Andrew Fleming

After many years of promise for inflation to return to happier times, inflation stubbornly persists with higher energy costs still a feature of the equation. Despite the tighter credit conditions brought on by sticky inflation, the economy has digested higher rates well; banks lead the charge with strong credit growth outlook and nay a bad debt in sight. Equally while consumers make a lot of noise about cost of living, spending has largely held up. We see clear risks going forward and believe it is prudent to price them into valuations.

In Walter Isaacson’s wonderful biography of Elon Musk, he recounts two Twitter IT infrastructure managers informing Musk that a data centre in Sacramento needed to be moved, and that it would take six to nine months to do so. “Does this timeframe seem like something that I would find remotely acceptable?” Musk asked. “Obviously not. If a timeline is long, it’s wrong.”

A long timeline in investment is what’s required when asset multiples are high; like now. The only certainty, amidst the plethora of assumptions behind these high multiples – inflation, equity risk premia, idiosyncratic risks and their magnitude, growth in free cashflow – is that, as Musk says, they will, collectively, be wrong. Across sectors, across timeframes, what seems like a sure bet today, can morph into the equivalent of a financial instrument laced with polonium tomorrow. Not that those buying assets are showing any fear; in the face of persistently higher inflation and interest rates through FY24 than had been forecast at the start of that year, asset prices have been immensely strong almost without exception, and the highest multiple assets have been strongest.

Whilst asset prices broadly have been strong, two standouts have driven the ASX through the past year.

The rise and rise of the Australian banks through the past year, notwithstanding no earnings growth, has been well documented (as we did, for example, in a recent monthly commentary^[1]). We remain underweight the sector and see little to change the view that an improvement in long returns for the sector remains challenging, even if nearer term margin pressures have abated. The best that can be said for bank performance in the context of the ASX is that the sector has not had downgrades through the past quarter, which in the context of a strongly rising market is a surprisingly good outcome. At record multiples, and with CBA trading at the highest multiple of a developed market bank in the world, the timeline required for an investment today in the Australian banking sector has never been longer.

In Australia through the past quarter, however, the timeline has mattered most of all. As can be seen in the chart below, if the rise and rise in the market capitalization of NVIDIA was purely an earnings phenomena, with the multiple attaching to the stock being unmoved (albeit not decreasing as would be natural if the current earnings boost was seen as unsustainable), that’s not what has happened with the ASX stocks that have most aggressively performed in reaction to the AI phenomena. Goodman Group, for example, provides a great contrast to NVIDIA in contrasting the extent to which market gains have been driven by earnings as opposed to rerating. This rerating of Goodman has seen it as a material contributor to the index performance through the past year – only CBA added more point to the index returns through FY24.

It is not as simple as contrasting NVIDIA as a flow company, that is selling a consumable item, with Goodman as a stock company, that is as the developer and owner of long term rental streams. NVIDIA is at pains to explain now why it is a platfrm company, especially with the release of the Blackwell platform. Whilst time will tell on that front, there is little doubt that very little of the Goodman valuation is due to its status as a landlord, with the property investment and funds management segments collectively representing far less than half of Goodman’s current market value.

If Alan Joyce was the high priest advocate of running a business for the short run, those legitimately doing to the contrary must often be frustrated by the lack of recognition they receive for running the business. An example of a change in philosophy in this regard is James Hardie, where in recent years and due to a cacophony of unrelated circumstances, much institutional memory has been wiped from the board and management. A new chair, CEO, CFO and now head of IR, each with a US base and mindset, has led to a different strategy and risk profile. As can be seen in the slide, Hardie has released the pricing lever in the past three years, lifting price more in that time than had been the case for the past decade. A margin frenzy has been the obvious reaction, with the “beats” provoking the predictable market response. As shareholders in Hardie, long may it last. However, we are not blind to some of the potential cost of this strategy. A former, long standing and highly successful CEO of Hardie, once asked us to hold him to account were he ever to allow margins to reach levels much lower than have been recorded in the past two years for the very reason that it would jeapordise the potential terminal penetration of fibre cement as a product in the US market, which was, and is, the major value driver for the group. Interestingly, for the first time on record, the US Census recorded fibre cement as losing share in completed single family houses in the US in 2023 (23% to 22%). It is of course true, as Hardie management now maintains, that the group’s margins and returns are so high that allowing laxness in opex and capex does not now matter too much; but that does little to acknowledge that it is only an asset that can be exploited because of the eternal vigilance on both fronts by those that preceded them. The long term benefit of a disciplined operating cost base, and capital expenditure, can easily be underestimated. Without such recognition and care, such an asset can readily be diluted or worse.

