Commentary: When the bulls go to sleep, La Pulga (The Flea) will rise


Every year I try to grow as a player and not get stuck in a rut. I try to improve my game in every way possible. I start early and I stay late, day after day, year after year, it took me 17 years and 114 days to become an overnight success. – Lionel Messi

Lionel Messi’s ascension to FIFA World Cup champion is befitting of a Harvard Business Review leadership story that would inspire any corporate executive. Messi’s career achievements are truly remarkable, which span one French League title, four European Champions League titles, ten Spanish League titles, and 22 top goal scorer awards, just to name a few. What’s more impressive is that Messi achieved all this despite being diagnosed with a growth hormone deficiency at age 11. From humble beginnings, Messi was able to defy poor odds of success due to his obsession with football and a growth mindset. Instead of focusing on his size and height disadvantage, Messi honed in on improving his agility and ball control to thwart defenders, hence the nickname ‘The Flea’. In 2022, Messi showed the world that hard work and a strategy “to get better every day” can eventually overcome adversity, no matter the odds.

Corporate leaders and board members should take note of Messi’s thirst for winning and relentless effort for continuous improvement. Like Messi did when he was 11, boards and executive teams will need to contend with a stunted growth environment in 2023, which will require ‘flea-like’ agility to manoeuvre to a different environment. Central bank regime changes, globalisation challenges from increased sovereign risk, and the fallout from climate change policies will translate into increased economic volatility. This is a stark contrast to the decade following the global financial crisis, which was characterised by a long cycle of declining interest rates and low inflation, capital markets awash with liquidity, and low sovereign risk which allowed globalisation to accelerate.

Strong governance and leadership make a difference.

In a stunted growth environment, strategic management missteps will have magnified results to shareholder profits and returns, especially if the company is highly indebted. When the going gets tough, executive leadership and board quality shine through. To use Warren Buffet’s words, “You should invest in a business that even a fool could run because someday a fool will”. Strong boards will challenge management’s strategy and capital allocation to ensure shareholders are not being exposed to undue risk. This starts with an experienced and independent board that champions good governance practices such as aligned executive compensation and accounting integrity. If poor management practices are left to fester, the organisational core and culture will rot, and, often, so too the financial performance. This is best shown below with the index of companies that score poorly on governance, where the effect is more pronounced across smaller companies.

commentary governance concerns chart

A recent example of this is Star Entertainment (SGR), where shareholders experienced the full force of poor governance and cultural practices in 2022. While Star Entertainment is not the only gaming company to have its dirty laundry aired, the NSW inquiry into Star Entertainment’s suitability to hold a license uncovered a number of ‘sharp practices’ and ‘poor sub-culture’ in the VIP business that circumvented regulatory restrictions and increased money laundering risk. Consequentially, the license remains suspended, and the NSW government has proposed a significant increase in gaming taxes which, if enacted, could impact Star Entertainment’s earnings by over 40%. Pending other penalties to come, this will increase the burden on an already geared balance sheet. Unfortunately for SGR shareholders, they have now been saddled with this regulatory risk, which has resulted in a total shareholder return of -52% in 2022.

Corporate strategy – identifying the winners and losers

Within industry sectors, there are plenty of examples where divergent corporate strategies and leadership practices can produce varied results. Historically, this has provided the long-short investor with a unique alpha opportunity to capitalise on these anomalies. While it is not evident at first which company has a winning strategy, often it is qualitative factors uncovered through meetings with management teams and competitors that help us understand the organisational capability and management skill set to execute a strategy. Delineating between skill and luck is done by benchmarking a company’s financial results such as market share trends or cash return on capital over several periods relative to the peer set, not just over a single period.

