1. A lot of large cap Australian Equities managers moved down the market capitalisation spectrum into Mid & Small Cap stocks. What are your views on Mid & Small stocks v Large at current valuations?
Objective measures such as enterprise value (equity + debt)/sales and price/book suggest minimal differential between large cap stocks and smaller counterparts. There is normally a tendency for fund managers to favour smaller stocks due to perceptions they are able to grow more quickly and hence deliver better returns for investors. Unfortunately this belief is not supported by facts. Over most time periods (including recent years), larger stocks have delivered better total returns (capital + dividends) than smaller counterparts, effectively meaning that despite payout ratios which tend to be higher than smaller companies, larger businesses have been able to match earnings growth rates of smaller peers, allowing investors to achieve better total returns. Our bottom-up valuations for smaller companies are not evidencing valuation disparity suggesting greater opportunity in this market segment. If anything, valuations are more supportive for larger businesses.
2. What are your thoughts on retail disruption (e.g. Amazon entering Australia) and the impact on retail environment?
Although we are not dismissive of the Amazon impact on discretionary retailers, we believe the pressure on retailers at present is more significant from the mounting pressure on disposable income and resultant anaemic growth in the overall spending pool available for the retail industry. With declining interest rates increasingly unable to provide ongoing support to discretionary income and a corollary impact to sentiment through booming asset prices, spending power is now restricted by wage growth (currently low) and impaired further by high levels of inflation in health, education and utilities.
On Amazon specifically, we believe the disruptive impact of online retail businesses has been evident for some years now, with all retailers being faced with the pressure of competition from businesses without the cost impost of ‘bricks and mortar’ retail networks. While Amazon clearly brings the combination of significant buying power and an efficient logistics network, the other primary difference in the Amazon business model is their propensity to accept lower margins than those to which retailers have been accustomed. Amazon is not an entirely new business model and the economics which prevail in its business are identical to other retailers. We believe there is every likelihood that Amazon will garner increased market share as a result of competitive pricing and an appealing customer offering, we see little which prevents other retailers from competing with this offering other than the need to accept lower operating margins. In turn, if Amazon shareholders become less tolerant of the relatively low levels of profitability the business achieves, its ability to exert ongoing downward pressure on prices will be compromised.
3. The government tried a tax on the miners and it didn't work. Do you think a levy on the banks will? Also how long until the banks pass the levy on?
The shortfall in government revenue versus expenses is an obvious and ongoing problem. We suspect the propensity to raise taxes from corporations rather than individual taxpayers will remain high. However, the issue of avoiding corporations passing on the impost to consumers will be a difficult one. In the mining tax, given the products sold have globally set prices, so the tax was obviously going to be met from profits and would detrimentally impact the cost position of miners. Additionally, given miners had historically not made significant excess returns through the cycle and invested heavily in the economy, the logic behind this tax was somewhat spurious. In the case of the bank levy, we believe there is solid logic (albeit it is highly unlikely this was the logic behind the tax) that the implicit government guarantee provides a significant funding cost advantage to the major banks and the levy merely recoups a portion of this advantage. Contrary to miners, there is ample evidence that major banks do generate significant excess returns, whilst meeting this levy from profits would not in any way jeopardise the stability of the financial system. As such, we do not see great problems in making a bank levy work. On the issue of whether it is passed on to customers, this is both difficult to prevent and difficult to isolate within the myriad of moving parts in overall bank earnings. However, from our perspective, if the banks are able to pass it on the logical conclusion is a need for greater competition rather than more stringent regulation. Competitive tension is by far the best solution in preventing price gouging and as long as the levy coincides with efforts to improve the competitive landscape, we believe it will be difficult for banks to sustainably pass on the levy.
4. What are your thoughts on Sydney (and Melbourne) house prices? What are you telling your children to do on this front?
There is little doubt that Sydney and Melbourne house prices are exhibiting increasingly ‘bubble like’ characteristics. The statistics on the level of house price growth relative to incomes and the level of housing debt relative to GDP are objective facts and are unarguably excessive versus both history and most global benchmarks. Additionally, the incentives created through Capital Gains Tax (CGT) relief, negative gearing, ongoing interest rate reductions and high levels of migration make Australia relatively susceptible to ‘bubbles’. It is the migration element which we believe has been the most important factor in creating the Sydney and Melbourne price conditions as most migration has been fed into these cities whilst restricted supply has exacerbated the imbalance. Significantly elevated prices which are not supported by fundamentals (incomes and rents) substantially increase the likelihood of a correction and make buying at present highly unattractive and I would certainly not be encouraging my children to enter the property market at present. High prices are generally a significant part of the cure (in stimulating more supply), whilst almost always presaging lower returns in the future. Australians have been inculcated with the belief that house and land prices always rise, driving them to invest a disproportionate percentage of wealth in this asset class and driving exceptional historic returns. It cannot continue indefinitely.
