Beneath the surface of the Aussie market, compelling value has emerged

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Livewire Markets

At a headline level, stocks are down around 11% since the end of last year, but this belies the fact that many company valuations have seen falls in the order of 30%, 40% and 50%. Much of the real carnage has been masked by the outperformance of banks and resources majors. This was one of the key messages imparted by Tim Carleton, principal and portfolio manager at Auscap Asset Management in a recent interview.

“If you use this sell-off sensibly, we think there are some very, very attractive opportunities out there,” Tim says.
“Many high-quality companies pulled back to levels that we found very attractive. It’s then a question of ensuring that you are buying the right sort of companies for this environment.”

Where should you be looking, at a time when buying profitless mega-growth stocks has probably passed? Tim and his team have found a raft of high quality, mature businesses that they believe are trading on depressed multiples.

He explains more in the following interview, which is a curtain-raiser for an in-depth webinar. This will see Tim delve further into sectors and specific stocks in Auscap’s crosshairs and also touch on the broader macro environment. 

Click here to register for the upcoming webinar.

Edited transcript

James Marlay:

Hi, I’m James Marlay from Livewire Markets, and I’m joined today by Tim Carleton, portfolio manager at Auscap Asset Management. With so many headline issues front of the mind for investors now, I’m going to be sitting down with Tim to discuss a few of those topics, ahead of a really in-depth webinar that I’ll be hosting in just a few weeks. Inflation, Tim, that’s the big one. It is front of mind, it’s the front of the newspaper. Should people be worried? And do you think we’re likely to see significant inflation domestically? 

Tim Carleton:

Well, it's extraordinary, isn't it? The US just printed 7.9%. The last time it was at that level, CDs had just been invented or were being rolled out to the public for the first time. That was 40 years ago. And we sit here today, even post the recent hike with Fed funds rate at 0.5%. Back then, the Fed funds rate was 15%. So we're in an environment where inflation looks like it's more persistent. Now, we're not seeing those sorts of numbers in Australia. And there are a few reasons for that. But if we just think about that broadly, why are central banks suddenly worried about inflation? A year ago, they thought that a lot of the inflation that we were starting to see was going to be transient. They blamed it on supply shocks, the rolling lockdowns in a lot of countries, and the fact that everyone was stuck at home. And as a result, there was pent-up demand for goods.

Much of the inflation that we saw was expected to dissipate over time and in fact, reverse. Fast forward to today, and what's the difference? We have tight labour markets. We've got a tight labour market in Australia, we've got tight labour markets in a lot of the developed countries around the world. And as a result, you're seeing wage growth accelerate. So in the US and the UK, the two central banks that are responding most quickly to elevated inflation, we're seeing wage growth of 4 to 6% per annum. And that compares to wage growth sitting at around 2% for much of the last decade. In Australia, we are a little bit behind. We're seeing wage growth of 2.3%, and we're seeing core inflation at 2.6%. So that's only the midpoint of the RBA's target 2 to 3% band.

And there are a few structural reasons for this. One of which is the fact that we have enterprise bargaining agreements that are typically two to three-year agreements in Australia. This means it takes longer for tightness in the labour market to result in persistent and higher wage inflation. And there are public service agreements that only roll off once per annum. We do think inflation is likely to be forthcoming, so we think we're going to see an acceleration and we think we'll see wage growth continue to trend higher, but probably at a slower rate than the US. And as a result, the RBA will be on a slightly different path to the Federal Reserve or the Bank of England.

James Marlay:

The other headline topic at the moment is conflict in Europe, which is obviously the invasion of Ukraine by Russia, which is a disaster. Is that something that factors into your thinking, or how are you thinking about that with regards to investing?

Tim Carleton:

Firstly, our thoughts and prayers are with everyone, every innocent party that's affected by that situation. If we look at it purely from a market and economics perspective, Russia's GDP is about 1.6% of global GDP. It's only a fraction bigger than Australia, despite the big population difference, Australia's about 1.4%. And so we need to think about it within that context. The Russian economy does not have a huge level of significance to the extent that it's now got some issues, in a global context. 

