Andrew Fleming, Deputy Head of Australian Equities, comments on the rebound in commodity prices, the challenge for banks and other opportunities within the market.
July was an extraordinary month for market returns, with the S&P/ASX 200 Index gaining 6% as market multiples again expanded from high levels, to now sit above 16 times earnings. The fact that market laggards, Banks and Materials (notably Mining and Metals), and Woolworths, led this market increase was unusual. Indeed for the first time in several years, commodity prices have risen this year and taken the equity prices of the smaller, leveraged commodity companies with them. And yet the effects of Brexit, commodity prices remaining volatile, the RBA again cutting rates to a record low of 1.5% and the S&P downgrade of Australia’s credit rating outlook without deficit reduction within two years, are all just more of the same of the post GFC playbook. Political uncertainty and economic weakness leads to no earnings growth and monetary stimulus. Other trends, such as small company performance and liquidity, are only accelerating, and are quickly becoming a new bubble.
Resource stocks have had a horrid couple of years as commodity prices have fallen and earnings have been crushed as the asset growth binge through the past decade comes back to haunt earnings through depreciation charges. This has changed markedly in the past quarter as commodity prices have rebounded such that resource stocks now represent the vast majority of the market growth forecast for the next two years. The smaller, leveraged metals and mining stocks have rallied in sympatico this year with commodity prices, although BHP is still relatively down 20%+ on a rolling year, which equates to $12b in market capitalisation, or approximately the entire market capitalisation of any of a number of large companies – AGL, Stockland, APA, Ramsay and even South32. In that same time, South32 has relatively outperformed by more than 15%, and many pure play miners have done much better, such as Fortescue (+145%) and Whitehaven (+60%), driven by operational and financial leverage, and in many cases, better operational performance than the major miners. The quantum of underperformance for large miners means the pressure for South33, then South34, then South35, etc. … can only increase. Operational performance is the only antidote to this pressure, and whilst this has improved, it is still poor relative to more focused peers. All the major miners have no right to grow until they are at least extracting value from their existing asset suite which is in line with better performing, smaller operators, with less privileged assets in the same industry.
Banks are at a vexed point. Multiples are low but earnings pressures are rising along with political scrutiny. ANZ and NAB are trading at very low price to book multiples (circa 1.25 times) by historic standards, and even the most expensive on this measure, CBA, is only trading at its average price to book multiple (circa 2.5 times). The banking sector has raised over $50b in equity over the past few years whilst revenues and profits have increased by a fraction of that amount. The capital raised, and still to be raised, has been to satisfy the objective of being "unquestionably strong”; not to facilitate further business growth. Return on equity has, of course, dropped. ANZ, for example, makes the same profit this year on almost $60b of equity as it did in 2013 when it started the year with little more $40b in equity. Further, as cash rates continue to grind lower, and repayments of capital remain strong, it would not take much now for system credit growth to be negative. ANZ is absolutely correct in its strategy of reducing absolute operating costs given this backdrop, and to the extent it can maintain retail market share whilst doing so this will prove a valuable strategy.
Opportunities exist in this broader market environment. Navitas is a good example. Through the past two years, the share price dropped almost 50% to below $4 as one of its major University partners, Macquarie University, announced that it was ceasing its long standing commercial arrangement with Navitas. Just prior to the announcement, Macquarie had represented almost one quarter of Navitas’ ebit. Our conversations with the Vice Chancellors of several of Navitas’s remaining University partners gave us confidence that the Macquarie decision was highly likely to prove idiosyncratic rather than a harbinger; and that those universities welcomed the opportunity to grow into the void left by Macquarie in hosting foreign students in Australian universities. Those conversations also highlighted how acutely sensitive enrolments were to the currency.
A year on, and Navitas’s reported numbers barely changed, with like growth (excluding the former Macquarie contribution) in revenues of 12.5% and ebit growth close to double that. Management here have done a good job in optimising the franchise value, and stabilising cashflows in the face of structural interruption to the business model, leaving shareholders warranted in bidding the equity valuation back up towards former levels.
As ever, catalysts remain elusive, even after the fact. We have often wondered what was the catalyst for major turning points in equity markets through recent cycles, such as the TMT boom and bust, and then the liquidity and Financials driven boom and bust in 2009, and now we have the mystery of why metals and mining prices collapsed through end 2015 and then rallied through February until mid year in 2016. Australian small companies are now enjoying a bubble environment in multiples and liquidity. Usually, it is as simple as greed and fear tugging at either extreme of market prices, and ultimately economics and required returns prevailing in the end. It was ever thus, as much as in the eye of the storm it is always hard to admit that human emotion governs short term returns as much as the most precise spreadsheets. In an expensive market where earnings growth has been absent for four of the past five years and will be again next year, we continue to see narrow pockets of opportunity, and for the first time in several years these opportunities are seeing their earnings stabilise or improve. That has led to an improvement in our trend of returns this year, whilst momentum strategies have started to falter, and we continue to believe that given the extremely high multiples attached to earnings momentum, our Portfolio continues to be embedded with a significantly better risk and return trade off than the broader market.
The full portfolio commentary can be found in the Monthly Report due out around the 12th business day on our website: http://www.schroders.com/en/au/advisers/funds/australian-equities/wholesale-australian-equity-fund/
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