A motley lot ignites diversity
At last, some diversity. The March quarter for the ASX saw a myriad of stocks and sectors lead and lag in performance. A motley lot – South32, Medibank Private, Newcrest, Vicinity, Santos and Transurban – were the best performers, whereas Macquarie, Incitec, the major banks, Computershare, Woolworths and Caltex were among the worst. Even though bonds still rallied through the quarter, it was a marginal move and the path was wild, and equity markets followed accordingly. It continues to be intellectually vacuous to believe that bonds are expensive whilst maintaining that the best performing stocks on the ASX through the past few years, which are almost wholly bond sensitives, continue to have the best prospects.
Of these broad themes, one stood out. Banks wobbled, mostly after ANZ disclosed bad debts had risen by $100m because of a few, large exposures, and after Westpac confirmed net interest margins are flat this half even after two repricings. Australian banks have enjoyed a generational “stronger for longer” run that dwarfs anything the resources market enjoyed before the consequent fall. To wit, BHP this year will make the same ebit it made a decade ago; CBA made $5b pre tax a decade ago and will make $13b this year. The driver for this increased profitability is simple; flat margins, and other revenues and costs growing in line with revenues, have meant that volume growth has been the game, set and match for bank earnings through this time. A little more than a decade ago, monthly housing finance approvals were $10b, and today they are in excess of $30b. No products innovated nor exported, no global competitive advantage, no efficiency in production, but some lessons were learnt from abroad as ASIC is now making public. It can be rightly argued that the banks have been rational in maintaining pricing through this strong volume environment, but BHP moved to a market linked price for iron ore as demand increased as well.
If management for the banks is as subject to human frailty as us all, and volume growth drove the great generation of performance, what has caused market nervousness through the quarter as to the prospects for the sector? Forecasts were too optimistic, on every line, but especially credit. Of course bad debts had to rise from all time lows relative to the like asset base. The issue now becomes what is a sustainable credit loss rate? We continue to assume a level above this year’s experience. We also model a “recessionary hit”, material bad debt charge, which we deduct from book value in our valuation. Valued on this basis, major banks on a lower price to net tangible asset basis now look good value relative to the market; the higher multiples attaching to CBA and Westpac continue to be world leading for banks, and subject to ongoing pressure as regulatory forces continue to crimp the extraordinarily high return on equity that have accrued to Australian mortgage portfolios in recent years.
Apart from pressures on the banks, the dispersion in drivers in return across the Australian equity market through the quarter followed the scrip written by Larry Summers in “The Age of Secular Stagnation”. On quantitative easing, he wrote “… More important, these policies are running into diminishing returns and giving rise to increasingly toxic side effects. Sustained low rates tend to promote excess leverage, risk taking and asset bubbles …” All four factors have impacted upon Australian market performance.
Sustained low rates have promoted “yield” stocks and bond sensitives, notably infrastructure and property, to the point where the dispersion between them and materials stocks is as wide as it ever has been. If the forces for low rates abate, we would expect at least some of this outperformance to unwind. And thus it went through the quarter.
Further, excess leverage is the financial drug of choice for corporate manic depressives. Nothing propels the highs, higher, nor the lows, lower. Consider the oil sensitives - Qantas as a winner and Origin Energy as a loser. Woodside has of course underperformed because it shares a reliance upon the oil price for its economics, but its underperformance has been half of Origin’s. Part of this is due to lesser operational leverage, but much more is due to lesser financial leverage. In 2013, Origin produced $1.1b in operating ebit and had $6.8b in net debt. In 2019 we forecast those same metrics at remarkably similar proportions - $2.2b and $11.5b. And yet, Origin’s share price has more than halved from the $10 per share seen in 2013, due to the need in the interim to raise $2.5b and issue a large number of shares in an endeavour to address leverage woes arising from malinvestment. Qantas management have done a stellar job since 2008. The equity performance, though, has been magnified by not just the oil price fall but also the operational leverage embedded in all airlines and entities with large on and off balance sheet lease liabilities (just ask any Woolworths shareholder).
In the Australian equity market context, we do not believe undue risk taking is rife among Australian corporate management now. Leverage, though, is meaning that the penalty for undue risk previously assumed, as in the Origin case, is now being called. The bigger area of undue risk for investors continues to be in the multiples paid for income streams perceived to be defensive; the gap in multiples between the highest and lowest rated industrial stocks continues to be at record levels. If asset bubbles exist in Australia, this is where they sit. Again, the quarter past was interesting in that for the first time in several years, on days when the market was pressured, low cost resource companies with lower levels of debt often performed better than infrastructure stocks. History would suggest that resource names outperforming in down markets in Australia is common, which is counter intuitive, but an essence of what is needed for our portfolio to continue to outperform.
In previous commentaries we have highlighted the six principles driving our fundamental views. They remain prima facie headwinds for earnings, and whilst multiples continue to adjust they are not yet cheap, but better described as fair. These principles also ignore two critical, issues; the price paid for the equity purchased, and the management intent to generate good returns on investment, even in the face of challenging conditions. We continue to seek to increase our exposure to positions where we feel operational leverage – evident across the breadth of the market, as discussed above by reference to the bank and energy sectors, but equally applicable more broadly – is accommodated within current valuations.
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