Time for a reality check?

Over five years, all ASX sectors are up with the exception of Telcos, where Telstra has been the perennial laggard. Over the past Covid year, however, more balance has entered the picture, with IT still being, by far, the dominant sector driving returns but with Materials being the next best performer, dominated by the iron ore names especially Fortescue. Several sectors – Energy, Utilities, Industrials, REITS and Health Care – underperformed. A year ago, was Health Care seen as the obvious underperformer through the course of a pandemic? More broadly, we would describe that performance through the last year as less of a value rally than as a balanced market, just as the so-called value rally on the ASX through recent months has been narrowly led by the banks, where lagged performance until the past several months is now starting to mirror the rage arising in the housing market.

Whilst a specious exercise in a market with characteristics like the ASX in any event, if it is to be done, a good way of measuring the value/growth rotation in the market is by reviewing multiple dispersion. In 2013, the market multiple was 18 times earnings and no stock was trading on a multiple higher than 27. Today, those same numbers are 21 and 36. Whilst the highest multiples in the market have reduced in recent months, they have still retraced relatively little of the expansion they have enjoyed through recent years. Part of this retracement has been because earnings expectations have been mugged; reality, meet high multiples. Whilst A2 Milk has suffered as one example of this, it is observable that some of the growth stocks that have proven relatively immune to the sell-off thus far are loss makers. When you promise nothing in the way of (short-term) profits, the scope for (short-term) disappointment is much less.

Within Materials, commodities have joined the party, and thankfully for the national accounts and the shareholders in Fortescue and other iron ore pure plays, iron ore has led the charge. Buoyed by iron ore exports, the Australian dollar has in turn been the best performing major currency against the USD through the year, more than doubling the appreciation seen in the GBP and the CAD against the USD through this time, for example. All major commodities are today trading at spot prices well above the 90th percentile of the cost curve (our proxy for long run prices). Nothing is more above this level than iron ore, which is more than double our long run price assumption, but equally very few commodities are less than 20% above our long run price assumption. Commodity producers are in clover; and nothing is more certain should this persist than a supply response will be imminent.

Alumina and Manganese Ore are two of the commodities that have been relatively left behind in the rally. Our large portfolio positions in South32 (which is also heavily exposed to both) and Alumina Limited, will benefit should this revert. A less understood further source of opportunity for these stocks is their CO2 efficiency relative to global Alumina producers, with their assets being deeply into the first quartile on an energy intensity basis with less than half the global average of emissions per ton of Alumina produced. As emissions increasingly are priced on a common basis around the world given the investor focus on carbon intensity, South32 and Alumina stand to benefit.

Soft commodities have been strong as well, with Canola at its highest level in more than a decade and all of soybean, wheat and corn also at high levels. Graincorp, IPL and many other rural related stocks are consequently trading at their highest level for several years. Ammonia, the primary feedstock for much of IPL’s fertiliser business, at $A700/t is at a decade high and more than double the price of far less than six months ago. IPL’s Louisiana Ammonia plant should be making 30% returns at spot prices; except it isn’t producing, being beset by yet another of the operational snafus which regularly beset the group. Whilst production is expected to resume within a month, these short periods of (vastly) excess returns assist in making a plausible investment case for a group which otherwise has spent a decade building assets at the expense of returns. The only salvation is IPL’s North Queensland DAP plant is producing, and as with Ammonia, prices of DAP and hence returns from this other major asset for IPL are currently at their highest level in more than a decade. New CEO Jeanne Johns has had a baptism of fire through the three years since she joined IPL, with plant outages, floods, tempests and other sundry acts of god regularly imputing themselves into earnings. If operational mishaps are behind IPL and it can make the most of current strong prices, it remains on a very low multiple.

IPL’s duopolist twin in the global AN market, Orica, saw Dr Calderon leave as CEO during the quarter. The role of CEO at Orica was a consolation prize for Dr Calderon after he was overlooked as BHP CEO with Andrew Mackenzie’s appointment in 2013. Strategies and shareholder returns continued to diverge ever since; Mr Mackenzie preached and lived a mantra of value over volume, with BHP continuously reducing costs and investment to make the most of its first-class suite of assets, much to the joy of shareholders. Orica “won” volume through Dr Calderon’s tenure as CEO with a pricing strategy which sees the business making $150m in ebit this half after making $450m in ebit a half prior to his appointment. A restoration of pricing discipline in the AN market beckons, as despite record volumes Orica is now needing cashflow to appease lenders, let alone shareholders. This will benefit IPL as much as Orica, just as pricing discipline led by the major players in the iron ore market has benefited all producers. The same promise is tantalising for shareholders in Boral and Fletcher Building; where, in each case, evidence of achievement as opposed to promise is harder to discern.