But probably the main impact is what happens to some of their key exports. And in some respects, there are some parallels with the deterioration in the Australia-China relationship a year ago, in that China stopped importing a lot of products that were produced domestically, with one being iron ore, and obviously, the exception in Europe at the moment is oil and natural gas.

And the reason for that was the extreme dependence of both economies on the supply from, in their case Australia, and in Europe's case, Russia, for still making and energy needs respectively. In terms of the rest of the exports that are being affected by trade sanctions and the like, we think that trade will just get rerouted elsewhere. I mean, we saw it with Australia, that a lot of the soft commodities and other hard commodities that we produced that were originally getting sent to China ended up going elsewhere. And that actually happened remarkably quickly because ultimately, you didn't have demand destruction. So China still needed to import the same amount of wheat, they just got it from elsewhere. And as a result, elsewhere there was suddenly a shortage and Australia filled in those gaps.

So you had a rerouting of trade, and probably high transportation costs. But ultimately, the product still found its end demand. And we suspect the same will be the case with Russia. You'll see a drop in the demand from developed countries, that will probably be picked up at a discount by a lot of emerging countries. And again, so you'll see a change in trade flows. Probably the bigger impact is potentially what's happening to Ukrainian exports. And the reason for that is we suspect that there's not a lot of production going on at the moment. So they are material in certain categories like corn, seeds, iron ore. And as much as it might be unfortunate to say this, in many of those categories, Australia is quite strong. So domestically, we'll actually see higher prices. It will be an unfortunate benefit to the domestic economy because we are a very large producer of a lot of the things that Ukraine produce. And we suspect that their production is actually being materially impacted.

James Marlay:

You've talked about this new regime that we're heading into over the next decade. What are some of the implications around where you want to be positioned at a portfolio level? And can you also tell me what you're seeing in terms of valuations across the market now?

Tim Carleton:

At the headline level, the market pulled back about 11% from peak to trough in late January. So it was a relatively mild pullback, but within that, there was actually a lot of carnage. There were a lot of stocks that were down 30, 40, 50%. So the broader index performance was being masked by the outperformance of the banks and the major resource companies. 

But beneath the surface, there's actually been a lot of damage. And a lot of high-quality companies pulled back to levels that we found very attractive. And so then it's a question of ensuring that you are buying the right sort of companies for this environment. We think the time for buying profitless companies has probably passed. They're at a natural disadvantage to the extent that we are in higher inflation, higher labour cost, higher cost of doing business environment. They're going to see their discount rates increase, the share compensation schemes that have been used to attract a lot of talent don't work if your share price is falling.

And if you're reliant on capital markets to fund your growth, this is not a great environment for those sorts of companies. By contrast, a lot of market leaders that are very profitable will actually do very well in an inflationary environment because they actually have the most efficient supply chains, they have the lowest cost of doing business. So to the extent that inflationary pressures, whether it's supply chain issues, whether it's higher labour costs, impact every player in a category, the best in breed businesses will actually have an opportunity to expand their margins over time. So we've taken, we had about 10% cash going into the correction. We didn't think that markets were appropriately pricing the risk of higher rates, and we have deployed all of that towards the end of January, and then again, towards the end of February because there has been some compelling value on offer.

So, we've just gone through a reporting season. A lot of the businesses that we own, that we think are very, very high quality, good businesses that should benefit from a high growth environment, are actually trading on reasonably depressed multiples at the moment. So we've been selectively adding to the portfolio and focusing on the highest quality businesses. 

Our portfolio now has a weighted average historic ROI of over 40%, which is remarkable to put that in context, the ASX 200 is about 9.5%. So we're very, very happy with how we're positioned. And if you use this sell-off sensibly, we think there are some very, very attractive opportunities out there.

James Marlay:

All right, thanks, Tim. Folks, if you're interested in finding out a bit more detail around some of those topics, Tim has touched on there, he is going to be hosting a webinar that you'll be able to discover via the Auscap website, also through the Livewire email. You can tune in, there's a really detailed presentation with a lot of data, a lot of slides, and also some detail around their positioning. Thanks for watching. And if you enjoy this video, hit the Subscribe button. We've got new content coming on our YouTube channel every week.

Register for the upcoming webinar

Visit the Auscap website to register for the upcoming webinar discussing the implications of inflation, interest rates and international conflict for Australian shares.


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