Mr Dowsett has more than 20 years of experience in the investment management industry, having worked across a range of roles including trading, equity analysis and portfolio management in both Australia and the UK.

He was a founding member of Touchstone in 2015. Prior to this, Mr Dowsett was an investment analyst at Five Oceans Asset Management, portfolio manager and analyst at Hunter Hall, and investment analyst for BT Financial Group.

Touchstone investment director and principal, Jack Chemello, said the promotion comes at a time of exponential growth for the business.

“We are seeing heightened interest in our investment style, which focuses on quality at a reasonable price, and boosting our research capability at this time is a logical step.

“Blake has a wealth of market knowledge and has covered a broad range of sectors, including financials and capital markets, industrials, consumer discretionary, utilities and technology.

“In this new role, he will formally take responsibility for the oversight, management and development of the broader research function within Touchstone.

“Blake will continue working closely with the wider team as we continue exploring new opportunities for the business,” said Mr Chemello.

Mr Dowsett has a bachelor of business, finance and marketing from the University of Technology in Sydney.

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“A lot of the commentary about a potential recession that is making headlines is quoting data from the United States. It’s important to make a distinction and be careful about applying that same data to Australia.”

“There are two reasons why a technical recession is unlikely to happen on our soil – China’s reopening and immigration influx,” says Sargeant.

Sargeant says that with China’s reopening there is a positive boost to Australia’s trade sector, and this should do relatively well. Additionally, post-COVID Australia has a very strong immigration stream coming through.

“Even though you might see a per capita recession, overall, we think Australia might just get through without a technical recession,” says Sargeant.

“However, a US recession will still affect Australian equity markets even if our economy is relatively resilient”.

“A US recession will affect the global economy. Regardless of how well Australia does to avoid its own local one, markets globally will be affected by lower appetite for risk assets and reduced liquidity.

“So we will still see some impact on our stock market, even though it might not be as pronounced as if we had a recession ourselves,” says Sargeant.

Touchstone Asset Management continues to implement its existing strategy of owning quality companies regardless of the economic cycle. Sargeant adds that although the market is in an uncertain economic environment, quality companies can still be identified and added to the portfolio.

“Always own quality, just be careful that you don’t overpay for it. This strategy has generally worked well for us and is particularly effective in any sort of cycle where you’ve got a lot of uncertainty, and of course, that’s right now.

“Some investors focus almost entirely on trying to work out what earnings are going to be and then try and derive valuations. Their assessment of the quality and sustainability of earnings can be very subjective and inconsistent. We leverage our team’s experience by using a qualitative approach to assess many aspects of a company’s quality with those insights, then input into a quantitative framework. This systematic approach includes evaluating the strength of the balance sheet, the board, management, the industry structure and other factors, such as ESG.

“Quality is unusual in that you can get a company that is very high quality, but if it has one chink in its armour and you go into a tougher economic environment, that one chink can lead to a significant fall in value,” says Sargeant. “In general, high quality companies, like Wesfarmers for example, find ways to create value regardless of the economic cycle. Lower quality businesses, or business in lower quality industries, can often see their value fall, sometimes in spite of quite sensible business strategies.”

Looking at the current market valuations, Sargeant says that the industrials ex-financials are trading at multiples over 23 times, with long-term average in the high teens, whereas resources are trading well below average.

“Resources are trading at 10 times multiples versus the average of around 14 times, which reflects an expectation that commodity prices will come down, as they generally do during a US recession.

“Putting that all into the mix, we are wary of some of the more expensive industrials where we think there’s margin risk, but we think some of the resources look more attractive, and in fact we have been able to add new stocks recently to the portfolio where we think the market has maybe taken too short-a-term view.

“These stocks reflect high quality, but they’re better priced than you would otherwise expect. The producer of separated rare earth materials, Lynas Rare Earths is a great example of that,” says Sargeant.