5. What are your views and outlook for specific stocks within Resources (BHP, RIO, FMG and S32)? Do you still hold them and are you buying/selling?
We remain of the view that most major resource stocks are relatively inexpensive based on our views of mid cycle commodity prices and the cash flows which these businesses will generate at those prices. While the rise in share prices over the past year has closed much of the substantial under valuation we believed was evident 12 months ago, BHP, RIO and South 32 remain more attractively valued than the vast majority of the Australian equity universe. While we have reduced our position in resources slightly versus 12 months ago, it remains our most significant sector position. At an individual stock level valuation appeal is most evident in larger capitalisation stocks and is spread across a range of commodities. Iluka Resources, Alumina, Rio Tinto, South 32 and BHP Billiton all have valuation appeal despite operating across a range of commodities at differing points in the pricing cycle (e.g. mineral sands are only now recovering from an extended period of depressed pricing whilst iron ore is now around mid-cycle pricing levels having spent time both above and below this level in the past couple of years. As always, resource stocks will not deliver a smooth earnings stream, however, for those willing to accept the ups and downs, we believe long term returns will be substantially superior to those available in the highly sought defensive category.
6. What are your views about infrastructure equities (Sydney Airport, Transurban) given the current state of 10 year bonds?
Versus almost all other equities in the market, infrastructure equities have seen outsized gains from both markedly higher multiples being attached to earnings and high levels of financial leverage which have buoyed returns. Although we are not in the camp that sees a significant probability of sharply higher interest rates in the future (given the inability of incomes to cope with higher interest rates), we see almost no prospect of the tailwinds which have supported these stocks repeating. These businesses now trade at exceptionally high valuations and are envisaging growth rates which we believe will almost certainly prove optimistic. Combined with ongoing high levels of financial leverage, we believe risks are under appreciated.
7. What is the outlook for the Telcos sector and Telstra specifically?
We believe the telco sector continues to have an appealing volume growth outlook from the perspective of demand for mobility and data and the propensity to offer new products and services. Despite this appealing volume growth outlook, the high fixed cost nature of the business and the potential for new competition make us far more cautious on whether this volume growth translates into improved profitability. TPG’s success in the recent mobile spectrum auctions has facilitated the entry of a new low cost competitor into the mobile telecommunications sector, an outcome which will almost certainly suppress returns for existing players. Given the Telstra mobile business is the dominant part of overall valuation, this is rightly being priced as a headwind for the business. Additionally, NBN competition remains relatively aggressive and the negative margin impact from the transition to NBN is becoming a reality for most industry participants. Although the impact on Telstra has been well telegraphed by the company, we are far closer to the earnings trajectory for the business moving into negative territory. The ability for the company to sustain the dividend as earnings move backward will also become an issue. Whilst much of this has already been captured in the Telstra valuation (to put this in perspective, Telstra’s enterprise value is currently almost identical to that of CSL despite a revenue base and earnings before interest and tax level around 3 times the size) , the future is undoubtedly challenging for the business. We do not believe Telstra is materially undervalued given our expectation of significant earnings decline, however, we believe risks are largely captured.
8. A lot of managers really like CSL and your analysis suggested it was good quality company. Why don’t you hold it?
CSL has been an exceptionally well-managed company over a long period and has grown underlying value faster than almost any business in the listed market. Despite this exceptional performance, we don’t believe it is a persuasive investment at current levels of valuation. Commanding an enterprise value (debt + equity) of around US$50bn, CSL generates revenues of around $US6bn and earnings before interest and tax of under $US2bn. This drives a multiple which is markedly higher than most of the broader market and a cash yield which is much lower. Given these dynamics, investors are placing a high probability on the ability of CSL to replicate historic growth in order to justify this valuation. Given the relatively narrow nature of markets in which CSL operates and the already high prices charged for its drugs, we are far more cautious on the ability of the company to grow substantially in the future, particularly given the pressure which ballooning healthcare expenditure is exerting on governments around the globe.
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