Natalie Davis has been appointed as the new CEO of Ramsay Health Care upon the retirement of Craig McNally, who has been in the business for almost four decades and led it for seven years. Since 2014, Ramsay has increased its asset base five fold, or A$16b, and yet eps has declined by 20%. Growth has been misdefined; the timeline was long, and unfortunately was wrong. The task now confronting Ramsay is two fold; firstly, much of the expansion in assets has been in the northern hemisphere, which has proven that being the champion private hospital operator in Wagga counts for little in France. The confounding aspect of this has been that Ramsay’s own accounts define the northern hemisphere operations as having lower returns and higher risk than its domestic operations and yet it continued to invest aggressively into the UK and French markets. Such expansion is now in the past, if only because the balance sheet has forced an interruption to what was becoming a series of unfortunate events, and with a new chair and now CEO the opportunity arises for Ramsay to realise its under earning assets (even at prices below book value), and focus upon harvesting returns from its domestic asset base. The privileged position of Ramsay’s local hospital assets should not be underestimated; they do have pricing power if managed adroitly and sustainably, and recent replacement value metrics across the market support the view that even if they were only average assets in their industry, their current replacement value is in excess of the market value. We have presented to the Board of Ramsay in recent years highlighting this as our preferred path for the group to create value, albeit to a mixed reception. A new chair and CEO creates the opportunity for a fresh assessment of the real value to be had as Ramsay metamorphosizes from the profitless prosperity of the past decade. Here’s hoping the timeline for this isn’t long at all.

Market Outlook

Whilst pressure upon consumers continues to mount, with rents, mortgage rates and general living expenses all remaining stubbornly higher year on year, consumption still remains strong at 4% yoy growth, and the impact is aggressively demographically skewed, with the lower income and wealth cohort (notably the young) being impacted to a great extent than others (notably, the not so young). The RBA has made it clear that persistent inflationary pressures are such that interest rate reductions are still some time away in Australia. We expect the earnings growth of 11% currently expected for the market in FY25 to be revised lower as reporting season progresses. Beyond 2025, large shifts in value are likely to globally arise as a consequence of several structural themes; fiscal pressures, redistribution of wealth and decarbonisation. Whilst it is tempting to add AI to that list no company we have spoken with, even those assessed as being AI  has yet been prepared to nominate a material economic benefit likely to be seen in the next few years. Whilst cognisant of Musk’s warning – if a timeline is long, it’s wrong – we continue to believe that Australia will be affected by each of these factors at least as much as most countries, and that those forces are all still nascent.

By Andrew Fleming, Deputy Head of Australian Equites 

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Notes:
[1] https://www.schroders.com/en-au/au/adviser/insights/commentary-just-do-what-the-customers-want/

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Andrew Fleming

Schroders is excited to announce that Netwealth has added the Schroder Equity Opportunities Fund to its super and investment solution.

The Schroder Equity Opportunities Fund is now available via Macquarie Wrap, HUB 24, mFunds and Netwealth. Lonsec has given Schroder Equity Opportunities Fund an initial rating of Recommended.

Graeme Mather, Head of Distribution says “We are pleased that Schroders have been able to accommodate the strong demand from the market through further platform inclusion.”

Lonsec reports: “Given the nuances of the local market, Lonsec believes the Fund’s ‘all-cap’, benchmark unaware approach can offer improved economic diversification relative to a traditional benchmark aware approach. Furthermore, Lonsec has high regard for the investment team led by Martin Conlon and Andrew Fleming as well as Schroder’s ‘bottom-up’ investment process”^[1]

Schroder Equity Opportunities Fund invests beyond the benchmark for greater breadth, taking insights from Schroders’ Australian Equities team to invest across the full market cap spectrum. At September 2017, the fund has delivered returns of 13% (net of fees) over the preceding 12 months.

Longer term, the Fund has outperformed the S&P/ASX300 index by 3.4% p.a. (net of fees) since its inception almost 10 years ago.

