Still the only game in town
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.
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.
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.