Dougal Maple-Brown

Viewpoint

• After bottoming in mid 2023, the Banks have outperformed the market by around 20%^[1].
• We have favoured the Banks over the past year, more off the back of reasonable valuations, rather than particularly exciting earnings growth.
• The recent re-rating of the Banks has seen us trim our positions, however the Bank sector still looks reasonably attractive relative to Industrials.

Any way you cut it; the Banks have had a pretty good run. After bottoming in mid 2023, the Banks have outperformed the market by around 20%^[1] and if anything that outperformance has accelerated into the first few months of this year. The reasons for that outperformance aren’t overly clear: only CBA reported full financial results in the recent February reporting season and those results were pretty underwhelming. At a pre provision profit level CBA actually missed consensus expectations, with the bottom line result saved in our view by a low credit charge.

There have been some reports of foreign buying of the Banks, particularly by Asian investors searching for ‘anything but China’. You can see why big, liquid Aussie Banks fit the bill here, particularly given Australian Resource stocks are generally considered a leveraged play on China.

Over the past year our portfolios have held overweight positions in ANZ, NAB and Westpac. Our thesis over this period was premised on sensible earnings forecasts and reasonable valuations, particularly when compared to many Industrial stocks. At the time we (and consensus) were forecasting lacklustre credit growth, ongoing Net Interest Margin (NIM) compression, growing costs and a modest credit cycle. Not surprisingly, those assumptions drove limited earnings growth and hence forecast total return was largely limited to the grossed-up dividend yield.

While that earnings profile didn’t look very exciting, in our view valuations were very reasonable. A year ago ANZ and Westpac were trading around book value or 10x forward earnings. On a bad day they even traded below book! NAB was slightly more expensive, but still well below the premium rating enjoyed by CBA.

Finally, market sentiment towards the Banks was terrible. This peaked after the May 2023 Bank ‘Reporting Season’ when NIMs were being crushed in the midst of a mortgage pricing war. Brokers were universally bearish and even Bank management teams we saw at the time were quite concerned.

Yet less than a year later, Banks have handsomely outperformed the broader market^[1]. As always, our job is to judge the stocks on what we see before us. Frankly, we believe earnings still look pretty sensible and yes still pretty unexciting. What has changed is the rating. The chart below from Goldman Sachs suggests the Banks are now trading on a P/E of around 16x – a 35 year high. Furthermore, Goldmans also make the point that historically P/Es have expanded when earnings are depressed. Earnings today for the Banks seem pretty close to ‘normal’ – as far as such a concept exists for Banks!

Source: Goldman Sachs, date to March 2024.

So where does that leave us on Banks?

We have been trimming our Bank positions as valuations have become less attractive. The speed of our selling is of course also influenced by other buying opportunities. It is here the story gets more complicated, given Industrials (ex Financials) as a whole still trade at a full ~25x forward earnings^[2]. Thus, relative to Industrials, Banks are closer to fair value rather than outright expensive.

Source: Goldman Sachs, data to March 2024.

Parting thought

The Big Four remain a strong pillar of the Australian economy and make up over 20% of our equity market. While arguably less strategic levers exist for bank boards than did five years ago, we continue to focus on the challenges facing the banking sector, earnings outlook and valuations as share price drivers. As a value-based active manager we will adjust our exposure to the Banks as valuations dictate, just as we have over the last year.

By Dougal Maple-Brown, Head of Australian Value Equities

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Notes:
[1] Performance of S&P  ASX Bank industry group versus S&P/ASX 300 Total Return Index for the year to 29 February 2024.
[2] Maple-Brown Abbott as at 14 March 2024

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Dougal Maple-Brown

Key points:

• Australian consumers, like their US counterparts, have proven remarkably resilient in the face of sticky inflation and rising interest rates. Discretionary spending has thus far held up, and with it, share prices of select discretionary retailers.
• With higher rates here for the conceivable future, as investors we need to work with, not against, the impact of higher rates. As such, we currently see merit in selective allocations to banks and general insurers.
• We continue to observe the deflation of stretched valuations for a number of high profile growth-oriented stocks. Pockets of value are emerging, but patience is key.

