Don’t be afraid to question convention
The S&P ASX Small Ordinaries Accumulation Index ended the financial year up a casual 13%. Coincidentally, resources and industrial components were up… you guessed it 13% and 13%, respectively. Some might consider this trifecta of 13’s a bad sign, not being superstitious I really don’t have a view. The most surprising element was perhaps that the small resources sector actually had a strong year and commensurately so with small industrials. Who would have thought given the all-pervading gloom encompassing small resources after a near 50% capitulation the preceding year. The so-called baby was thrown out with the bath water – with higher quality names like Western Areas (WSA) and Independence Group (IGO) retracing GFC low’s despite long reserve lives and relatively low costs. As the Buffett adage goes… “in times of fear it is best to be greedy”. Again we have witnessed the wisdom of Buffett’s words as investors in these higher quality small cap miners were handsomely rewarded. Before moving on from index performance, we can’t help but highlight the mirror image performance of the S&P ASX 200. Can you believe the large index was up 17% and its industrial and resources constituents were both up 17% respectively? What were the odds of a double trifecta?
Again whilst few admit it, if you actually went against the grain and bought several of the ‘dogs’ of FY13, you would have made the proverbial motza. Three of the top five performers were Billabong (BBG), Saracen Minerals (SAR) and APN News & Media (APN). All three were incarcerated in FY13, only to have their share prices rebound 230% to 270% in the last year. That’s right, you would have more than tripled your capital outlay if you bought these stocks on 30 June 2013. The lesson to be learned here is always remain open
minded in small caps and never be afraid to question conventional thinking. Whilst momentum investing is thought to prevail in small cap land, substance tends to override popularity in the long term whether it be large or small cap equities. Fortunately, we defied herd-think to a degree and were beneficiaries of the turnaround at APN. Plaudits must go to the new APN CEO, Mr Michael Miller, and his team, who in a short period of time have engineered a stunning recovery in spite of the starting point being a rickety balance sheet and set of disparate assets with a complex ownership structure. An espoused, well executed and sensible strategy of simplification and investment ahead of the curve won over our unwitting minds.
On the economic front, as the Starks from Game of Thrones would say “winter is coming”. Ironically, it was too little too late for the retailers, who in unison downgraded earnings on the back of unseasonably warm weather that killed demand for winter stock. Whilst the weather patterns are transient, the flotilla of foreign entrants is making life permanently difficult for the many of the domestic retailers. Very few incumbents are taking share and many of the high flyers are running on empty (denial pervades) as store footprints mature and additional stores are marginal contributors at best. In a relatively static market, there appear few remedial actions other than renegotiating leases with landlords, closing uneconomic stores and improving supply chain efficiency. The overhang of stock from winter will likely suppress earnings in first half of FY15 and the difficulty in passing on rising costs from a lower Australian dollar remains a pressing issue, albeit the dollar has regained some ground in recent months.
Whilst a sobering environment for retailers; it’s far from Armageddon for the consumer as compensation in the form of looser monetary policy remains on the agenda, the result of several dynamics including a harsh federal budget that will constrain disposable income, a slide in capital expenditures as the mining boom fades and weakness in our terms of trade as iron ore and coal prices plumb multi-year lows. Given the latter commodities are Australia’s two largest exports and we have little manufacturing of consequence, lighting the fire under the financial economy is the only apparent lever remaining. Lowering interest rates resulting in stratospheric house price increases and lifting household debt levels to unsustainable levels is hardly a long term solution but is simply adding fuel to the eventual catastrophic fire. It would not surprise if measures to restrain house price appreciation (lending controls?) were implemented to protect us from the aftermath, although this may be too late given the extraordinary house price growth witnessed in recent times.
The stubbornly high dollar is needless to say destroying the fibre of this country by debasing our primary industries. Coal is under the most pressure due to weak prices and the burden of onerous labour agreements and take of pay rail agreements struck during boom times. Many coal companies are losing money let alone recovering their cost of capital. If this trend continues the pain felt in the Hunter Valley, Illawarra and Central Queensland will be akin to a nuclear winter. Coal is the lifeblood of these regions. At some point the Australian dollar will snap, in effect providing the automatic stabiliser that the coal mining industry requires to be viable. Until that point the Australian economy and its coal industry is essentially collateral damage in a global currency war where we are just a firm bystander. Until the damage is front of and centre of mind, say via burgeoning unemployment statistics, it appears the real economy will remain ensconced in its winter woollies.
Fundamental issues afflicting many of the companies in our universe including challenged profitability and outright solvency issues remain papered over by oodles of concerted global central bank liquidity. You would think this cannot go on forever. Our response remains to buy real world companies that are under-geared, generate strong cash flow and are not a construct of the financial economy or someone’s furtive imagination. In this environment we think unconventionally that defence is the best form of attack. To date the absolute and relative performance of the funds employing these tactics has positively surprised us. Conservatively struck mid-cycle valuations that eliminate the rampant noise remain the crux of our investment process.
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.