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2022 saw the long overdue normalisation of interest rates, and with it the end of this way of thinking. In 2023, markets were abruptly reminded that the value of a company is a function of its present capital structure and its future cashflows. So, the questions to ask during reporting season are: 1) did the company finish the period with more or less assets or liabilities than expected, and 2) is there anything that offers an insight into the level of profit and cashflows the company will generate in future? With that in mind, in this article we review the February 2023 results.

Overall, this reporting season we found around 13 per cent of ASX-200 results beat and 28 per cent missed, with the misses skewed to smaller companies. This ratio of 45 per cent beats to misses is the lowest we have observed in five years, well below the average of 76 per cent. The price reaction to results was greater for misses than beats, with misses punished more than historical experience. This is symptomatic of deteriorating economic conditions.

It’s also concerning that the strongest sector for beats was consumer cyclicals (beats to misses of 175 per cent). This sector was the beneficiary of unsustainably strong consumer spending and is expected to be the most impacted in 2023 from higher interest rates. In fact, we expect it will likely be a good source of misses in future earnings periods.

Revenue was strong, boosted by inflation

Strong revenue was somewhat expected in the results given high inflation and the resilience of the domestic economy in 2022, which supported both higher volumes and prices. Overall revenue beats outnumbered misses by more than 3 times. This pricing power was particularly notable in some industries such as online classifieds (real estate, autos and job ads), supermarkets, insurance, and telcos.

The weakness was particularly notable in businesses with European exposure and in some commodities, where softening demand meant realised prices were lower than the headline commodity indices. This issue with commodity pricing is one we have been expecting to show up in reported numbers, with particular weakness expected in prices realised by the lithium sector. As the global economy slows, we expect this will continue to be an issue for Resources companies. It was notable that the miss to consensus earnings in Resources occurred despite persistent downgrades over the preceding 6 months.

Large misses in operating margins (which we expect to continue)

Since the outbreak of COVID, analysts have struggled to incorporate volatile cost movements and operating leverage into earnings. This reporting season was no different, with 40 per cent of companies missing expectations for operating margin. This was largely due to higher costs, particularly for labour and energy.

While most companies think input cost increases are moderating and supply chains are normalising, labour markets remain relatively tight. While we concur with the RBA that inflation has probably peaked, the risk is that inflation remains elevated. It was notable that Brad Banducci, CEO of Woolworth, said, “We underestimated how long it takes for things to flow through the value chain … Cost inflation in areas like wages, energy and supply chain remains material and well above recent history”. Contractors are particularly exposed to high labour costs, with Monodelphous commenting that “labour shortage remains the most significant challenge”.

An alternative indicator regarding the tightness of labour markets was the worsening safety metrics of many companies in the most recent reporting period. Jarden recently completed work showing that amongst the Mining and Oil & Gas sectors, Total Recordable Injury Frequency Rates (TRIFRs) rose for 45 per cent of the companies they analysed, with seven fatalities at listed and unlisted miners. Among the Industrial sectors similar trends were found, with their hypothesis that this may have been at least partially caused by labour issues – including a lack of skilled and semi-skilled labour, higher staff turnover and increased use of contractors.

Debt levels and interest costs come back into focus

Another line of the P&L that mattered more than it has in recent history was interest expense, with higher interest costs on average a 3.5 per cent drag on Industrials earnings growth. Leverage generally remains low, although for many corporates – most notably the Real Estate Investment Trusts (REITs) – it is clearly pressuring earnings.

We note that across our REIT universe the average cost of debt rose ~30 per cent in 1H23 and ~45-65 per cent for some of the lower quality names. This is expected to worsen, with distributions at risk and even the potential for recapitalisations if conditions deteriorate. Dexus said “the macroeconomic environment remains challenging … Higher interest rates will continue to impact our results in FY23”. GPT similarly commented that “higher cost of debt is a headwind for 2023 FFO growth”.

More recently, we’ve noticed that some of the smaller companies outside our investment universe may be unable to refinance debt, with highly dilutive raisings or changes of control the likely outcome. While the interest cost on debt has already increased, the spreads that corporates pay over benchmark rates (to account for risk) could still widen significantly, meaning interest costs may continue to rise even as central banks stop their tightening.