Consumer resilience

We have been of the view for some time that inflation would likely prove to be ’sticky’ and thus interest rates would remain higher for longer. Given the sharp rise in interest rates, the resilience of the Australian consumer has surprised most commentators. To date, consumers appear to have generally coped well as fixed rate loans continue to reprice (much) higher, although it is still early days. More recently we have seen a softening in consumer discretionary spending, although thus far it has been ’less bad than feared’. This view was supported by solid trading updates from several discretionary retailers during the August reporting season:

• Wesfarmers (WES) reported Bunnings maintained their second half sales growth momentum into early FY24 and Kmart also saw solid growth.
• Super Retail Group (SUL) reported sales growth across its Supercheap Auto, Rebel Sports and BCF chains for the first six weeks of FY24.
• JB Hi-Fi’s (JBH) Australian chain saw sales fall modestly in July, but they were still 39% higher than pre-pandemic FY19 – hardly a collapse.

Buoyed by results such as these, the Consumer Discretionary sector was the best performing sector in the August reporting season.

Bank share prices already discounting tough conditions

In a similar vein, the credit data reported by Australian banks during August showed what we perceive to be very benign trends. While stressed exposures have increased modestly, this is off a very low base. As such, credit losses remain below long term averages. We favour the banks – also beneficiaries of higher rates – with our positive view premised on two attributes: inexpensive valuations and sensible earnings forecasts.

The chart below highlights the price to book valuation metric of the banks, excluding Commonwealth Bank (the one bank which remains overpriced in our view). Collectively, the other banks are trading in line with where they bottomed out in the GFC and only modestly above where they bottomed out in the pandemic. While return on equity will be lower for the banks today than in prior years, largely due to increased capital requirements (and thus improved resilience), it appears to us that bank share prices are already discounting tough conditions.

The second attraction of the banks is that earnings forecasts appear ’sensible’, particularly when compared to some of the ‘high flying’ industrial stocks (which we will look at later). Of course, almost all forecasts will be ’wrong’ but for the banks, the market expects low single digit credit growth, ongoing Net Interest Margin (or NIM) compression, modest expense growth and increasing credit charges. Our forecasts are similar. This produces a relatively flat earnings profile; however, we forecast most banks can still generate a satisfactory total return to investors, largely driven by high single digit gross dividend yields (including franking). Further upside exists if our credit charges prove too pessimistic, which has been the case so far, and the potential for modest capital management.

General insurers

Within the equity market, one of the few beneficiaries of rising interest rates are the general insurers: they collect premiums upfront, invest the so-called ’free float’ before ultimately paying out claims. As the free float is generally invested in cash and short-dated fixed interest, returns improve as interest rates rise. While the general insurers are also impacted by climate change, via increased claims and re-insurance costs, the recent Bureau of Meteorology announcement of the arrival of an El Nino climate pattern should help reduce the incidence of costly natural disasters this summer in Australia. We remain favorably disposed to the general insurers.

Fallen angels

We have been writing for some time about the extended multiples many stocks within the Industrials sector continue to trade on. During the pandemic Industrials (ex-Financials) peaked at ~30 times forward earnings. As this was an average, many stocks traded far higher. For example, CSL, at the time the largest stock in our equity market, traded on ~45 times forward earnings! Since then, as interest rates have risen, Industrials sector multiples have fallen somewhat, but still (on average) are around one standard deviation more expensive compared to history at ~22 times.

In addition to expensive multiples, many of the favoured industrial stocks were also trading on elevated earnings and / or elevated earnings expectations. Over the course of the most recent reporting season, and indeed the ’confession’ season that now precedes it under the continuous disclosure regime, some of these stocks started to unravel. In most cases it was the inability of the company to deliver the lofty earnings expectations that the market demanded to essentially justify the share price.

