Have You Been Paying Attention?
Something fundamentally has changed in the Australian share market and I believe the early beginnings of it can be traced back to late 2012/early 2013.
It wasn't clear at that time what exactly was happening, and very few would have been paying attention, but as time went by the characteristics have become obvious and visible to everyone.
The past five years have seen the Australian share market generate positive returns, but behind the public facade hides an unspoken of, widespread dissatisfaction carried by large parts of the Australian investor community.
Returns from Australian shares have been noticeably lower than those generated in offshore markets, not the least on Wall Street. Also noticeable is the fact local banks are no longer the strong pillars they had been for almost two decades, GFC not included. Since 2012, banks have been weighing down the performance of local indices, exacerbating the performance gap with foreign markets.
It's not just the banks. Large caps in general are structurally underperforming vis-a-vis smaller cap peers in Australia. Over the past five years, there have been temporary hiccups, when money flowed back into large cap stocks, but these have proven but a fleeting push back. Overall, the trend has been very much in favour of smaller cap, mid-sized stocks with the ASX20 and ASX50 unable to keep up, even with historically large dividends and franking included.
Also noticeable is that value-oriented investment strategies have found it hard to consistently make their mark. The past five years have very much favoured "growth" stocks instead, as illustrated by the significant outperformance of CSL (CSL) among the Top 50. CSL never trades on a low PE, yet the shares are up more than 170% since mid-2012, ex-dividends.
In comparison, the ASX200 went up less than 30% over the same period, ex-dividends. CommBank (CBA) has managed to more or less keep track while paying out an above average yield, but all of ANZ Bank (ANZ), National Australia Bank (NAB) and Westpac (WBC) only managed share price gains between 14-19%, or a very much sub-par 2.5-3.5% per annum, ex dividends.
Macquarie Group (MQG), on the other hand, is up 190% since mid-2012 and pays out a dividend that is able to compete with the Big Four. You don't really want me to line up the performance of smaller cap industrials such as a2 Milk (A2M), NextDC (NXT), or Altium (ALU) over the period. It'll break your heart, unless you own these stocks in your portfolio, in which case you know all about the sheer difference in performance.
The most important question is: what is causing this tectonic shift in Australia, that favours smaller sized companies over blue chips, growth over value, offshore over domestic?
The Cause Of Changing Dynamics
I believe the answer lies with "disruption". The Australian economy has long operated as a basket of close-knit, powerful duopolies/oligopolies. Investors have unknowingly benefited from this over a long period, as companies in control of their destiny generated consistent and reliable rewards for shareholders, but now dynamics and market forces have become less supportive, and the local share market is simply reflective of that.
The key difference between a2 Milk and Wesfarmers (WES)?
The latter has a suite of maturing businesses that are trying to cope with changing consumer spending, as well as with increasing competition. The former is young, dynamic, smaller in size and carving out its own niche by grabbing market share from incumbents.
A similar comparison can be drawn between CSL and Cochlear (COH), Aristocrat Leisure (ALL), Xero (XRO), ARB corp (ARB) and Corporate Travel Management (CTD) to name but a few in the same position as a2 Milk, and on the other side AMP (AMP), Brambles (BXB), FlexiGroup (FXL), Harvey Norman (HVN), Fortescue Metals (FMG), Japara Healthcare (JHC), G8 Education (GEM), Mayne Pharma (MYX), and Healthscope (HSO), among many others in the same position as Wesfarmers today.
The key factor for investors to understand is it is a lot easier for skilled management teams to generate positive rewards for loyal shareholders when their businesses are not encumbered by lots of extra barriers and obstacles.
"Disruption" is not solely linked to emerging new technologies and online competition. Today, rising costs and low growth in wages are putting pressure on household budgets, which leads to changes in consumer spending. More populist politicians and governments are becoming less predictable, with more direct interference. Increased scrutiny from APRA, ASIC and the RBA is heavily impacting on insurance and mortgages being sold locally. Lower share market returns, and rising popularity of passive investment tools and products are putting pressure on active managers to show performance, and reduce their costs and fees. Et cetera.
Many of today's "disruptions" were quite embryonic five years ago, but they are increasingly growing in importance, and nowhere near running out of puff.
The all-important question that needs to be asked therefore is not whether Wesfarmers shares look "cheap" or "undervalued", but whether management has transformed the business sufficiently in order to cope with, and to re-conquer successfully, a market place that is now dominated by different dynamics.
At best, I think, this challenge will take time. But until that key question can be answered in the affirmative, any consideration about "cheap" or "undervalued" will be short term only. I note Wesfarmers shares have been inside a sideways tracking pattern since early 2013. Given the broader context, is anyone surprised?
'Value' Is Not The Same Anymore
Share market dynamics over the past five years make a lot more sense when viewed through the prism of "disruption". This also explains as to why I have been a lot more sanguine about owning High PE stocks, unencumbered and fast growing, than many other experts and commentators, even in the face of rising bond yields.
Sure, the share market is constantly exposed to excessive greed and irrational fear, and disasters can happen, with or without bond market conniptions, but until these business models lose access to end users, or they are being disrupted themselves, my view is investors should watch out for excessive exuberance rather than the next interest rate hike by the Federal Reserve to assess their exposure and share market strategies.
FlexiGroup does not all of a sudden become a better company because shares in AfterPay Touch (APT) might surge too close to the sun. Nor does Primary Health Care (PRY) become a better investment because ResMed (RMD) might temporarily face headwinds from a weakening USD.
One of the unmentioned truths about the Australian share market in the past five years is that lower valued stocks simply generated lower returns in comparison with their higher valued peers, with the occasional exception attracting way too much attention. Compare Macquarie Group and CommBank; a2 Milk and Murray Goulburn (MGC); Aristocrat Leisure and Ainsworth Gaming (AGI); Xero, Reckon (RKN) and MYOB (MYO). NextDC, TPG Telecom (TPG) and Vocus Communications (VOC).
The answer lies in the fact that traditional sectors and old economy stalwarts are being upstaged, and the share market is taking notice. A company like Xero might be trading on a PE ratio well above the market average, but when investors look three years out, they see a substantially larger company with substantially more customers, sales and profits. They simply cannot be that confident about AMP, Myer, CommBank, or IPH ltd.
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