One company well placed to traverse these waters

Nicholas Leitl

K2 Asset Management

As we kick off a new financial year, we consider some of the important factors that will influence our portfolio construction and stock selection. We also highlight one company that is well placed to navigate this landscape and deliver strong shareholder returns.  

In October 2018, Fed Chairman Jerome Powell commented that interest rates were “a long way from neutral,” putting central banks on a course to end a decade of ultra-accommodative global monetary policy. 

The path towards ‘rate normalisation’ was in motion, despite global equity markets crumbling at the prospect of higher rates, the Fed raised in December and suggested that “some further gradual increases” in the Fed funds rate would be necessary. While cash rates in Australia ended the year at generational lows, market implied pricing showed this was likely to remain the case for the foreseeable future. 

Fast forward 6 months and consensus now expects the Fed to cut rates twice this year and the RBA, having cut rates to a historic low of 1.25% in June, are now also referring to ‘unconventional’ methods of monetary policy. A remarkable turnaround in a relatively short space of time. 

Despite a decade of conventional and unconventional monetary policy, budget deficits, US tax cuts, strong employment and equity markets near record levels; investors are now faced with another rate cutting cycle. Adjusting to a world of zero interest rates as the new normal, has unleashed a new wave of demand for growth and income stocks, propelling them into bubble territory. 

In Australia, expectations are for another cut this year, which would put them 50% lower than where they were in May! While the law of small numbers exacerbates the percentage move, this just highlights the impact on valuations for long duration and growth assets. 

In theory, valuations can go to infinity. But just like trees, they don’t grow to the sky. At some point, it will stop, and the valuation pendulum will swing back.

Test the philosophy of 'Growth At Any Price'

We believe that valuations in these effervescent waters are a risk for investors. There is both market risk and execution risk. While we like many of the business models in the technology space, the valuations are implying near-perfect execution and outcomes. Navigating the competitive and regulatory landscape, while managing the investment required to capture the profit expectations is no easy feat. 

Even those few companies that have become market leaders have stumbled along the way. We expect to see more of those speed humps emerge, especially as share prices diverge further from reality, which will test the investment philosophy of Growth At Any Price (GAAP) currently being employed by large cohorts of investors. 

A second order risk for the endless pursuit for growth is relative valuations. We believe there is a raft of growth companies that have enjoyed a re-rating on the back of a rising tide. Costa Group (CGC AU) and Reliance Group (RWC AU) are two prime examples that were swept up in the growth wave, only to have fallen short of lofty expectations due to normal changes in business conditions. Both companies have suffered savage share price falls. We believe these are good businesses that were trading on valuations that left no room for disappointment. 

There is no dispute that the outlook for rates has shifted dramatically over the past six months, but the impact on valuations is more academic. Equity market risk is still significant when investing and this needs to be considered despite the relative merits. We do not have exposure to those well-known technology stocks, as valuation remains a key pillar of our investment process

Equity markets are forward-looking and usually, discount future economic prospects. The surprise coalition victory eliminated substantial policy risk for equity markets and, along with interest rate cuts and APRA’s easing standards, have propelled a post-election rally in equity markets with growth now more prospective. 

Given the economic stalemate in the leadup to federal elections, it is not surprising that profits have disappointed relative to expectations, particularly for consumer and housing-related companies. The fact that markets have failed to look through these backward-looking results is of more interest. 

Profits could disappoint before improving

We believe that profits will continue to disappoint in the short term, however, considering accommodative fiscal, monetary and regulatory policy tailwinds we may see some improvement as we cycle into the back end of this year. The headwinds from the decline in residential property investment and how these flow into unemployment will have a large bearing on economic fortunes over the coming quarters. 

Given these competing forces and considering the greater than average market valuation, we feel that higher levels of cash are currently warranted. We will look to deploy capital as earnings risk materialises, valuations become more attractive and the outlook for growth improves.

As we look beyond this year, Australia should be entering a period of relative stability. Political leadership should be assured for the next three years and policy consistency should follow. We believe that it is increasingly likely that Australia’s animal spirits will re-surface towards the end of 2019 and as a result 2020 could be a year of growth. 

We would expect to see a revival in the level of business leader and household confidence. This should see a lift in business investment along with an improvement in household consumption.

Ultimately, we feel that boards of Australian listed companies should now reduce the retention of profits and prioritise re-investment in the pursuit of growth. Dividend payout levels should subsequently decline and return on equity should ultimately rise. 

Should signs of improvement begin to emerge on the horizon, the Consumer and Industrial sectors will provide substantial upside for investors. This space has been a value trap over the current cycle, as valuations have tracked earnings expectations down. If the operating environment does improve, then a positive earnings outlook combined valuation support is a recipe for strong shareholder returns. 

One company well placed to traverse these waters

Austal Ltd (ASB AU) is a military and commercial shipbuilder with facilities across USA, Australasia and South-East Asia, and that provides support services through six service centres. 

Austal’s product offering is highly differentiated in the shipbuilding world, specialising in high speed, low weight aluminium military and passenger vessels. 

The ferry industry is currently enjoying strong demand from customers that are looking to replace an ageing fleet, satisfy the International Maritime Organisation (IMA) marine fuels regulation (effective 2020) and take advantage of buoyant conditions in Europe. 

The US Navy has set out several new vessel build programs, representing a major growth opportunity for the company. Having one of the most advanced naval shipyards in the US allows the company to significantly reduce delivery times, and we see them well placed to win a share of the work and ramp up their earnings profile over the medium term. 

Austal also runs a support and sustainment business, which helps service their active fleet, and contributes to 20% of the group’s earnings. This has delivered strong growth over the last three years and, given the increased fleet size, is expected to continue into the future. 

Operationally, the company continues to execute well, as improved efficiency and higher margin contract wins flow into earnings. In the three years to 2021, the company is expected to deliver over 20% EPS CAGR with significant upside risk from further margin improvement and additional contract wins. 

With net cash on their balance sheet, free cash flow yield of 9% and a robust growth outlook, we see the valuation of PE 16x next year’s earnings as compelling. Austal Ltd (ASB) is a core holding for the K2 Australian Small Cap Fund.

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Nicholas Leitl
Portfolio Manager
K2 Asset Management

Nick is Senior Portfolio Manager for K2 on stock selection within both the Australian ARF and Asian ARF. He previously held roles within Macquarie Bank, BT Alex Brown and JM Financial Group. Nick holds a Bachelor of Economics and Finance from RMIT.

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