Within industrials, we have expressed our admiration for the operating performance generated by both Cleanaway and Bingo in recent years. Cleanaway has led the industry in productivity but struggled for innovation and organic sales growth, whilst Bingo has excelled at organic sales growth and innovating to increase recycling rates to industry leading levels. However, whilst very different in culture, both are now in the midst of an M and A imbroglio which will have a material impact upon returns offered for shareholders given the large changes proposed to the asset base for Cleanaway and the equity ownership (and in turn then asset base) for Bingo.

The Cleanaway bid for Veolia, if completed as proposed, is very valuable, as reflected by the initial market reaction. Given Cleanaway has a small landfill presence in Sydney to start with, and a life of two to four years at that, to acquire two of the largest landfills in Sydney, each with a licence to operate for another 20 years, along with a menagerie of just as valuable surrounding transfer stations for only $500m, is in itself a potential coup. To then also have acquired the residual Australian network of landfills and transfer stations across many major Australian cities from Suez, together making $190m in ebitda, for $2.5b is a potential company maker for Cleanaway. On one condition. Most M and A fails, in part because of the price paid but also due to poor execution. Cleanaway point to their successful acquisition of Toxfree as vindication of their M and A execution record, which is fine except that the then CEO has now left the group, the then CFO is now on the cusp of retirement and the acquisition is being made without a CEO in place. The execution risk is hence high, however on balance this is a potentially very good transaction for Cleanaway. Of course, should the unthinkable happen and Veolia’s acquisition of Suez be agreed before 6 May, then only the Sydney assets accrue to Cleanaway (at a remarkably low multiple of 7x ebitda), which is a consolation prize better in value terms for Cleanaway than the entire proposed transaction. There has been much talk of PE interest in waste assets; the next few weeks will prove whether there is cash behind the talk, as the Suez assets in Australia are being sold to the highest bidder by 6 May. Among others, it is difficult to believe that the proposed bidders for Bingo would not be interested in bidding for this suite of assets.

Cleanaway five years ago, and IPL more recently, proves that sometimes, the laggards can come good when they start to focus upon returns on assets rather than just growth in assets. Brambles has frustratingly but consistently underperformed through recent years as cashflows continuously fell short of “adjusted/normalised/trust us” earnings. Last month, my learned colleague Mr Conlon highlighted the perils for central banks when confidence is lost in them. The same risk applies for listed companies. The market has lost trust in Brambles’ record of capital allocation and is concerned that this tendency to misallocate may be about to recur, in size, with plastic pallets being currently considered at the behest of Costco. More recently, and notwithstanding an aggressive buyback, Brambles has continued to be a poor performer because of the concern attaching to the plastic pallets initiative. With a new Board chair, who has recently focused Telstra upon returns leading to a long-awaited better experience for shareholders, it is to be hoped that the same approach may lead to the same improved outcome for Brambles shareholders. Many unregulated, global franchise companies listed on the ASX are trading at record multiples relative to the market; Brambles is in the exact opposite position, presaging attractive potential returns from this point should capital allocation improve.

Portfolio Outlook

Not a lot has changed in our eyes relative to a few months ago. Much of the reversion that has been experienced in recent months is relatively minor in the context of the powerful moves compounded through the past several years. We continue to be surprised at many equity market moves through the past year, and yet perhaps we shouldn’t be given the extent of stimulus put into Australia and the relative paucity of Covid-19 infection, let alone deaths. Global liquidity jumped by US$20 trillion in 2020, 25% of global GDP, fuelling a dramatic recovery in asset prices.  It took a decade for activity to recover prior levels in the 1930s Depression, and two years after the GFC. It took less than a year to recover from the Covid-19 economic shock. As can be readily gleaned from performance differentials through the prior month and earlier, our portfolio remains positioned for a continued transition from longer dated (hoped for) cashflows to shorter dated ones; from (very) high multiples to lower multiples. Whilst simplistic mean reversion is highly unlikely, it remains the case that the multiples attaching to the highest rated stocks on the ASX remain at unprecedented levels, and hence remain fragile should growth not be delivered, absolutely and relative to the rest of the market, as the March quarter has highlighted.

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