For losers, the main culprits tend to be those routinely actioning overpriced merger and acquisition transactions or pivots into new markets where the company lacks expertise. Successive management turnover (especially at the Chief Financial Officer level) without a renewed strategy is often a red flag. The winners, on the other hand, typically foster a culture of excellence in a few areas, whether it be cost leadership, product innovation, or service levels superior to industry benchmarks. The simpler the strategy, the better. Above all, strict return metrics force management to triage capital allocation, as every dollar spent is spent sparingly. This is where the board plays an important role in either vetoing or authorising a deal.

Divergence – the brave and selfless

The case study of two of Australia’s largest banks is another great example. CBA is the best-performing bank over a 10-year period, delivering an annualised return of over 13%. Like Messi, CBA has had a relentless focus on one thing: to become a simpler and better bank for its customers. Prioritising customer service and technology leadership has led to superior customer experience, which has translated into net promoter scores in ‘consumer digital’ and ‘business digital’ significantly ahead of peers. The better customer experience has meant a higher deposit funding mix of 69%, and a lower reliance on the broker channel for mortgage origination at 46%, compared to the industry at 60%. This all translates into a sector-leading ROE of 12.7% and a whopping valuation of 2.3x price to book value.

Westpac over the same period has delivered an annualised return of 6.9%, with ROE sitting at 6.9% in 2022. Westpac has been plagued by cost headwinds and, like ANZ, lost market share in 2021 due to poor broker experience, given the blowout in mortgage processing times (>20 days). Among brokers, Westpac has the worst net promoter score of -6.9, followed by its other brand St George at -5.9, according to Roy Morgan. To make up for poor service, WBC is offering sharper pricing for its mortgages, which means a lower net interest margin for shareholders. Unlike CBA, technology has not been Westpac’s strong point, which includes historic cost blow outs on its wealth platform Panorama, and more recently the decision to enter into discussions with Tyro (TYR) to compete with CBA in small business payments. All this translates into a discount valuation to CBA and NAB at 1.2x book value.

banks sector relative performance commentary

Another case study is in the listed packaging sector, where there has been a stark performance between Amcor (AMC) and Pact Group (PGH). ‘The Amcor Way’ has long been upheld through its senior management ranks, which starts with attaining commercial excellence, innovation to develop differentiated products, and most of all, cash and capital discipline to maximise shareholder value. Amcor’s shareholder value creation model combines organic capital expansion and bolt-on acquisitions to deliver 5-10% EPS growth per year. This blueprint was formed under Ken Mackenzie’s leadership and was turbo-charged by the acquisition of Alcan in 2010, which is one of the most shareholder-value accretive acquisitions in Australian corporate history.

Pact Group on the other hand, has had a mixed acquisition track record over the same period, which has translated into its EBIT margin and return on capital halving from 2015 to 2022. Over the same period, EPS has declined from 23 cents per share to 4 cents per share. Current CEO Sanjay Dayal is making some positive headway in undoing acquisitions made by previous leadership with his simplification and asset sale strategy and by positioning PGH as a leading circular economy business. Unlike previous Pact Group leaders, Dayal understands the importance of strategy: “What I’ve learned in business is you need a sustainable, competitive advantage, something that makes you special.”

packaging sector relative performance

Clearly, these case studies demonstrate that management strategy and governance play an important role in shareholder returns. Assessing which strategy is likely to be successful requires qualitative judgment, and is something that cannot be picked up with machine learning or quantitative strategies. You won’t find the answer in spreadsheets, but if you spend enough time with management teams and bury yourself in annual reports, you might just realise why some companies compound growth above their industry peers. Overweight the winner in the portfolio and pair the loser in a short position, and the returns can be rewarding.    

The year ahead

The end of 2022 marks the end of cheap money, goods and services. The new world has begun where central banks will no longer come to rescue financial markets, given the arrival of inflation. Speculation, or buying loss-making assets in the hope of reselling them at a higher price won’t be a viable strategy until the next bull market. In our view, we believe investment markets are likely to be influenced by the following three seismic changes which were not present in the previous decade.

