It’s the valuations, stupid*
The king of the Australian equity market during the month, again, was the bond market, with the selloff in bonds presaging a late month sell off in the equity market, led by the hitherto all conquering banks. Not far behind the king in influence was the crown prince of commodities, with commodity prices continuing to falter, and mining sector capex plans continuing to be wound back aggressively, seeing the second and third tier miners and mining service providers as battered as Greg Bird after State of Origin. No royal family is complete without a court jester leaving the assembly in stitches as they parlay their tomfoolery; the Federal Budget was released to rapturous silence during the month, and soon thereafter the Australian dollar dived, seeing foreign earning equities listed on the ASX keenly sought after. In all, this trinity of factors converged to produce an outsized return; just as was the case last month, albeit then on the less pleasant side of the ledger.
Valuing stocks on any basis other than the sustainable underlying cashflows produced, is playing with fire. This is a central tenet in the six principles underpinning our fundamental framework for investing in markets driven by policy experimentation (as outlined in the March commentary). Yield investors have found this out the hard way during May; in April the yield flames climbed high into the night, only to light the sacrificial rite. A buyer of Westpac during late April now has a 15% capital loss to go with the 6% dividend yield. Elders reported $280 million of write downs during the month to bring total write downs over five years to $1,430 million and leaving net assets now at $250 million. Elders’ investors have found the cashflow lesson out the hard way as well. When it comes to valuations, it’s the mid cycle cashflows, stupid; and when it comes to where stocks will ultimately trade, it’s the valuations, stupid.
The major banks’ correction followed an amazing past year for all financials on the ASX200. Collectively, without underlying profit growing faster than the economy or expectations, the market capitalisation of the banks increased by $100 billion during the year to April. Both general insurers with a domestic focus have relatively performed far better again. Even AMP, with a wretched performance history since listing, has materially outperformed through the past year. Whilst their pricing power in the retail market remains powerful, rising unemployment will see escalating bank credit losses through the next several years, which will impair bank profits and dividends. Equally, whilst the general insurers are currently enjoying an economic Indian Summer, we see nothing to suggest they will not remain deeply cyclical stocks subject to global liquidity and local competition. When Suncorp releases an aspirational RoE target of 12%, whilst trading at a higher multiple of NTA than all the major banks, its fundamental appeal is limited. We have noted before that the multiples of NTA paid for Life Insurers remains unduly elevated given the poor cashflows produced, seeing the sector under perform in the vast majority of recent years. We remain very underweight listed property. As bonds have rallied, the money changers won; but, symmetrically, once bonds sold off through May, the financials faltered. It’s the valuations, stupid.
Commodity prices continued to be hit hard. Coking coal prices have halved and iron ore prices have dropped more than a third from their peaks. The miners have led many aspects of the Australian economy in recent years; ten years ago real investment spending by the miners was a quarter of that of the rest of the economy; now it’s almost 50% larger again than the rest of the economy. Miners have also been, by far, the largest underlying buyers (by industry) of the Australian dollar in recent times (per ABS data) – so much for the sovereign wealth fund bid keeping the dollar forever more above parity independently of the terms of trade. Having said that, the major miners have started to perform well, reflecting their “Biggest Loser” strategy with respect to costs and capital. This is not a luxury afforded their second and third tier mining peers, and mining contractors, where there is no time left to start again, and the only option now is to be nimble and quick in reducing costs and debt. Mining contractors are like lonely teenage broncin’ bucks with a pink carnation and a pickup truck; but, unfortunately for them, driving in circles in fly in fly out towns, devoid of dancing partners. As uncomfortable as it seems with an expectation that commodity prices will still fall further before reaching mid cycle levels, we remain overweight major miners, and cautious of all others in that sector further out the cost curve or providing services, many of whom may be starting to think it’s best to catch the last train for the coast. For the Portfolio, though, it’s the valuations, stupid; the major miners remain among the least expensive stocks in our investment universe.
The demerger of News Corporation and 21st Century Fox will no doubt again place the focus upon environmental, social and governance (“ESG”) issues relating to investment. Our views on ESG accord with those of Bill Gates, who stated “The most controversial thing that we own are US government bonds. I disagree with a lot of things that the US government does” and “We’re not the ultimate court of justice – we merely buy investments policed by government”. Our remit is simply to maximise the risk adjusted wealth of our investors relative to the Australian equities universe we invest in. Within that context, though, our voting power gives us the right and responsibility to encourage management to act in the best interests of shareholders, by optimising the growth in net tangible assets per share in the longer term. We consistently vote against the AGM resolutions for those ranked relatively and absolutely poorly on this measure, and where no strategy likely to change that outcome in the future is apparent. Consequently, we have voted contentiously on 18% of resolutions put to us for consideration through the past year. Shareholder activism is neither talk, nor threat; nor public posturing. It is about voting “Against” when appropriate, within a cogent framework tied to an investment philosophy, and designed to encourage better returns for investors through changes in governance.
Outlook & strategy
As a direct consequence of extreme levels of western world monetary policy distortions, Chinese industrial production over capacity, and government ennui, the king, crown prince and court jester are likely to continue to influence Australian equity market returns, and indices are far more likely to continue to resemble zig zags than shooting stars. We haven’t seen monthly divergences in returns like this since the maelstrom of the GFC years, giving substance to our more recent dirges. These distortions are not abating; as the US withdraws, other countries are eagerly adopting quantitative easing. The domestic economy is facing a period of tumult, with unemployment as likely to surprise to the upside as growth is to the downside, for years to come; a once in a century investment and terms of trade boom, now officially ended, is highly unlikely to be followed by an economic pause that refreshes. The Portfolio will continue to reflect these themes, which means our valuations will tend to favour stocks with four characteristics; sustainable earnings and cashflows, a focus on productivity (more commonly associated with foreign earners), an ability to make the price for the goods and/or services the investee company sells, and an appropriate financial structure.
*"The economy, stupid" is a phrase coined during Bill Clinton's successful 1992 presidential campaign against sitting president George H. W. Bush. The phrase has become a phrasal template repeated often in American political culture, usually starting with the word "it's" and with commentators sometimes using a different word in place of "economy”.
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