Another year (almost) over, and assets have again been on a tear. All ASX sectors have performed well this year, with most generating double digit returns, consistent with global experience. The other global norm is the notable sectoral exception to this great performance; Telecommunications has been the laggard, underperforming by 30% through the past year as both challengers (TPG and Vocus) and incumbents (Telstra) have been outsized underperformers.
Telstra’s strategy day compounded its poor performance. In unveiling its vision as “a world class technology company“, outlining its intent to exploit new business and revenue opportunities from IoT (internet of things), 5G and big data, Telstra was no doubt reacting to the stellar performance of Technology stocks globally through 2017; in Europe up almost 20%, the US and Japan up almost 40%, and emerging markets 60%. Unfortunately, Moeen Ali can be called a spinner, but if the ball doesn’t spin … Telstra is not a global technology company, as much as it may now wish to call itself one. It is, alas, simply an inefficient, domestic, telecommunications company. Telstra’s labour costs to sales are almost 20%; TPG and Vocus are operating at half those levels, and Optus (a fairer comparator) is almost 40% lower. Spark in New Zealand has slashed its operating costs and now has labour costs to sales almost 25% lower than Telstra’s. The investor day highlighted how Telstra is forecasting record levels of ongoing mobile network capex, at almost $1.5b per annum for the next couple of years, and all industry competitors are also projected to spend at record levels. To be the high capex, high opex operator in any market is a dangerous market position as services commoditise. The market does not believe Telstra has the cultural capability to be a technology company, which together with a strategic focus upon growth rather than efficiency, has seen the share price underperform by 30% through the past year. There is an option, albeit a theoretical one at present. A refocus upon efficiency, even just by benchmarking itself to Optus, could see Telstra generate $2b in extra ebit. Telstra’s current ebit of almost $6.5b is forecast to decline to $4b in mid cycle. A $2b productivity prize on a $4b ebit base may not be alluring to the current management and Board, but as we have seen with Woolworths, and BHP, in recent years, sub optimal strategic paths are rarely allowed to continue unimpeded by capital markets for too many years, where a viable, alternative strategy exists. Brambles is another portfolio holding which has performed poorly through the past year and appears strikingly inefficient relative to peers, and where we suspect management will need to either choose to address this issue themselves or, as with Telstra, have an uninvited party offer to assist them to this end.
Whilst Telstra and Brambles have not had any growth in recent years, the truth is the market hasn’t had any material earnings growth either. Through the past several years, market eps growth only broached 5% once (in 2017), and even then this was simply because Resources had a large contribution following a poor year in 2016. Industrials eps growth hasn’t exceeded 4% any year in the past cycle, and Bank eps growth is roughly half that level on average. Over the longer term, Resources are second only to Healthcare in terms of eps growth for ASX sectors. We suspect eps growth forecasts shall again prove optimistic in 2018 and 2019, and ultimately achieved levels of eps growth will be sub 5%, akin to that seen through the past several years.
It is thus tempting to say that as growth is scarce, where it is available, it should attract a higher multiple than ever before. That is, in fact, what has happened, with a market on high multiples across the board, seeing the greatest premiums relative to history being paid for the highest multiple cache of stocks. Unfortunately, should stocks in this category fail to deliver to expectations – and TPG and Vocus fall into this genre through the past year – the derating is swift and strong. Prior market darlings such as Domino’s and Aconex, and healthcare stocks such as Sirtex and Mayne Pharma, may all have idiosyncratic reasons for their fall from grace and dramatic underperformance through this year, but they all started from a base where multiples were at record highs, and cashflow was poor relative to reported earnings (and often always had been). The stand out sectors in terms of high multiples on the ASX today are defensives, which trade at record high price to book levels. If 2018 is to, indeed, see bonds sell off globally, then these multiples are most at risk of aggressive derating.
We see low cost, lowly geared, long life resource stocks such as BHP, RIO, Alumina and Iluka as still offering relative value, albeit with commodity prices as well above sustainable levels in almost all cases. Within the mining sector, capital and cost discipline remains strong albeit weakening at the margin after two disciplined years, which may seem a short time frame for such behaviours to change however it is significantly longer than that practiced by most capital markets participants. Importantly given the Telstra scenario we outlined earlier, the mining sector has actually taken material dollar costs out of their cost bases in the past several years. No other ASX sector has seen this happen, to the same extent, with Financials being the greatest laggards on productivity.
Finally, the commission of a Royal Commission into the Banking sector was announced during November, seeing equity values for the banks sell off to the point where they are now relatively attractively valued, so long as underlying earnings are able to be maintained and bad debt cycles are not worse than that experienced in Australia’s last recessionary period. In our opinion, one issue dwarfs all others in the context of Commissioner Hayne’s inquiry, and that is the amount lent for mortgages against household income. More than doubling this ratio from three times (to currently seven per major bank “How Much Can I Borrow” online calculators) is the single greatest direct and indirect source of misconduct the Financial sector has imposed upon the Australian community in the past two decades, and the full consequences of this avarice will only be understood in an economic downturn. It is inconceivable that the Australian community expects the banking system to allow it to borrow almost double for housing, relative to income, what could be borrowed elsewhere in the developed world. For example, the Bank of England in 2014 mandated that mortgage lenders are not able to lend more than 15pc of their total new residential mortgages at loan-to-income ratios of 4.5 times or above. A recommendation along those lines in Australia, albeit currently not contemplated, would act as a brake on sector earnings for many years to come. The Banks conduct and pricing decisions in recent years have allowed the opportunity for a populist push for a Royal Commission to ferment, and more recent attempts at public image remediation are reminiscent of the public debate between Jonathan Taplin, the manager of The Band and the producer of “The Last Waltz”, and Alexis Ohanian, the founder of Reddit, concerning the ethics of the digital economy diverting profit from the creative arts from artists. In response to hearing of illness visiting upon a member of The Band, and that person having little financial means to treat it, Ohanian offered to promote a charity concert to raise money, prompting Taplin to shut him down: “You are so clueless as to offer to get the Band back together for a charity concert, unaware that three of the five members are dead. Take your charity and shove it. Just let us get paid for our work and stop deciding that you can unilaterally make it free.”
The banks need not now have ads explaining their public benevolence. They just need to stop inexplicable out of cycle price rises for mortgages, in conjunction with stemming (and ideally reversing, albeit this is complex) hitherto ever expanding house price to income ratios. In response, we suspect their net promoter scores would rise in sync with the benefit to household disposable income; they would, indeed, have traded long run sustainability for near term earnings.
For reasons outlined in this commentary, we continue to be most overweight the Mining sector and its long life, low cost, lowly geared constituents, albeit at levels well below where we were a year ago, and we are still most underweight bond sensitives such as Infrastructure and REIT stocks. Portfolio performance in the past couple of years has come from these two positions, but also meaningfully from owning better run industrial companies with cashflows matching earnings, and further aided by the fall from grace from some of the investment stars of the prior few years. We believe all four of these themes have further to play out.
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