The first obvious one is the change of central bank regimes, where the control of inflation over growth is now the priority. The good news is that key inflation indicators such as freight rates, container ship queues, commodity prices and retail inventory orders have started to decline. However, the labour market still remains incredibly tight, which is likely to see central banks hold off on any stimulatory policies until there is more slack in the labour market. As seen in the chart below, the puzzling effect of COVID has been a decline in the labour force participation rate due to either retirement or reduced participation among 20-24 year-olds (where are all the crypto bros at?). So while interest rates increases will begin to moderate, a return to the ultra-loose monetary policy of 2020-21 is a far shot from here. 

labour force participation rate commentary

The other element of central bank regime change, and arguably more important, is the unwinding of quantitative easing. During the last quarter, the European Central Bank (ECB) and Bank of Japan (BOJ) fell into line with the US Federal Reserve, with ECB President Christine Lagarde announcing that the asset purchase program will decline by 15 billion euros per month from March 2023. The BOJ also surprised the market by allowing the 10-year yield to trade as high as +0.50%, which has seen Japanese yields reach a seven-year high. These are massive shifts, given that the ECB purchased more government bonds[1] than were issued by Italy, Germany, France, and Spain in 2021, and the BOJ’s holdings have grown to 50% of the Japanese government bond market. The unwinding of asset purchase programs by central banks may well keep a floor on long-term interest rates, even if inflation declines, which will continue to have ramifications on long-duration equity valuations.

The second seismic shift is the acceleration of climate change policy. The transition to renewable energy is likely to be inflationary, as traditional investment in fossil fuel production dwindles, leading to structurally higher energy prices. The explosion in demand for rare earth, copper and other commodities will likely mean shortages and higher pricing, which will feed into finished goods. Regulatory measures to force adoption such as carbon or fossil fuel taxes will also be inflationary. Currently in Italy and Germany, high electricity prices due to gas shortages have led to a marginal difference in fuel costs compared to charging. Despite this, the world will transition to clean energy, and a significant amount of investment will go into gas import terminals, renewables, mining and processing plants—but this will take time and a significant amount of capital and human resources.

The third seismic shift is deglobalisation due to increased sovereign risk. While tensions with the West and China have been elevated for some time, China’s COVID zero tolerance did expose vulnerabilities in global supply chains. The US rules around advanced chip exports combined with the US Inflation Reduction Act will accelerate deglobalisation as sovereigns increasingly seek to secure the domestic security of clean and advanced technology manufacturing. USA reshoring job announcements are at a decade high, which will only continue to gain momentum under the US Inflation Reduction Act. The EU’s ever-increasing sanctions against Russia will only complicate the flow of commodities and goods, which does not look to be reversing anytime soon. 

US reshoring jobs announced per year commentary

We believe that the portfolio is positioned to benefit from these seismic changes, with an overweight position in energy and commodities that will likely benefit from decarbonisation. In an inflationary and higher interest rate environment where return hurdles are increasing, the value of sunk infrastructure and real assets will increase. At the same time, we believe companies trading on high PE valuations where the market valuation is heavily skewed to the terminal value will be prone to further de-rating since investor return requirements have increased markedly as a result of central bank regime change. Consequently, the fund remains underweight healthcare, technology, and REIT sectors.

We expect our short book to benefit both from the impending earnings recession and the higher discount rate environment yet to flow through into some sectors. It has a mix of positions across a range of sectors where earnings forecasts are yet to reflect the changing economic environment. Like Messi’s journey to the pinnacle of FIFA World Cup champion, the road ahead for corporates won’t be smooth and will require management teams to execute strategies with precision, dedication and an obsession for continuous improvement. For those that do, shareholders will be rewarded. For those that don’t, equity markets will not be as forgiving, given that risk-free assets now provide investors with an attractive alternative once again.

Learn more about investing in the Schroder Australian Equity Long Short Fund:

Schroder Australian Equity Long Short Fund – Institutions

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[1] https://www.reuters.com/article/ecb-qe-idUSL8N2P94I7

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