Ever tried? Ever failed?
It wasn’t just Stan Wawrinka quoting Samuel Beckett - “Ever tried. Ever failed. No matter. Try again. Fail again. Fail better” – through January. The English cricket team recited it regularly; and a broader cadre of devotees were found in management teams returning from languid holidays, having been dumped by surf or snow alike, only to find that sales growth remains insipid, while costs continue to rise at a faster pace than the excel plan had promised. Downgrades ensued – failing expectations, try again.
The fall in the Australian equity market echoed that in all other equity markets, and especially in emerging markets where the uncertainty being created by the great unwind of the QE experiment is prompting a “Houston, we have a problem” moment. Interestingly enough, sovereign bonds in developed markets rallied through the month – the concern for investors is clearly one of growth, not risk. We have thought for several years that Chinese sponsored over capacity in all material markets, combined with demographics and a wary consumer eschewing any opportunity to rapidly regear after the tumult of the past five years, was likely to combine to lead to growth being less than forecast for sovereigns, and corporates alike. In turn, deflation is more of a concern than inflation. As Australia has been, in most areas, an outsized beneficiary from the installation of fixed asset investment in China, it is unlikely to be a benign observer as this process matures. This is a longer run thematic; the prospect of a growth scare to the upside in Australia is far less than the likelihood of investors again being wary of sovereign risk.
The sectoral losers through the past two years as China has weaned itself off this industrialisation binge, albeit marginally, have been energy and materials, and energy was again one of the poorer performing sectors through January. We are overweight several of the larger energy stocks as they migrate from development phase to producers with assured cashflows and aggressively declining capex profiles though the next two years. This profile mimics, with a lag, that of the major miners, BHP and RIO. Our valuations for the major energy stocks have been far more stable than their share prices through recent years, and we suspect that with the completion of major LNG projects through the next few years, releasing significant free cashflow, may see these stocks start to perform better.
As Yoda implored of Luke, “Patience you must have my young padawan”. We have been patient with our overweight positions in the materials sector, and in the main this was rewarded with these stocks performing relatively well last month. Our positions in the major miners remains, reflecting our confidence in their ability to have increasing levels of free cashflow available to shareholders through the next few years, whilst most of corporate Australia is heading in the opposite direction. Other positions in Alumina and Iluka reflects the fact that these low cost operators are operating in an environment where the underlying commodity price driving their revenues is less than what we see as mid cycle. Even Newcrest performed well in January, as it would want to off a low base and amidst a strong global rally in gold miners. A world witnessing ever larger quantitative easing programs, the failure of economic growth to match fiscal program sponsors’ expectations and the emergence of political and social unrest, as we have seen through the past couple of years, would be fertile ground for a large gold stock. Globally, this did not transpire, and all gold stocks underperformed. None more so than Newcrest, however, reflecting an inappropriate financial structure, largely arising due to the debt used to fund the goodwill paid for the Lihir acquisition. We failed to fully account for the cost of development and production from this new capacity, and have paid the price. Ever tried, ever failed.
In contrast, banks struggled as the market faltered through the month. We remain underweight the sector, but within it overweight NAB, which for more than a decade has been a steadfast corporate adherent of the Samuel Beckett philosophy. Fail again; fail better. Just as with Stan, however, a run of glorious defeat was shaken through the past year as NAB became the best performing bank among its major peers. Given it remains on the lowest price to NTA multiple of the major financial stocks in Australia and is enjoying the tailwind presented by its UK assets – where sector valuations and underlying profits have doubled through the past year, and loan growth, margins and core tier one capital ratios all compare favourably to the Australian system – we suspect NAB stands a fair chance of enjoying another year of relative outperformance in 2014. By way of contrast, we continue to see almost all of the insurers as expensive on a price to NTA basis, albeit the domestically focused general insurers enjoyed a wonderful past year of equity market performance as premium increases boosted operating returns. Hard as it is to believe, AMP has underperformed NAB through the past decade, despite in market consolidation (AXA acquisition) and aggressive efficiency drives, and yet continues to look fully valued.
We don’t hold Treasury Wine Estates, having struggled with high valuations which have been ascribed to consistently low levels of earnings and cashflow, through several corporate structures over the past decade. Perhaps we were fortunate to have previously held a wine stock which had neither appealing product nor returns for investors, notwithstanding, in that case, management doing all they could to optimise returns within a bad industry structure. We do learn from some mistakes; in that case we learned that paying high multiples for low returns in industries beset by overcapacity is rarely a winning strategy in the long run. Nor is investing in companies where the corporate strategy is set around a word that had hitherto not been required after 500 years of the English language. Upon reflection, there is probably a very good reason why “Masstige” – paying premium prices for sub premium product – had hitherto not been required in either the English language or corporate strategy. We also doubt it will enjoy broader adoption in either anytime soon, after a profit warning saw TWE fall 25% during the month.
Portfolio outlook & strategy
After two years of exceptional returns, amidst only moderate earnings growth, it would be churlish to suggest that equity markets are absolutely cheap. For most domestic cyclicals, we suspect earnings growth will ultimately prove to be derisory, whereas foreign earners will prove relatively more robust. The best performing Australian equity investments in this environment may continue to be price makers and management teams showing an ability to generate productivity gains; the operational excellence candidates, such as James Hardie, Brambles and Orica. As the RBA has noted, human nature means that productivity gains usually lag a poorer economic environment, and hence Australia has a currently poor productivity environment, which as the SPC Ardmona case highlights, is often a management issue as much as a union related one. A productivity focus, manifested in strong free cashflow, will be a key ingredient for equity market outperformance amidst a local demand environment that we continue to see as increasingly faltering as unemployment rises.
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