The Schroder Equity Opportunities Fund allows unconstrained investing and avoids the pitfalls of cap-weighted benchmarks without the stock concentration normally associated with ‘high conviction’ portfolios. The team also manages the Schroder Australian Equity Fund, which has held Morningstar’s highest analyst rating for 10 consecutive years, retaining the ‘Gold’ Morningstar Analyst RatingTM^[2] in September 2017. Schroders was also awarded 2017 Fund Manager of the Year in Domestic Equities – Large Caps Category, Australia. Morningstar Awards 2017 (c). Morningstar, Inc. All Rights Reserved.

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[1] The Lonsec Rating (assigned as follows: Schroder Equity Opportunities Fund – 28 September 2017) presented in this document are published by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421445. The Ratings are limited to “General Advice” (as defined in the Corporations Act 2001 (Cth)) and based solely on consideration of the investment merits of the financial products. Past performance information is for illustrative purposes only and is not indicative of future performance. They are not a recommendation to purchase, sell or hold Schroder Investment Management Australia Limited products, and you should seek independent financial advice before investing in these products. The Ratings are subject to change without notice and Lonsec assumes no obligation to update the relevant documents following publication. Lonsec receives a fee from the Fund Manager for researching the products using comprehensive and objective criteria. For further information regarding Lonsec’s Ratings methodology, please refer to our website at:http://www.lonsecresearch.com.au/research-solutions/our-ratings This rating is not to be circulated or distributed and is solely for the information of financial services professionals, such as a financial adviser.

[2] © 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf . You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 (“ASXO”). The Morningstar Analyst Rating for Schroder Australian Equity Fund strategy is ‘Gold’ as at 21 September 2017.

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Andrew Fleming reviews the outlook for Australian equities.

The only game in town continues to play for Australian Equity investors. Over the past year the ASX200 index is flat, but Resources and Energy are both down 25%. Every other sector is up. We were overweight Resources and Energy a year ago and are more overweight now. Last month the bifurcation in returns stretched to a record extent. The egg is still drying on our faces, as the red ink is dripping from our portfolio sheets.

Commodity prices have clearly been hit hard, and with them have gone resource securities. Even our positions in the low cost, long life, lowly geared, quality resource names have underperformed aggressively in line with commodity price falls, with BHP and RIO both underperforming by more than 20% though the past year. Our assumptions on mid cycle earnings are about to be tested; amidst an archipelago of assumptions made in valuing shares, the key ones for Australian resource names – major commodity prices and currencies – are now close to our assumed long run sustainable levels, for the first time in many years, and hence the earnings and cashflow produced by the resource stocks in our portfolio this half should give us comfort, or pause for thought, with our valuations. That of course doesn’t account for the depth and breadth of time that may be spent “below the curve” as commodity markets continue to adjust to lower demand levels than had been envisaged, but of course this scenario also has broader implications for the Australian economy and market.

In that context, foreign earners have been well sought. All of Aristocrat, CSL, Resmed, Macquarie, Recall and Amcor have outperformed by more than 40% through the past year. Prima facie, buying foreign earnings before, or as the Australian dollar corrects to equilibrium, is a sensible strategy. Ultimately, however, multiples matter, and can’t divorce themselves from a sustainable growth rate; refer 2000, 2008, et al. We have owned most of the names on that list through the past year, but clearly not enough, and we own far less now than we did a year ago, albeit still more than our models suggest to us is now justified purely on valuation grounds. Resmed, for example, is now trading on 20x EBIT for low single digit growth; and it is far from the most egregious example of the rerating which has been funnelled into the healthcare and IT sectors globally, but given market composition especially healthcare in Australia, through the past year.