Preserving cash the focus while management remains cautious

While the P&L is the part of a result that gets most of the headlines, it is often the cashflow statement that is the greater source of truth – and the first half of FY23 saw a sharp deterioration in cashflow. Only 16 per cent of ASX-200 companies reported strong (>100 per cent) cashflow conversion (operating cashflow / profit) vs 28 per cent reporting weak (<80 per cent). This ratio of 57 per cent was well below the average of the past five years of 87 per cent, driven largely by working capital and continued high levels of inventory. The inventory deterioration was at least partially driven by channel destocking as those companies near the consumer prepare for weaker future demand. We note that Australian corporates inventory levels are below trend versus the US.

While operating cashflow was already weak, the equally revealing part of the cashflow statements was what companies did with their free cashflow. In short, they chose to do nothing; hardly a sign of buoyant optimism. Despite several capital expenditure blowouts owing to the cost and availability of labour and parts (particularly in mining), capex for the market overall came in below expectations. Similarly, payout ratios were around 3 per cent below expectations. Overall, 52 per cent of industrial and resource companies reported free cashflow (after dividends and capital expenditure) that was materially (>10 per cent) below expectations.

Scans of company transcripts found that management sentiment generally leaned negative and had deteriorated since full year results in August 2022. Sentiment was worst in utilities, packaging and building materials.

Consensus earnings remain optimistic

Consensus earnings for the Australian market have been largely flat overall for the last 10 months, following a large increase in early 2022. Reporting season saw around 34 per cent of stocks receive earnings upgrades, with 64 per cent downgrades.

In terms of the revisions, a skew to downgrades is typical and this season was no different, with the average upgrade +2.7 per cent and the average downgrade -4.9 per cent. The aggregate downgrade for the ASX-200 of around 3 per cent for FY23 and per cent for FY24 was driven by energy, transport, utilities and consumer durables, although several companies reported weak results but maintained full-year guidance. Consensus industrial estimates now suggest that full year earnings will be skewed to 2H23, which is at odds with the usual practice of around 56 per cent of earnings being generated in the first half and 44 per cent in the second half. This highlights a risk to FY23 earnings, but we are still seeing upgrades by analysts in our portfolio stocks such as Qantas, Wesfarmers and CSL.

In Australia, the ASX-200 earnings are ~13 per cent above trend with consensus earnings per share (EPS) growth for FY23 of ~5 per cent driven by growth in industrials of more than 20 per cent. This extreme level of growth is driven almost entirely by a small number of COVID impacted stocks for which earnings are recovering. QAN alone contributes 40 per cent of the Industrials growth in FY23, with the general insurers (QBE, Suncorp, IAG) another third. Consensus growth in each of FY24 and FY25 is still marginally positive, although this reflects large falls in earnings for Materials (-8 per cent) and Energy (-30 per cent) and a large rise in Industrials (+30 per cent), with around 70 per cent of this expected rise in Industrials earnings based on margin expansion. While slowing inflation may support margins, we expect this may be more than offset by lower pricing power, more competition and lower volumes. 

… too optimistic

Given the deterioration in reported results, and the deterioration in quality which often precedes further falls in reported earnings, we continue to think consensus forecasts are too high.

This logic has solid fundamental underpinnings. To start, a US recession is probable. Some recent work from Minack Advisors showed that earnings have become increasingly sensitive to cycle downturns over the past 35 years, with the suggestion that US EPS would likely fall 20 to 30 per cent in even a moderate recession. We also note that global monetary conditions in the past have led earnings by around 18 months and valuations by around 12 months. The global reduction in liquidity is therefore expected to weigh on earnings and the market over the next 12 months.

In Australia we are less pessimistic about the economy and the earnings outlook than the US, although we’re only just starting to see the real economic impact of higher inflation and interest rates. The CEO of Commonwealth Bank, Matt Comyn, recently said, “Across the board from a business perspective, trading conditions are really strong … but if you look at consumer sentiment and intentions data, you would think we are in the middle of pretty significant economic shock – which we aren’t.”

