Trade wars. Tariffs. Quantitative easing and modern monetary policy. Rate cuts. Bond yields breaching new lows. The AUD hitting its lowest level against the USD in a decade. No deal Brexit. Queexit if Adani isn’t approved. No earnings growth on the ASX outside of resources in FY19, and FY20 forecasts rapidly unwinding. Multiples at their highest levels ever on the ASX for growth and yield stocks. Active management is underperforming passive to a greater extent, and for longer than has ever been the case in Australia.
It is all happening on the ASX, with the level of noise deafening and the absolute and relative value on offer sending mixed signals due to this unprecedented environment.
Separating the signal from the noise is important. At a macro level, we have long had the AUD/USD long-run cross at $0.75, and of the commodity suite only iron ore as well above sustainable levels. We have not and do not expect global or local growth to accelerate much from current levels (trade wars or not), nor do we expect domestic consumption or house prices to improve from current levels – which are still elevated following 30 years of buoyancy.
Our long-run bond rate assumption in Australia is 2%; each 1% change obviously has a big impact upon multiples, but also earnings growth, hence the slew of downgrades we are currently experiencing and we expect to continue so long as rates remain compressed.
At a micro level, our investments in the ASX-listed waste companies, Cleanaway and Bingo, are a case in point. Cleanaway’s share price was languishing at less than $0.50 when a new CEO was appointed four years ago. Since then, on flat revenues apart from the Tox acquisition, EBIT has tripled, and the equity market performance has been better.
Having struggled to find demand to list at $1.80 two years ago, the share price since for Bingo transcended $3, subsequently retraced to close to $1, and during the month has closed at about $2.50. Meanwhile, if one did not have that price chart but simply looked at the financials, one would not expect the massive share price rollercoaster that holders have experienced. In both cases, the biggest driver to equity value – long-run ability to invest at good returns – is arguably largely unchanged, but that economic reality is massively divorced from the investor experience.
As Christof, the puppet master in The Truman Show said: “… We accept the reality of the world which we’re presented. It’s as simple as that”. As an investor in Australian equities (as an example, but the principle extends across asset classes and markets), the world presented to us today is more extreme with distortion than has ever been seen. Extremes on the ASX abound. The multiples attached to high P/E firms, 10-year bond yields, and the multiple differential between mining and industrial stocks are all at extremes hitherto unseen in Australia. The currency is at its lowest level relative to the USD in a decade, with the price of our major export still well above our long-run assumption.
Usually, a natural course of action for an investor in a stable system is to look for abnormal variations to normal relationships, and position a portfolio to capitalise upon this variation reverting to type. This year, however, it is clear that we have neither a stable financial system nor (for the same reasons) a basis upon which to believe historic norms should be a natural order. Mean reversion is a flawed strategy when fundamental shifts occur, whether that is with respect to the cost of capital, or community and political expectations of acceptable returns for corporations and the level of acceptable penalties that can apply should those expectations be breached. We still believe that sustainable return on capital is the best basis upon which to value company equity across industries, but that belief has been tested by many of the policy changes implemented through the past decade with increasing fervour. We are left as investors with the same dilemma that confronted Winston Churchill as he considered varying forms of government, only to conclude that, “Democracy is the worst form of government, except for all the others”.
Nufarm Limited is a case in point. It has been a poor performer, with the equity down 40% through the past year, such that it has never been priced more cheaply against the broader market than is the case today on climate-afflicted earnings. Operationally, Nufarm’s strength – a business relatively equally diversified geographically by providing agricultural crop protection and seed technologies to markets in Australia, Asia, Europe, South America and North America – has turned into a vice; a once in a hundred year flooding in North America occurring the same year as the once in a hundred year drought in Australia has seen profits lower than expectations, and cashflows worse again. Compared to two years ago, the contribution from Australia is down by $50m – or almost 20% of group EBIT – and working capital stresses saw Nufarm issue a $98m preference security to its largest shareholder, Sumitomo. Sumitomo has a coupon of 6% on the notes for a year (and 10% thereafter), and can convert to ordinary shares at $5.85 (the price at which Nufarm raised equity last year) per share from FY22 (which would take their holding from the current 16% to 19.9%). Nufarm can repurchase the notes at face value prior to that time.
Nufarm has a valuable seeds business with a patented development undertaken with the CSIRO of Omega 3 canola seed. This seed has a unique profile, which includes long-chain omega-3 fatty acids, offering substantial nutritional advantages through increased DHA levels, helping to fill the shortage in fish oil, the traditional source of DHA. Nufarm subsidiary Nuseed received USDA deregulation approval for cultivation in 2018 and doubled its contracted production of Nuseed Omega-3 Canola in 2019. Little is currently priced for the success of the Omega 3 Canola seed’s commercialisation in Nufarm, when it could start making a meaningful contribution within the next 18 months. In the meantime, little is spoken of this as the parlous balance sheet of the group has rightly taken centre stage nearer term.
One of the best performers for the funds through July was Lendlease. CBA was also one of the best performers. What happened in each case? Nothing particularly good; it was but even that was simply an unwind from a previous level that had seen undue pessimism priced in at a time of maximum stress for the company. The list of ailments at such a time is always long, and the truth is they rarely fundamentally change as the market price improves, they just receive less focus. As indeed was the case with Cleanaway and Bingo.
In The Truman Show, Christof told Truman: “I am the creator – of a television show that gives hope and joy and inspiration to millions”. When Truman then asked, “Then who am I?”, he is told by Christof, “You’re the star”. The RBA is Christof; and the lower rates go, the more yield becomes well bid, and the yield stock suite becomes Truman. Indeed, globally – so long as policy sees currencies continue to be debased – the more gold becomes Truman, as well. Our portfolio biases pivot from those receiving undue attention to Christof’s ministrations, simply because they are unpredictable and, as indeed was the case in The Truman Show, the risk is always that the actors lose confidence in the puppet master, as is happening in several countries around the world currently, in a civil form. The financial market equivalent, should confidence in the wisdom of official bodies wane, could be just as messy.
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