Four points to note as resources rally
Little more than a year ago, we were struck by how far materials, dominated by minerals producers, had fallen as a proportion of the ASX through time. Just as commodity prices and, in turn, minerals producers’ earnings oscillate, we felt valuation support justified a significant overweight to that sector even when commodity prices were at dire levels. A year on and the ASX resources index has rallied 61%, with the industrials index doing 6%. Materials have reverted from 12% of the market to 17%; a move, however, only reflecting the earnings changes through that time, and not a rerating. Multiples on material stocks are still low and, hence in the main, we still see more attractive valuation support for minerals producers, such as BHP Billiton, Rio Tinto, South32, Alumina and Iluka, than we do for the market as a whole. In contrast, the big loser as a proportion of the market through the past year has been financials (including REITs), even though earnings have been relatively flat through that time.
Within that context, we would make four points on where we now see value. First, the market remains acutely sensitive to earnings revisions. CSL increased by more than 10% during the month, reflecting an earnings upgrade of 10%, while Brambles lost more than 15% as earnings were decreased by 5%. This is especially the case where high multiples are the starting point, especially among mid- and small caps. Enter Aconex. Its share price fell 40% during the month after the building-software company downgraded its outlook by a similar amount. Given the company’s operating cashflow is forecast to be less than $10 million this year, even with net revenue of $50 million, Aconex’s market capitalisation of $600 million after the large correction, requires nothing short of large, sequential cashflow growth for many years to come. The last year has highlighted to us, yet again, that picking inflection points in earnings momentum is precarious; who picked the commodity price rally from March last year? What was the catalyst? It is why we continue to anchor to valuations in terms of portfolio positions, but nonetheless the power of revisions in market performance month to month is clear.
Second, while Aconex undoubtedly has a strong growth outlook and our concern rests with the multiple, it is a banner stock for a small companies index that continues to trade at a premium, for inferior earnings growth for industrial stocks. The ‘illiquidity premium’, which reached a zenith mid-2016, has unwound somewhat but may have further to go.
More rational than radical
Third, our portfolio positions are still overweight materials, especially miners, and underweight bond sensitives, reflecting valuations. While both these positions are less pronounced than they were a year ago, their convergence has commenced but is still nascent, especially if bond yields continue to sell off – we use a 3% bond rate as a mid-cycle proxy, slightly higher than the spot rate of 2.7% (which was less than 2% as recently as four months ago). While the resources sector has moved from book value to 1.6-times book through the past year, defensive industrials continue to trade at a much higher multiple (2.7-times book), still 25% above their long-run average. Looked at another way, we still have 10%+ downside to our valuations for almost all REIT, healthcare and utility stocks; whereas we still have upside based on valuations for some of the resource names in our portfolio. The valuation gap remains large but, of course, as it has narrowed through the past year so our portfolio tilts have converged as well.
Finally, while different from the norms of the past decade or more and, seeming to attract emotional responses, it appears at an objective level that many of the policies of US President Donald Trump are rational, albeit radical, in their implications for earnings for many ASX 200 stocks. For example, allowing US states to block buy healthcare in order to exercise pricing power for ‘low-income citizens’ appears to be economically and politically sensible and it remains mystifying why this hasn’t happened already. For ASX-listed companies exposed to the US healthcare market, this will provide a changed environment after many years of strong revenue growth as prices increased, while returns on capital started high and went higher. Why is it rational for a US politician to preserve a system that sees US taxpayers and voters pay more for the same drugs than citizens of other countries such as Canada and Australia? Maybe part of the equalisation of consumer prices globally sees prices in those markets increase and not just US prices decline. This will obviously affect many ASX-listed healthcare stocks but especially Mayne Pharma.
Encouragingly, US energy independence is also rational policy, albeit the promotion of the development of existing shale, oil and natural gas reserves will suppress energy prices globally. Increasing infrastructure spending is also rational, especially to the extent that it is funded from savings in existing government expenditures. (Wastage in Pentagon outlays has already been highlighted.) A proposed relaxation in US bank regulation has not just seen US banks stocks respond but has seen bank stocks rally globally through the past quarter, including in Australia. Finally, if a protectionist agenda is pursued, given trade is about one-quarter of GDP for the US, about half of that of China and less than one-third that of Germany relative to GDP, the US may be hurt least from such a policy, notwithstanding all its attendant complications. In all, a renewed focus by the US on fiscal policy, rather than the undue focus upon monetary policy, will have a material impact upon many sectors in the market and the pricing of assets (through increasing interest rates). In some ways, to the extent the above policies are implemented, it is difficult to see them being wholly reversed by subsequent administrations. Hence, the impacts may be long lasting. The ‘Trump rally’ will not prove durable; assets are expensive, especially as interest rates normalise, and earnings growth is still weak. However, the resetting of returns across the sectors detailed above that have otherwise had mostly stable experiences through the past 20 years will continue. Investors are best to see current directions as an early warning signal, rather than a blip in a long-run trend.
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