Faster, higher, stronger
July followed June’s gains, led by the major banks, Telstra and the supermarket stocks (Woolworths and Wesfarmers) which combined made up 2/3 of the index gain for the month. Yield stocks led the rally, whilst resource stocks continue to be beset by concerns of slower global growth, finishing July at close to four year lows. Our fundamental views haven’t changed much. Six principles of this line of thought are:
- lower (global growth) for longer, driven by overcapacity and demographics;
- an ongoing need for deleveraging by the government, financial and household sectors, albeit deferred (but ultimately exacerbated) by political realities;
- there is no long term monetary solution to indebtedness;
- in line with unemployment rates, the Australian economy is far above mid cycle whereas most other developed world economies are below;
- business plans extrapolating prior cycles are folly; and
- the two golden rules for corporate success in this low volume environment remain the ability to exert pricing power, and a productivity focus.
To the contrary, three thematics which have provoked us through the past year causing us to question our embedded beliefs include:
- the political capital invested in bond holders being kept whole (and the consequent ongoing rally in sovereigns to unprecedented levels, and the knock on effect in equity markets);
- the ongoing robustness of the Australian dollar in the face of falling commodity prices (albeit we think the correction in bulks to date is mild relative to our long run assumption); and
- the readiness of corporates to regear and add capacity, in the face of ongoing tumult in debt markets and broad based declines in demand, respectively.
Surprises, though, can sometimes be helpful in prompting us to rethink paradigms and stress test our assumptions... just as the Queen, jumping from a helicopter with James Bond, did!
If our fundamental views haven’t changed much, equity prices have. CBA ($90bn market capitalisation) has outperformed BHP ($100bn market capitalisation) by 40% through the past year. Think about that. In dollars, you can buy any of the domestic energy, insurance or listed property sectors with that amount of market cap. The treatment of miners is, we feel, somewhat indiscriminate, with the majors being treated just as harshly as some of the second and third tier stocks, despite being significantly better placed in terms of both operating and financial leverage than many of these smaller peers. We can hardly be accused of being cheerleaders for resource stocks through the past cycle but rather than becoming more vocal as prices correct, we have increased our weighting to the majors as they trade ever further below fair value, even with mid cycle commodity prices remaining below spot (especially in the case of bulk commodities). The sensitivity of resource equities to pro cyclical (and dilutionary) capital allocation, however, can best be calibrated by the fact that earnings per share for the resources sector will end FY12 lower than it was five years ago, even with commodity prices at higher levels.
Whilst it has been an uncomfortable year for resource names, being caught in a (corporate) rip can sometimes be a good experience. Throughout the past quarter, banks have belatedly been picked up by the market and repriced on the back of their yield, which had risen to record premiums over bonds. This may have run its course, however, unless they accelerate nascent and to date fumbling attempts at (real) productivity gain. With its gigantic market capitalisation, CBA is now the seventh biggest bank in the world, and $35bn larger than NAB, which has the biggest asset base and the lowest market capitalisation of the major Australian banks. In fact, its discount to the peer group is now close to the largest it has been in twenty years, following poor performance relative to the majors over the past year. CBA led the way, despite NAB winning most market share and CBA shedding the most share. The message is clear. In a low growth environment, value is most enhanced through harvesting the existing book (ie. leading repricing) rather than discounting to win share. The NAB ‘break-up’ campaign may have won gold medals in the advertising community, but they have been more than offset by brickbats from the stock market. Finally, sins of omission are often as culpable as sins of commission, even if less overt. NAB has spent twenty years building up a presence in the UK market, only to watch during the last month as The Co-operative Group acquired 5 million customers, and a fully funded balance sheet, from Lloyds for £350m, or A$500m. We are often critical of prices paid in M&A transactions – the two exceptions to this rule through the past cycle were Amcor’s US$2bn purchase of Alcan packaging from RIO and CBA’s $2.1bn purchase of Bankwest, both counter cyclical and at low multiples (as opposed to the typical transaction which is pro cyclical and at high multiples). However, The Co-operative Group transaction, is in another league again – in Olympic parlance, if this was a gold medal acquisition by The Co-operative Group, Amcor and CBA tied for the silver, but a long way behind. NAB shareholders have paid a high price over two decades waiting for a credible business in the UK, only for it to reverse tack months before this transaction occurred. Given a low transaction price was predictable given the parlous financial state of all other potential acquirers NAB’s strategy as the corporate is equivalent to Mr Bean playing Vangelis.
The high Australian dollar is hurting only some of those we would have anticipated, in an investment sense. Domestic manufacturing is predictably hurting – Caltex closed their Kurnell oil refinery (330 jobs lost) and Ford (44), Accolade Wines (175), Public Transport Australia (367) and LTQ Engineering (164) all saw jobs lost. CSR spent $1bn acquiring a glass business over the past five years and is now equivocating over whether to spend another $150m in capex for the acquired plants, or cease currently loss making local manufacturing. Being an importer for marginal commodity product has given an immense cost advantage over local manufacturing production through recent years, as Adelaide Brighton (to its gain) and Boral (to its cost) have found out in cement, and Arrium and Bluescope have endured in steel. Some foreign earners, though, have escaped relatively unscathed, as the US economy, and especially housing in that market, gradually improves. James Hardie, for example, is now one of the best market performers through the past year, even with US housing starts at very low levels. The fact that it makes the price in its markets – putting prices up through the past few years of depressed volumes – and is ruthlessly focused on productivity, resulting in a margin above 20% through this time, and it has no net debt, highlights the ingredients of strong equity market performance even with a poor macro backdrop. Newscorp has been an even stronger performer, driven by the cessation of dilutive M & A transactions finally joining good operational performance. Both of these stocks, dominated by US dollar earnings, have prospered even in the face of a strong Australian dollar.
Finally, the Kay Review of UK equity markets and long-term decision making was released during the month. We agree with the conclusion that the core purpose of equity markets is to enhance the performance of companies, and to provide returns to savers. It suggests short-termism is an underlying problem in equity markets, principally caused by a misalignment of incentives within the investment chain and the displacement of trust relationships by a culture based on transactions and trading. Our turnover has long been such that our average holding period is four years or more. Last year we have voted against almost 15% of resolutions put to us for consideration, based upon relatively objective criteria tied to our investment philosophy, in an attempt to encourage better performance from our investee companies and better align shareholder returns with executive reward. We also wrote a detailed paper to Treasury last year on executive remuneration, expressing the view that incentives should be payable on growth in net tangible assets per share, and fully in shares, which vest progressively through five years. Only active management can meet both of Professor Kay’s objectives. We are failing in our duty as active managers if we do not use our vote prudently. A gold medal for Professor Kay!
Portfolio outlook & strategy
The six principles we spoke to in setting the scene for our market outlook at the beginning of this commentary are prima facie headwinds for both multiples and earnings. They ignore two, critical, issues; the price paid for the equity purchased, and the management intent to generate good returns on investment even in the face of challenging conditions. As equity markets underperformed, these risks did not become larger and hence we have increasingly assumed more cyclical assets in the portfolio, albeit those which generally are exposed to offshore cycles and feature lower levels of financial leverage. Finally, the tide has gone out – good (and bad) management is being laid bare, and the better performers have laid a path to how equity holders can be well rewarded even in low growth environments.
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.