Commentary: The times they are a-changin
The best performing sectors in 2019 and 2020 were the worst in 2021 and 2022, and vice versa. Abundant liquidity propelled higher multiple sectors until the emergence of inflation saw a change in regime. 2023 has started with a third regime; a mix of the two, and some large M&A, and we expect this stock picking environment to continue.
“The battle outside ragin'
Will soon shake your windows
And rattle your walls
For the times they are a-changin'”*
Performance in recent years on the ASX has been quite binary. As Dylan wrote, for several years windows were shaking as massive liquidity injections boosted growth stock multiples to levels never seen outside of the TMT bubble. And then, in more recent times, walls were rattling as these multiples unwound and a great transition started in relative performance for equity markets globally and the ASX200 in particular. Thus far, 2023 has reflected more of the former than the latter, although the nature of relative performance has been affected by a spate of takeover bids for relatively large companies, across industries – such as Energy (Origin), Consumer Staples (UMG), Lithium (Liontown), Banking (Suncorp) and Gold (Newcrest) - notwithstanding higher costs of funding and the prospect of ever increasing regulation.
A standout underperformer during the quarter was the banking sector, which continues to be our largest sectoral underweight. On every important line in the profit and loss account, we see more challenges than opportunities. Credit growth has been well above GDP and population growth for several decades, driven by housing lending which in turn has been fueled by laxer lending standards (on a loan-to-income basis) than is the case in other major economies. The margin expansion seen through last year has reverted in force, with CBA highlighting that monthly net interest margins peaked last October, and intense competition in the mortgage market has seen ongoing deterioration in margins ever since. Market share shifts have been consistently adverse for the major banks through the past decade; but this has progressively accelerated to an unprecedented level through the past two years, as the chart below highlights:
There are some alarming facts to arise from our study of market share shifts in the Australian mortgage market through the past decade:
- There is no single year where the major banks combined have won market share.
- There is no single year where Westpac has grown market share.
- There is no single year where Macquarie lost market share.
- There is no instance of a major bank or even Macquarie organically winning more than 1% market share in a given year. Last year, Bank of Queensland won 1.3% market share. Following the departure of the then CEO at the end of the year, the Chairman spoke of the need for an “… uplift in our risk culture, frameworks, processes and control …” in his AGM presentation.
These revenue pressures, combined with an inability to reduce absolute dollar costs on a like for like basis and bad debt expenses which can only increase, means that current forecasts for 2024 profit growth for the major banks to be in line with 2022, is optimistic. The bigger issue with costs for the sector isn’t just the quantum, but the efficacy of their spend. It is not credible to suggest that an annual IT spend of circa A$2b per annum for each of the major banks is an underspend in systems; it may have been misspent, but it is not because of a paucity of investment. The prospect for higher taxes upon the sector, as has recently been introduced in Canada and before that in the UK, for example, cannot be dismissed as a real and present danger for shareholders when next month’s Federal Budget is released. Finally, and unlike with hard commodities, multiples for the banking sector have not been compressed to allow for this element of over-earning, albeit to be fair the spread between the higher multiples (CBA and Macquarie) and the lower (ANZ, NAB and Westpac) is as wide as it has ever been and hence our skew within the sector is obvious.
In most commodities, prices remain well above cost curve support. Lithium has had a torrid quarter, with the ten bagger in spodumene and lithium prices forming a peak which was well in the rear view mirror after prices more than halved through the quarter, and it was unsurprising that in turn IGO, Pilbara and Mineral Resources were among the worst performers in the index during the quarter. The exception was Liontown Resources, where Albermarle bid A$5.5b for a group where production is still some years off and which had four employees less than two years ago. The US Inflation Reduction Act is certainly causing inflation in asset prices in WA! On the one hand, Albermarle may ultimately be the Time Warner of the decarbonisation rush. On the other, the push by the owners of reserves for Australia to mimic the US IRA and use incentives to promote downstream investment is a meritorious one, however funding these investments with a stretched fiscal deficit is an issue. While the chart below contrasting Norwegian -v- Australian taxation of Oil and Gas sector revenues may be exaggerated, the principle is correct, and in turn assuming free cashflows from excess commodity prices continues to accrue to shareholders may be optimistic:
This may be why, along with the banking sector, the energy sector is another that has been speculated to potentially be subject to increased levels of taxation in the forthcoming budget. In progressing their protracted A$19b bid for Origin Energy, Brookfield and EIG Partners clearly do not believe material changes in the taxation arrangements for the sector are in the offing, although the social license imperative to continue to invest aggressively into renewable capacity to replace carbon intensive generation capacity as it is withdrawn, will be unrelenting. This is especially the case as the RBA has highlighted prospective increases in energy prices as a hit to household finances through the remainder of this and next year, and notwithstanding that spot energy prices fell during the March quarter prompting the energy sector, along with financials, to be a poor performer.
The strain on household finances from increasing household energy costs, and increasing mortgage costs, means that short interest for many housing and discretionary names – such as Realestate.com, Domain, Harvey Norman, JB Hi-Fi, Nick Scali and Stockland - are at their highest level for a year. It remains an underweight sectoral position for the portfolio.
While the consumer may be pressured, the portfolio continues to have significant exposure to building material companies. While James Hardie is exposed mostly to US market activity, Boral and Fletcher Building are exposed far more to the Australian and New Zealand markets respectively. Again, the RBA has called out a shortage of housing stock relative to population growth as another source of looming inflationary pressures for the economy, and we also expect that new management will bring about a sharper focus on pricing at Boral than has been the case, such that the abysmal history of returns will have an upside skew in a tightening market.
“And don't speak too soon
For the wheel's still in spin
And there's no tellin' who
That it's namin'
For the loser now
Will be later to win
For the times they are a-changin'”*
It may well be that sectoral and stock performance continues to be choppy and recent winners and losers toggle as interest rates and interest rate projections change. After a stellar year, Computershare had a wretched quarter. After a poor couple of years, Xero, Cochlear and Aristocrat all enjoyed great performance through the first quarter of 2023. At some point, however, the first principles – cashflows and multiples – always transcend the ephemeral driver, in this case bond yields as a proxy for ‘growth’ stock performance. And our view continues to be that multiples for industrial stocks on the ASX are higher than they have been for most of the past several decades, and yet the cashflow growth they are producing is no better. The past reporting season reinforced this point; with the notable exception of Qantas, revenue growth was much easier to come by than cashflow growth for industrial names. Inflation reverting but settling at closer to 3% and liquidity continuing to be withdrawn, is a different environment for equity markets than a 2% and less inflation number with abundant liquidity. In this environment, it is likely that the multiple convergence that started in the past couple of years could continue for some time yet, just as metal prices may continue to trade well above traditional cost curve support.
*Dylan, Bob. “The Times They Are A-Changin' ” 1963
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