The table above highlights the plight of some of these ‘fallen angels’. As an example, CSL provided a trading update in June that led to consensus FY24 earnings being downgraded ~10% resulting in a share price that has subsequently fallen almost twice that. In fairness to CSL, it isn’t that earnings are expected to go backwards, CSL is still forecast to grow earnings in FY24 by around 12% in USD. However, for investors it was enough that CSL missed the market’s ambitious earnings forecasts for the stock to be punished.

We continue to monitor these so-called fallen angels but haven’t invested in any yet as even after the downgrades and a derating many still screen as expensive. While we are unlikely to be investing in WiseTech Global on ~75 times earnings (better than the 100 times it peaked at!), there are other names that are starting to look interesting. We do believe that after a decade (or longer) of falling interest rates, it will take some time for the higher rate environment to be priced appropriately by equity markets. As such, we believe patience may be required but will ultimately be rewarded. In the meantime, our portfolios are tilted towards the beneficiaries of higher rates such as the banks and general insurers.

Parting thought

Market commentators continue to focus on the macroeconomic environment both here and overseas, and a chorus of bears continue to recite their recessionary lines. As bottom-up stock pickers we are alert to the broader environment but remain focused on in-depth analysis at the stock level and structuring our portfolios to take advantage of emerging pockets of longer-term value.

By Dougal Maple-Brown, Head of Australian Value Equities

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Dougal Maple-Brown

Viewpoint

• Winning stocks within the Australian bourse have to date largely been those appearing to offer a more ‘certain’ outcome
• It is clear to us that investors are ‘hiding’ in a select group of what are perceived to be ‘safe’ or defensive stocks. Valuation is no more than a secondary consideration
• In our view the market is overly complacent with respect to the likely earnings trajectory and we believe the strength evidenced by the market to date is going to be tested.

Over the past year we have become increasingly aware that seminal changes in investment markets were underway, driven by a break-out in inflation not seen for decades and the necessary response of central banks globally. The reset of long-term interest rates in light of these two factors has – and in our view will continue to –  impact investment markets. The past few months have, in some ways, been a testing one for this thesis. On reflection however, what has tested this thesis is not so much the economic developments but rather the unexpected response of markets to those developments. In our minds that is a very different matter.

We expect to see rising tensions between fiscal and monetary policy in many economies, including our own, and in recent months the Reserve Bank has come under increasing scrutiny. Market forecasts of global interest rates have consistently undershot actual outcomes and rates are not declining at the pace the market had initially expected. Indeed, recent comments by the Federal Reserve Chair that the fight against inflation “has a long way to go”^[1] seems to warn against complacency. This background hardly seems conducive to leading stock markets finding strength, but that has been the case, hence our comment regarding the unexpected outcomes of markets.

Poor breadth puts all eyes on earnings

One of the most unusual features of the US market over the past few quarters has been the extremely narrow breadth, with most of the market gain being driven by a small group of large capitalisation tech stocks such as Apple, Microsoft and NVIDIA. The chart highlights the sharp outperformance of the S&P 500 Index (market capitalisation weighted) over the S&P 500 Equal Weight Index, illustrating the poor breadth of the market. This was similarly the case during COVID which was followed by a sharp reversal.

While the Australian market has lagged global markets, we have observed that Australia too has seen a small group of stocks providing most of the market upside over the calendar year. Given the Australian market has limited exposure to tech stocks, the winning stocks have largely been those that in our opinion appear to offer a more ‘certain’ outcome in an economy increasingly under pressure from inflation and interest rates. These stocks, largely falling into the growth stock category, enjoyed extended premium ratings well before this latest period of strength, and the premiums have expanded further at a time when interest rates have continued to increase. This is a highly unusual outcome.