The banks continue to exhibit Resmed tendencies – low underlying growth with high multiples. The Australian Prudential Regulatory Authority (APRA) executive have been speaking repeatedly as the sector increases its capital base, and did so again during the month (14 July), where the APRA mandate of balancing safety with efficiency and competition, and in so doing promote financial system stability, was addressed. In this speech, APRA made two interesting points. Firstly, the credit rating for the banks is premised upon a rating agency view that “… the Australian public sector will stand behind the Australian major banks in times of stress, thereby protecting bank creditors …”. Secondly, “… because the major banks are currently profitable, competitive and efficient, increasing their capital requirements would be unlikely to unduly impair, and might marginally improve, the financial system’s competitiveness …”. Oh, for the prescience of a regulator. A week later, ANZ accepted the invitation to treat and increased their rates for investor lending by 27bps, citing “… the criteria we look at when setting rates including our competitive position, our regulatory obligations and …”. CBA bowed to the South, thanked ANZ and copied and pasted the announcement a day later, and NAB and Westpac also effectively followed within the week, just to assuage any doubts as to the competitive intensity in the sector. The second tier institutions really got the competitive juices flowing, with AMP lifting their rates by 45bps on existing loans and withdrawing from the market for new loans. No Aldi in that lot, and nothing beats a banking regulator stirring the competitive juices. As investments, major Australian banks have issues – profits are unsustainably high as volumes dissipate and bad debts increase, and multiples are high – but as an example of an industry egregiously using pricing power to protect and enhance industry return, this was breathtaking. There is $1.6 trillion of housing loans in Australia, and almost 1/3 of this is investor loans. A 27bps price increase on this stock is almost $1.5b. The net effect is not this much (not all investor loans are interest only) but the principle remains – this is a big call on the economy. This price rise by the Banks is economically equivalent to Woolworths putting up supermarket prices by almost 5%. ‘Tis a fine line, it would seem, between destroying a franchise on one hand, and proving the strength of a franchise through exercising pricing power on the other, even when the industry structure is very similar. Apart from pricing strategies, bank management have been adroit at raising capital this cycle. Last cycle they raised almost $15b at closer to book value than a multiple of it. We are on track to raise the same amount this cycle, but at double the multiple.

The tricky issue for Australian bank investors now is how do you price the residual liability arising from the Government support, in the event of a downturn, as referred to in the APRA speech? In each of the US and UK markets, penalties levied upon the financial system have risen sequentially every year since the GFC, and are still rising. Government guarantees are not ultimately costless to shareholders, even though the premium is clearly paid in arrears. We have not yet seen a valuation yet which considers the impact of this recompense, let alone costs it.

Banks, healthcare and resources aren’t the only listed entities where price trends have driven returns by market multiples compounding the earnings adjustment. But, they are the poster children on the ASX through the past year. The sectoral bifurcation we addressed up front tells you that – being long Resources or Energy was the only way to underperform the ASX through the past year, as those duelling banjos of financial misery jammed through all four seasons. Having debased earnings, and multiples, as commodity prices have fallen to or below our assessment of sustainable levels, and given the transmission mechanism that will infect many other sectors across the ASX should these assumptions ultimately prove optimistic, we continue to believe the risk reward equation continues to favour major resource names.

Outlook

Many of the traits which characterised the market boom of 2006 through 2008, before the GFC, are again in force. Equity markets have risen apace for several years now, at a much faster rate than earnings growth. Three to four years ago, given low bond yields and the prospect of them going lower, and low multiples for equities, we thought buying equities was a credible investment strategy. That is now subject to many caveats. High multiple stocks, which on the ASX are almost wholly industrial stocks with a healthcare, technology and/or yield tinge, are now at multiples so high they have never before presaged gains for investors. As multiples have dropped in sync with commodity prices, materials stocks offer good value, especially for the higher quality names with long life, low cost reserves, due to the cocktail of better than expected outcomes for volumes, and capital and operating costs dropping dramatically.

By Andrew Fleming, Deputy Head of Australian Equities

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For professional investors only. Not suitable for retail clients. Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 (“Schroders”) or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.

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In synch with a global bond market selloff, banks underperformed and resources, energy and industrial stocks, outperformed.

The bank underperformance was not a function of poor earnings. Rather, they are a direct reflection of renewed focus upon bank capital, credit quality and culture, with the Regulator explicitly forewarning on all three fronts. In the past month alone, Wayne Byers, the APRA Chairman, has made two speeches on point, one titled “Sound lending standards and adequate capital; preconditions for long-term success”. In short, his message was lending standards were unsound, capital inadequate, and culture poor. Two quotes from these speeches summarise the official view; capital requirements are increasing, and soon;

“… The Basel Committee meets again in June to review the way ahead on its various proposals. I do not think it will be too long after that that we are able to announce how we will respond to those issues that are easiest to tackle sooner rather than later. Other items will take a little longer to pin down the precise detail. But the direction is clear, and we fully support the FSI’s recommendation that Australian ADIs should be unquestionably strong. So it also makes sense to start early and move forward in an orderly fashion wherever possible: affected ADIs should, provided they take sensible opportunities to accumulate capital, be well-placed to accommodate these changes when they occur…”

As well as flagging concern with credit and capital, Mr Byers also expressed concern with respect to culture, which strikes at the heart of operational risk (and hence again capital requirements);

“… We regularly see instances where participants in financial markets, when faced with an ethical dilemma, fail to ask themselves ‘is this right?’ Instead, the question has often been ‘can I get away with this?’ – or, more ominously, in some cases it appears no question was asked because the attitude was ‘if you ain’t cheating, you ain’t trying’. For an industry that is ultimately founded on trust, something serious is amiss, and strong and ethical leadership within financial firms is needed to set this right….”