The change in behaviour in response to higher interest rates and overall costs from both consumers and corporates is only just beginning. The full impact will become particularly acute over the next couple of quarters as households face a peak in mortgage resets, which is expected to lead to a sharp deterioration in consumer spending and economic growth.

Buying quality companies at reasonable prices remains the best strategy

Given the uncertain macro-economic environment and potential policy responses, we continue to see value in owning quality companies that will be relatively resilient to negative external forces. Overall market valuations look reasonable at just over 14x (versus the long-term average closer to 15x), but this masks a high valuation for industrials ex financials (over 23x, versus long-term average of around 18x). Resources are trading just below 10x (versus the long-term average of around 14x), reflecting an expectation that commodity prices will fall over the medium term.

We have recently been able to add new stocks to the portfolio and as the year progresses and the downturn matures, we expect to have the opportunity to add further high-quality companies that have used the turmoil of the past few years to consolidate market share, hire good people from weakened competitors, reduce costs or opportunistically acquire cheap assets. These companies might operate in more cyclical sectors and thus offer more upside as the cycle turns.

While this is certainly not an easy time to invest, we expect 2023 to provide plenty of opportunities for fundamental active managers.

By Ron Sargeant, portfolio specialist

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Mr Sargeant said that while higher interest rates have had a very limited effect on the behaviour of Australian consumers to date, the next stage of the market adjustment will see rates start to have an impact on their spending.

“We expect the current resilience in consumer spending to last through Christmas and into early 2023, and our conversations with company management teams suggest strong price rises will continue during this period.

“While inflation should then start to ease in the second quarter of next year, it will remain at elevated levels. This should see stronger-than-expected wage growth in 2023. It is no surprise that with many workers already seeing real wage cuts, the current level of industrial action is near 20- year highs.

“Combined with high energy prices and prolonged impacts to supply chains, many companies will enter the second half of 2023 with elevated cost structures.

“The danger is that households will then start reducing spending in response to higher rates – particularly those with mortgages that will reset from fixed to variable rates. Corporates may then have a combination of lower sales (with negative operating leverage), higher cost bases and higher levels of promotional activity. This would drive a squeeze on margins and trigger earnings downgrades in the second half of the year.”

Mr Sargeant said one of the unknown factors in 2023 is how this pressure on company earnings may flow back into labour markets as corporates reduce costs.

“We think one of the key factors in the resilience of consumer spending – despite the growing pressure on households – has been the rock solid labour markets. The risk is that this changes in the second half of 2023.

“Overall, there is clearly a higher level of economic uncertainty than usual, and risks are skewed to the downside. Despite this, a number of companies are well-positioned to thrive despite the uncertain times. We have seen companies such as Wesfarmers able to invest capital at attractive returns despite the tougher economic conditions. As the cycle progresses M&A activity is likely to pick up, creating opportunities for investors.

“Another area of opportunity is commodities. At Touchstone, while we have been long energy since the COVID lows, we have had limited exposure to the miners. This is due to our view that China’s property downturn was worse than widely appreciated, and stimulus programs and reopening would prove problematic due to low vaccination rates amongst the elderly Chinese population. We expected these headwinds to be compounded by slowing global growth and improving supply in some commodities.

“This thesis has played out, but many resource stock valuations remain elevated relative to the price of the underlying commodities they produce. Our general expectation is that commodities should strengthen post Chinese New Year, but broad macro weakness and a strong USD through 2023 may continue to be a challenge.

“Overall, 2022 has essentially seen the first stage of the market adjusting to a more normal level of interest rates after a decade of low inflation and artificially low rates. We expect that 2023 will see stage two of the market adjustment, with consumers cutting back on spending and corporates seeing margins narrow. For investors, the aim will be to identify the quality companies that can take advantage of these conditions to continue to generate strong cashflows and growth, while avoiding those that are vulnerable to cost and industry pressures,” Mr Sargeant said.

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