Valuation a secondary consideration

As we meet with market participants it is abundantly clear that investors are ‘hiding’ (to use a technical term!) in a select group of what are perceived to be ‘safe’ or defensive stocks. Valuation is no more than a secondary consideration based on a view that a group of stocks, overpriced at first glance, might look more like fair value once earnings downgrades flow through the rest of the market. In our view, this is always a risky strategy as a defensive business is often not a defensive stock, particularly when trading at a significant valuation premium. The downgrade to CSL’s market consensus earnings numbers during June is a particularly interesting case study. CSL is indeed a defensive business given its healthcare exposure, but in providing earnings guidance for FY24 that was below market expectations, it succumbed to a combination of currency moves, challenging operating conditions and overly bullish analyst forecasts. A review of market consensus numbers highlights that forecast USD earnings have declined in excess of 10% over the FY24 and FY25 years. Interestingly, the stock has fallen by less than the earnings downgrades, thus enjoying a small rating upgrade despite already trading at an elevated valuation! This is a rare outcome. We have often written about the premium rating the market attributes to this stock given a view that significant annual earnings growth is all but assured. This downgrade has clearly not shaken market confidence in CSL but also illustrates the market’s current obsession with apparently defensive stocks, even when circumstances suggest some element of caution be exercised towards these stocks.

It is, however, not difficult to understand why (at least conceptually) the market is so focused on defensive attributes. The past quarter has seen a raft of earnings downgrades begin to flow through some segments of our market (notably consumer discretionary) as the impacts of higher interest rates begin to be felt by Australian consumers. Until recently the consumer has been protected by a range of factors including savings buffers built up during COVID and low fixed rate mortgages signed during interest rate lows. However, these benefits are waning and there are also signs of the broader economy slowing. The long-awaited repricing of commercial property is underway and other unlisted assets are reportedly also facing some valuation fallout from higher interest rates. The upcoming reporting season is thus likely to be one of the more interesting ones for some time as management teams reflect on what the FY23/24 financial year might look like. In our view the market is overly complacent with respect to the likely earnings trajectory (both domestically and in the US) and we believe the strength evidenced by the market to date is going to be tested. Investments with defensive attributes thus have appeal, except as already noted valuations generally look excessive. In addition, as we have seen with CSL, earnings expectations for many of these stocks are likely to prove overly optimistic and the market may not treat these other premium-rated companies as favourably when that becomes evident.

Parting thought

History teaches us that valuation is never a secondary consideration for long and we remain of the view that the better valued part of the market is going to be the preferred place to invest through this uncertain time, notwithstanding earnings uncertainty. In this latter regard we note a recent White Paper from GMO which concludes (using comprehensive US data) that “the common assumption that value is destined to underperform in a recession simply does not fit the historical data.”^[2]

By Dougal Maple-Brown, Head of Australian Value Equities.

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Notes:
[1] Jerome Powell’s testimony before the House Financial Services Committee, 21 June 2023.
[2] Value Does Just Fine In Recessions, Ben Inker, GMO White Paper June 2023.

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Dougal Maple-Brown

The two key issues heading into mid 2023 are the outlook for inflation, and hence interest rates, and uncertainty around corporate earnings, according to Maple-Brown Abbott.

Chief investment officer Garth Rossler said while inflation may have peaked, there is concern the market is ignoring the risk that inflation may remain at a higher level for longer.

“Our concerns are derived from two issues: the global issue that commodity prices will remain elevated for longer, driven partly by supply constrained by under-investment, and the local issue that wage inflation may still be rising.

“A further uncertainty is what happens to corporate earnings. Despite rumblings on the horizon, there has still been very few out-of-cycle earnings downgrades for domestic industrials. The latest quarterly earnings from the US have, if anything, confirmed that the impact of sharp interest rate increases and tightening of lending conditions are yet to materially show up in earnings reports,” he said.

