Are tech stocks now in bubble territory – and where can you find real value?

We interviewed Martin Conlon, Head of Australian Equities, following reporting season. Click here to watch the videos. 

What were the highlights of the most recent reporting season? Who were the winners and losers? 

For me, the biggest surprises to come out of reporting season were the strength of a lot of the retailers. The spending that came through after government stimulus was a lot stronger than expected. JB HI-FI, Harvey Norman and Bunnings had very strong results and much stronger than we would have thought six months ago.

Tech stocks also had incredibly strong share price performance. For us, it's not really that their results were that fantastic, it's just that they happen to be the epicentre of momentum in the market. We've been cynical on this sector for a fair while, wrongly so in a share price context. To me, the results didn't go anywhere near justifying the values that are attributed to them. It's interesting that most of them are trying to focus on EBITDA, not on statutory earnings and a lot of the accounting underneath is starting to become more questionable. Investors are voracious for growth and they're doing whatever they can to appear like they're growing quickly to support those valuations. We still look at is as very bubbly and frothy, and for the most part we don't think most of those companies are likely to have anywhere near enough sustainable earnings to justify the valuations that are there at the moment.

On the other side of the equation, the banks are still under pressure a bit with dividend cuts. A lot of those more traditional businesses, like Telstra, who are still under pressure, haven't received as much of the government stimulus.

On the whole, there are probably at least as many positives to take out of reporting season as there were negatives.

How did the Covid-19 crisis affect results? Where there any surprises?

The most difficult thing with coronavirus, particularly the government stimulus, is to work out how much of this is going to be sustainable, how much of it has artificially supported results and importantly, what are things going to look like next year? That's really the case in retail. The artificial strength in some sectors like hardware and homewares are fantastic at the moment, but will it be sustainable? To be fair, a lot of the companies are at least disclosing how much they've received in government stimulus.

On the other side of the equation, things like retail shopping centres are problematic as tenants aren't paying a lot of rent at the moment. We need to work out how long we think that's going to last and when it will get back to normal. We then try and value the companies based on where a more normal level of earnings is, rather than what we're seeing at the moment which is clearly unsustainably high for some companies and unsustainably low for some such as airlines, airports and retail shopping centres.

Government stimulus seems to have been effective in offsetting the initial economic impact from Covid-19. How do you see this developing over coming months as stimulus is reduced?

Government stimulus is a fantastically interesting topic at the moment because monetary policies have obviously been the dominant force in the last 20 or 30 years. Asset prices have been everything and the transfers have generally been towards those asset owners and away from the people who are unlucky enough to not own assets.

We think we could be at the real cusp of a macro economic change in the sense that there'll be a lot more pressure to transfer money away from the wealthy and the asset owners towards the unfortunate people in the economy within tourism, retail and some of the harder hit sectors where it is not fair that they are expected to get by on nothing. I think that transfer environment is going to be with us for a while.

In an economic fairness context, the only fair outcome is going to be that those transfers are possibly sustained for longer than anyone thinks, and probably will have to be sustained in higher quantum that people think.

What results helped/hurt the portfolio and why?

In general, across results we did reasonably well particularly given that we don't have a lot of exposure to the technology sector that did exceptionally well this month. But, some of the results in the waste sector, like Bingo and Cleanaway, and stocks that we've held for a long time like News Corp did well for us.

It was a bit of an eclectic mix as a lot of the resource stocks are still producing strong results with strong dividends and cash flows which is really important given the dearth of that in the market at the moment. There are a lot of companies doing well that aren’t delivering much in terms of dividends back to shareholders.

We had a broad mix of stocks across the portfolio that generally did well. Some sectors like gold, that had been strong, weakened a lot however we don't have a huge exposure to that so fared reasonably well in resources.

Where do you see opportunities in the market?  

I think what the economy really needs is some investment in areas that will provide productivity of the future, like renewable energy, new energy and old infrastructure. All those things to us are the capital that should be being provided to the market, not just inflating the valuations of intangible companies that actually don't need much capital anyway. That's where all of the attraction is for us, because the flow of money in that direction has meant that there's a lot of opportunity to provide what the economy really needs.

Looking forward, are there areas of the market you are concerned with?

At the frothier end of the market, particularly in technology, we have a lot of concerns as valuations are high, and higher than we have seen historically. The trade-off is far better in the more traditional resource type sectors of the market that haven’t been the epicentre of the speculation. They’re far more of an attractive trade off where they're already providing ongoing profits and dividends. They're not extremely aggressively valued versus history, and they don't have the excitement around the sectors. With the reduced breadth of the market in technology, more of the market returns have been driven by fewer stocks. I'd say it's a bubble.

Can healthcare continue to grow? Despite being expensive, do you see any pockets of value that you are willing to allocate to?

Healthcare has always been a conundrum for us because the fundamentals are undoubtedly strong with an aging population and increasing government spend on health care. Obviously, it creates an attractive backdrop. The headache you've got is that a lot of the companies, particularly CLS, RESMED, Fisher and Paykel are already earning extremely high profits and charging high prices to the taxpayer.

The productivity that needs to come out of the healthcare sector in the future really raises some question about needing to get better value for the taxpayer in terms of how much it's delivered for that sector.

The combination of very high multiples on what are already very high profits for the healthcare sector creates some headwinds for them in the long run. Despite the fact that the macro backdrop remains a positive one, we found some attractive opportunities like Sonic Healthcare that we bought in March during a more depressed environment.

Honestly, it's still reasonably tough to find companies that we think are attractively priced.

The potential for bank bad debts seems a significant issue in driving caution from investors on banks. How do you view these risks in light of current bank valuations?

Unfortunately, the trade-off for bank shareholders isn't particularly attractive at the moment. With very low interest rates and the inability to grow credit from a base that is already an indebted economy, their margins are being squeezed and the likelihood of bad debts in the future continues to rise. Effectively you've got this uncomfortable trade off, where the future looks like it's going to get tougher in a bad debt sense, and that's always a tough time for shareholders, and the ability to grow your margins and grow profits to pay for those bad debts looks a lot worse than it has been historically.

Unfortunately, that leaves us in a situation where the summary for banks is that it's not a particularly palatable risk return trade off.

How are you positioning the Schroders Australian equities portfolios?

The portfolio, much to our cost has probably had not enough exposure in the technology and healthcare sectors that have been narrow areas driving returns, however we’re very well exposed in some material stocks that have done well. There are several stocks we think offer opportunity for the future and we have a broad exposure to resource businesses and waste businesses, like Bingo and Cleanaway, that we think will be the drivers of future growth and less at the speculative end, particularly if government stimulus and the money starts to go into the real economy rather than asset prices which has been the story of the last 10 or 20 years. We think the portfolio is positioned to do far better in that sort of environment.

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