Notwithstanding bank CEO’s public exhortations, these comments make it clear; this regulator is not for turning.

The quantum of capital to be raised is subject to much variance in estimation. Our initial assessment is that the amount required because of an adjustment in risk weightings for mortgages is likely to be between $2b and $4b for each of the majors, and that this may be needed sooner rather than later. Those that have raised funds through equity raisings or asset sales already have this requirement covered. We suspect no more than this amount may need to be raised again, and that this second tranche will be subject to transitional provisions, such that it can readily be accommodated by dividend reinvestment plans. This estimate is at the low end of market estimates. Given starting equity for all major banks is close to $50b, even raisings of this amount could be meaningful for return on equity metrics, in the absence of repricing. Given the newly appointed Westpac CEO gave an unchanged RoE target of 15% in his first strategy announcement through the past month, clearly repricing is being assumed by the major banks.

Other factors than changing regulatory structures are often larger drivers of returns, as Telstra highlights. David Thodey assumed a six year period as CEO of Telstra in the midst of the NBN maelstrom, and during his tenure the market capitalisation of the company doubled to $75b. Earnings before interest and tax started at $6.0b as he assumed the role, and ended at $5.9b; dividends started at 28 cents per share and were also largely flat. The amazing part of this tenure was the “Vodafail” effect; Telstra’s most profitable and highest returning business, mobiles, grew EBIT by $1.5b through this period due to the market share gains Telstra accrued as their only competitors commercially self immolated through network failure. We suspect that competitor seppuku and the resultant once in a lifetime shift in mobile market share was not part of the Telstra five year strategic plan when Mr Thodey assumed the position; and if perfect knowledge of that extraordinary outcome was to be had, we highly doubt that no resulting net growth in group EBIT would have been forecast. As with the Telstra example, commercial factors often overwhelm regulatory changes in their contribution to investor returns. Given we highly doubt the competitive environment in mobiles can improve from here for Telstra, the risk is EBIT falls materially through the next several years, as opposed to the gentle growth currently built into market forecasts.

Some stocks do not have gentle growth next to their name. James Hardie has long been a holding in the portfolio, and we have spoken to its attributes of pricing power and being the lowest cost producer in its markets. The F15 result released during the month highlighted both qualities, with the US division producing EBIT per housing start of US$288, the second highest result ever recorded by the group, and an improvement of almost 40% on the most recent cycle. Given this is a leveraged number – the higher starts go until Hardies runs out of capacity the higher the EBIT per housing start will be – and starts are still well below mid cycle levels, Hardie is well placed to continue to grow EBIT aggressively from this base of US$300m through the next several years, even with only mild further increases in US housing starts. Hardies has both promised and delivered much; however, as with any of the few ASX stocks in this position, the multiple now captures much of this exceptional performance.

At the other end of the spectrum, when much is expected but not delivered, life can get very messy. Realestate.com fell almost 20% because it confirmed revenue growth of only 13%, shy of the 20% expected by analysts but presumably not the former CEO who resigned in March last year after an exceptional tenure. Since his resignation the stock has underperformed by 30%. Many are called but few are chosen; extending the duration of excess returns is always hard for any business, and in most cases investors ultimately overestimate the reality.

Outlook

Many of the traits which characterised the market boom of 2006 through 2008, before the GFC, are again in force. Equity markets have risen apace for several years now, at a much faster rate than earnings growth. Two to three years ago, given low bond yields and the prospect of them going lower, and low multiples for equities, we thought buying equities was a credible investment strategy. That is now subject to some caveats. High multiple stocks, which on the ASX are almost wholly industrial stocks with a technology and/or yield tinge, are now at multiples so high they have never before presaged gains for investors, even after some notable corrections through the past six weeks. Materials stocks remain reasonable value, due to the cocktail of better than expected outcomes for volumes, and capital and operating costs dropping dramatically, notwithstanding their recent hiatus after a horrid year.

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