Dougal Maple-Brown, head of Australian value equities, sees opportunities for investors in the energy and broader resources space over the medium term, albeit with the risk of shorter-term volatility.

“Commodity prices remain elevated and we see potential for this to last longer than expected, with supply constrained by underinvestment and ongoing geopolitical turmoil. In the energy space we continue to see value in Santos (STO) and Woodside (WDS), and favour Rio Tinto (RIO) in the materials sector.

“With the rapid rise in interest rates already observed, we see opportunities in companies that benefit from this shift such as insurers and banks. There are also a number of opportunities in out-of-favour companies with depressed earnings or multiples. At a market level, we see risks among the premium-rated growth and yield stocks where valuations have not yet fully adjusted to a higher interest rate environment.

“In our view, it is more likely we will have a stock picker’s market in which past excesses continue to be addressed, an environment that should suit our value investment approach.”

Emma Pringle, head of ESG, says that ESG integration, when done well, is critical to realising returns in value-aligned stocks. Value names can tend to be in ESG-challenged industries and so typically score poorly against traditional ESG ratings.

“We believe there is more upside to be had than the market has yet priced in. At the same time, given the nature of these industries, the ‘real world’ downside when companies get it wrong can be so much greater and why we place such a focus on stewardship.

“Energy and resource stocks, for example, are highly carbon-intensive and tend to score poorly on backward-looking ‘out of the box’ ESG ratings. However, to avoid holding them would mean missing the opportunity to be part of the energy transition – through both facilitating access to capital and then engaging to advocate for sustainable long-term outcomes for shareholders and ultimately supporting better outcomes for the world we live in,” she said.

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Dougal Maple-Brown

Stagflation fears and the end of easy money have already resulted in the de-rating of many high-flying stocks but it is likely there is still further to go which should favour value investors, says Dougal Maple-Brown, Head of Australian Value Equities at Maple-Brown Abbott.

“Valuations had reached extreme highs by historical levels and even though they have fallen significantly, we believe there is still a fair bit more to go,” he says.

“We are currently structuring our portfolios to take advantage of the continuing narrowing in dispersions.  We believe our value investing approach will position us to benefit from the emerging opportunities in the current market.”

Mr Maple-Brown said that, depending on which measure is used, the highest rated stocks were more than three standard deviations more expensive at the peak relative to their lowly rated peers, and many sectors are still above their historical levels.

“Furthermore, after spending such a long time so far above average, it would not be surprising if the situation flipped and the highly rated stocks traded below long-term averages for a period of time.

“The wide value dispersion in the Australian market suggest that our value style of investing will continue to deliver for our investors,” he said.

The Maple-Brown Abbott Australian Value Opportunities Fund, which was launched last year, has performed strongly in the past 12 months and has also received a Recommended rating in its first review by Zenith Investment Partners.

In its report, Zenith said: “Zenith believes that the portfolio is managed in a consistent and effective manner, with Maple-Brown effectively leveraging the insights generated by MBA’s experienced investment team.

“Despite the strategy’s relatively short track record, Zenith has confidence in MBA’s investment approach, which has consistently been applied across multiple investment cycles.”

The Fund is a benchmark unaware Australian share portfolio consisting of the Australian Value Equity team’s highest conviction opportunities. It targets an active share of more than 75% which tends to limit exposure to the top 20 stocks in the S&P/ASX 300 Index. The Fund will typically have 25-40 stocks across large, mid and small cap Australian companies.

“Performance for the Maple-Brown Abbott Australian Value Opportunity Fund has been strong in the 12 months to 30 June 2022, returning 5.8 per cent^[1], and we believe it is well positioned to benefit from the current environment,” Mr Maple-Brown said.

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[1] The Maple-Brown Abbott Australian Value Opportunity Fund’s performance is based on the movement in net asset value per unit plus distributions and is before tax and after all fees and charges. Imputation credits are not included in the performance figures. Past performance is not a reliable indicator of future performance.

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