeah. When we’re looking at those sectors, we’d look at those on a relative basis. Two things we’d look at is, how is the sector currently valued relative to itself over the last 10 years, firstly – and say, if we look at IT, IT’s trading on around 80 times earnings, which is a 215 per cent premium to its long-term 10-year average PE. And if you look at it versus earnings growth, which is the second thing we look at, forecast 26 per cent earnings growth, but relative to the multiple you’re paying for access to that growth at 80 times, we think it’s overvalued at this point in time. Versus something like, say, financials at 16 times – now, financials are trading at a 25 per cent premium to the long-term 10-year average to themselves, so if you look at that and say, “Well, banks are trading at a premium at the moment…” but relative to earnings growth we’ve got 30 per cent EPS next year for the banks, going to close to 15 per cent the following…

30 per cent?

Yeah. Relative to earnings growth, we think there’s two measures of relative valuation. One is relative to how that sector’s traded to itself and relative to the earnings coming out of it. As we position for that COVID recovery, some of those more COVID challenged sectors like financials will show very strong earnings growth as they come off a lower base of earnings. That’s the way that we’re thinking about…

You’re at 6.5 per cent of some of the banks, are you?

Yeah, we are, I think, 6.25 in ANZ and Westpac, we’ve got Macquarie, we’ve got Virgin Money in the portfolio. But, just as an example of sector positioning, there’s some of the things that you might look at and probably answers part of the question as to why we’re underweight IT as well.

And where are you at with CSL?

We’ve been underweight healthcare for quite some time, but as we’ve seen bond yields firm, some of those healthcare businesses have started to come back into the radar for us, which is what I was saying earlier around how the composition will change through time. We’ve recently added Ramsay Health Care as an example, as they’ve de-rated during COVID and we’re doing a lot of work on Cochlear at the moment, not that we own it but it certainly has come back for us to be in the sweet spot and CSL would form some of that. Although, we still think on balance we can’t quite get there on a relative value basis. As we see some de-rating of those more defensive growth sectors as bond yields firm and as people position for COVID recovery, that will then provide us some opportunities as well.

What about the travel stocks like Sydney Airport, Qantas and so on?

We’ve got Sydney Airport and Flight Centre in the portfolio position for those. Sydney Airport’s probably the better quality way of some of your subscribers looking to get exposure to the increased travel demand, which we think will come domestically first and then international next year. But if we look at Sydney Airport we think that that is a monopoly asset, very high margins, good diversification and so we think that is well-positioned to benefit from some of the shift in consumer spending back towards travel. We think although international will be slower and potentially corporate travel will be less than it was previously, we think that’s very much in the price and so someone like Sydney Airport is where would be our best positioning for that recovery.

Just finally, on the sector questions, what’s your thinking on resources at the moment, miners and energy?

We positioned overweight resources a few years ago back in 2015-16, when there was a significant correction there. As a large-cap manager, getting that positioning between the banks, the financials, industrials and resources is really key to your outperformance. We positioned well for that in Rio, BHP and Fortescue and we’ve been reducing those exposures, reducing the weightings to BHP and Rio and we actually removed Fortescue from the portfolio.

You’re out of Fortescue entirely?

Yeah, we sold Fortescue. We bought that at very low sort of $4 to $5 dollars around that ’15-’16 period when there was a big discount to lower grade iron ore and we thought that was an opportunity for them that they’d paid off a lot of their debt and the balance sheet was looking a lot stronger than what it was previously, but we’ve seen a fairly strong pickup in iron ore prices on the back of vale production as well as the stimulus that’s going on in China. We don’t see from here, the opportunity that we had a few years ago in resources. Although, we still think they’re high-quality businesses, particularly BHP and Rio, we are certainly not overweight at this point in time.

Well, Fortescue would have helped you being out of Afterpay, Fortescue would have helped offset that a bit?

Yeah, that’s right, it’s been a lot better than what we thought it would have done when we first positioned to it. It can show you what can happen and how – you know those timeframes that I was talking about earlier, Alan, that timeframe arbitrage between the short-term sell-side broker activity versus the three to five-year time horizon, we consistently get those opportunities come through.

Do you ever go to cash, or you’re fully invested all the time?

No, we can go up to 20 per cent weighting in cash in the Australian equities large-cap portfolio, maximum is 20 per cent. Our view is that usually investors are allocating that for equities, that’s why they’re using us. We don’t feel that we should then put the money in cash because that would be their choice around how they allocate capital. But we want the flexibility that if there is systemic overvaluation across the market, if we wanted to be in a position to hold more cash we can do so.

Where’s your cash at the moment?

We’ve drawn that pretty low, although we’re still a reasonable weighting, I think we’re sitting at around 3.5 to 4 per cent cash, so that’s pretty fully allocated to equities and we built that up pre-COVID and gradually reallocated that out from about 7.5 per cent allocation of cash to where we are now.

What does that say about your view of the cycle, where are we at in the cycle, do you think?

I think for us it’s really about the macro sector positioning as well as some of those bottom opportunities, so stock picking is going to be really critical, as it always is, but given the macro scenario is so unusual given what’s happened with COVID, we think that’s critical for investors doing well going forward. I’m probably more the optimistic part of the team, but I think given the fiscal support that we still have, the monetary support that’s out there, the fact that we have got the vaccine rollout, we are seeing some pretty strong consumer and business confidence numbers on the back of that, on balance, even though we’ve seen bond yields firm on inflationary expectations, we still think that that’s overall very supportive for equities as well as property. Really, there’s very little choice for investors and so we think that that does support asset prices more broadly, as well as having a fairly favourable macro picture.

Yep, very good. Great to talk to you, Andrew, thanks.

Okay, talk to you soon.

That was Andrew McKie, who is one of the Founders and Portfolio Manager of Elston.

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