3 issues that are challenging investors in today’s market

Rhett Kessler

Pengana Capital Group

In our recent investor webinar, we discussed three issues that are challenging investors in today’s market and how we are managing these issues in Pengana’s Australian Equities Fund.

#1 Low-interest rate environment and inflationary risks

More than a generation of investors in today’s market have experienced nothing other than a falling interest rate cycle, which has created a tailwind for long-duration assets.

With long term rates now at all-time lows (and near zero), we see limited scope for further downside, suggesting at best an end to The Great Tailwind.

Furthermore, with inflation now rising ahead of long term rates (and with further inflationary pressures in the system), real interest rates have turned negative, raising the question of the sustainability of interest rates at these all-time low levels. What happens if interest rates start rising?

To manage this dynamic, we look to business models that have elements of inflation protection (such as Telstra’s NBN income stream), pricing power in their value chain (such as Woolworths) or business models that perform well in a rising rate environment (such as NAB).

These businesses do not require an inflationary or rising rate environment to perform well, but in the event that one does materialise, should provide the fund with, not only protection but hopefully additional upside as well.

#2 Elevated forecasting error associated with COVID and lockdowns

In order to accurately forecast or predict future cash flows, we establish financial models which aim to provide us with a reliable base. As we stand today, the past two financial years have been heavily influenced (positively and negatively) by the COVID pandemic and this has continued in the current period with extended lockdowns in Victoria and NSW.

The result is that forecast risk remains extremely high as we attempt to accurately distil what a normalised or underlying earnings and cash flow trajectory looks like. As a result, we lean more towards our core investment methodology of focusing on defensively characterised transparent business models.

That’s not to say that such businesses have not experienced a variation in their earnings through COVID, but more so that the underlying drivers are clearer, less volatile and more predictable, such that we can more accurately predict a new trajectory of earnings post-COVID. Examples again include the likes of Woolworths, CSL, Ryman, Ramsay Health, and Mirvac Group.

3# Supply chain and inventory disruptions

One of the enduring impacts of COVID is the substantial pressure it has put on global supply chains. In the first instance, the availability of raw materials or components has been severely impacted (eg computer chips).

Second, manufacturing and assembly lines have in many cases ground to a halt given lockdowns and staff shortages. If an importer has been able to secure inventory, freight and logistic availability have also become scarce and costs have skyrocketed.

As a result, aside from the inflationary element, lead times have blown out making inventory management very difficult and, in many cases, resulting in a supply limitation to revenue growth.

The key to managing this dynamic is twofold. First, a company needs to have a balance of power, not just domestically but globally, in their value chain to elevate themselves up the pecking order when scarce inventory is allocated globally.

A good example of this is Rebel Sport within Super Retail Group. Rebel is a leading customer of Nike (and other sporting brands) globally such that, during the pandemic, the global brand manufacturers were re-allocating stock from lower-tiered customers/regions to Rebel in Australia.

The second key factor is to have the balance sheet strength and integrated supply chain infrastructure to be able to go long on inventory. Again using Super Retail Group as an example, the company was able to make use of its debt-free balance sheet as an enabler for management to build elevated levels of inventory well in advance of key sales periods.

Furthermore, global manufacturers who typically rely on third-party logistic providers increasingly used Super Retail Group’s substantial distribution centres and supply chain network in order to get their goods into and throughout Australia. Other examples of businesses that are well-positioned in this respect include Aristocrat, Accent Group and JB Hi-Fi.

To be clear, managing these (and other) issues has not required a change in our investment approach, rather adhering to it has focused our attention on what we characterise as hard assets.

We think of hard assets as business models with long-term contractual arrangements at favourable terms with strong counterparties; owning unique or scarce assets; being the lowest-cost producer, or owning superior non-trivial intellectual property.

With an average after-tax cash earnings yield of approximately 7% across a portfolio of largely toilet paper and toothbrush-type stocks, we think that we can accumulate 7% in value on a fairly reliable basis, with opportunities for management teams to leverage generally under-geared balance sheets to create additional value from accretive M&A or capital returns.

We are pleased with the fund’s performance in the first quarter of 2020-21 and remain focused on our primary objectives of capital preservation and generating a reasonable real return for our investors.

We continue to believe this is best served by a disciplined approach and consistent investment methodology. A variety of good businesses run by honest and competent management teams at the right price will create a well-diversified portfolio of ever-growing cash earnings streams.

Read more about Pengana’s Australian Equities Fund, or view the funds latest webinar update here. CPD points applicable for Australian Financial Planners.

Pengana Capital Ltd (ABN 30 103 800 568, Australian financial services license number 226566) is the issuer of units in the Pengana Australian Equities Fund (ARSN 146 346 929) (the “Fund”). A product disclosure statement for the Fund is available and can be obtained from our distribution team. A person should obtain a copy of the product disclosure statement and should consider the product disclosure statement carefully before deciding whether to acquire, or to continue to hold, or making any other decision in respect of, the units in the Fund. This report was prepared by Pengana Capital Ltd and does not contain any investment recommendation or investment advice. This report has been prepared without taking account of any person’s objectives, financial situation or needs. Therefore, before acting on any information contained within this report a person should consider the appropriateness of the information, having regard to their objectives, financial situation and needs. Neither Pengana Capital Ltd nor its related entities, directors or officers guarantees the performance of, or the repayment of capital or income invested in, the Fund.

Fund Manager, Pengana Australian Equities Fund
Pengana Capital Group

Rhett is the CIO and Fund Manager of the Pengana Australian Equities Fund, and joined Pengana in October 2007, bringing with him over 18 years of experience as an investment professional at the time.

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