Insights into the Australian Equities Landscape: A Conversation with Katie Hudson
Praemium Investment Leaders podcast host Damian Cilmi recently sat down with Katie Hudson, Executive Director and Portfolio Manager at Yarra Capital, to discuss her insights from over 200 meetings with CEOs during reporting season. Read on for a glimpse into the key themes and observations Hudson made and what they mean for investors in Australian equities.
Listen to the podcast episode with your preferred podcast (just search "Praemium Podcast") or listen here.
Damian Cilmi: Our discussion will centre on Australian equities, which is timely considering that reporting season for the first half of 2023 is nearly done. You and your team have already had over 200 meetings with CEOs to discuss their results and outlook, all against a backdrop of significant market changes - such as inflation levels not seen in 30 years, interest rates increasing by over 3% in six months, and the forecast of a looming recession.
These changes have led to a lot of volatility, which some argue creates excellent conditions for fundamental active funds management.
Let's delve into reporting season now that it's over, what were some of the key themes and observations you made during this reporting season?
Katie Hudson: Thanks Damian. If I was to draw inferences across all the meetings we've had, and it's always hard to draw conclusions, universally, but if I was to call out some key themes, I'd say that price has been a very strong driver of revenue growth. But that's been more than offset by margin headwinds. So, we've seen cost inflation emerging and the margin headwinds have really meant that overall company results missed expectations.
So, we had almost 50% of companies miss their results, downgrading. Overall we've seen quite significant downgrades over the last month to the point where now earnings forecasts for FY23 are around 1-2% growth, which is quite a significant step down from where we were before.
Damian Cilmi: I imagine it took some time for these cuts to go through the market. Did the observations and commentaries from the CEOs align with your thinking about economic conditions in Australia? Did anything change in your thinking after all these meetings?
Katie Hudson: Yes the comments and observations from CEOs were largely consistent with our expectations, and we haven't made major changes to the portfolio based on them. One thing that we were expecting, and saw evidence of, was that inflation trends were starting to moderate. This was due to factors such as freight and supply chains normalising, as well as a decrease in both hard and soft commodity prices. So, many of the important drivers of inflation are starting to reverse, and we saw evidence of this.
That being said, one thing that was a bit surprising was what was happening to pricing power. Over the past year, we've heard a lot of investors saying they want to invest in companies with pricing power. However, we're now starting to see the early signs of pricing power fatigue. There are issues with volume response and elasticity, and getting the next round of price growth through is going to be much harder for companies. This will be another pressure on margins.
Damian Cilmi: That's interesting. You mentioned earlier that inflation is moderating, but what about labour costs? Have you seen earnings take into account those increasing labour costs?
Katie Hudson: Yes, we are seeing inflation move from goods to services. While we've seen a lot of inflation growth for goods, we are now starting to see it move through to wage rates. During our meetings with CEOs, we asked about their intentions around labour inflation and wage rates. They've indicated that 4-5% growth is the new normal, compared to the previous range of 1-3%. This will take effect in FY24 and will likely prove to be a stubborn area of inflation for companies to manage.
Damian Cilmi: That's challenging for the RBA as well if inflation remains stubborn. We've talked about normalisation in this market, with shifts in consumption during COVID. Now, there's a sense of over-earning and some potential value traps in the value complex.
Katie Hudson: Yeah. I think you have to be careful at this point in an economic cycle at leaning too much on price multiples because they can give you the wrong sort of sense of valuation. Certainly, there are a number of sectors that we think are still over-earning, where that normalisation of earnings still has to play out. Retail I think you referenced is one example of that. Retailers had a great COVID, their sales levels are still elevated relative to historical trends. Their margins are still elevated as well. And there's some argument to say they're going to go from over-earning to a period of under-earning if we're heading into an environment where the consumer discretionary pressure is greater. And that's something we're alive to.
There's a number of other sectors where we think they're probably still over-earning. Agriculture has had a great three years with almost perfect weather conditions, housing construction…
Damian Cilmi: Because they had price and volume.
Katie Hudson: Correct. That's exactly right. And we're seeing all early evidence of that starting to come back. Housing construction has been very strong, along with energy. So, there's a number of sectors in the market where we think earnings are still elevated. And we just want to be careful that you're not leaning into a price signal that might not reflect the fact that earnings still need to come back.
Damian Cilmi: And I know it's not really your position, but with smalls versus large, do your large cap counterparts see value a little bit differently than you do?
Katie Hudson: Well you've had an environment over the last 12 months where in 2022, the large cap sector ended the year flat. Predominantly because of energy, banks and probably insurance to some extent, whereas the small cap sector was down 18%. And that was from a starting point where valuations were already larger than they were historically.
So that's widened further, and you've now got an environment where the small cap sector is trading, particularly the industrials, at a 20-year discount to large caps at north of 20%.
Damian Cilmi: That is very interesting. Starting to look a bit further afield, what do you think will be the characteristics of successful companies looking forward for your portfolio?
Katie Hudson: Yes, I think it's really interesting. There's a lot of discussion at the moment about whether we will have a softer or hard landing for the economy? Will we have a recession? How deep will it be? We are looking over the horizon to the environment that we are going to be operating in post that. That's the investment horizon that we think about when we're picking companies. And I think the environment we're going to be operating in is one of low growth. We've had an environment over the last 10 years of interest rate declines being a tailwind, that won't be present and instead we will be operating in an environment of potentially some pretty significant population growth headwinds for a number of major economies.
And so, against that backdrop, I think the sort of companies that will win will be those that can generate earnings growth. If you think about the last 10 years, there's been a PE re-rate or a multiple re-rate on the back of interest rates. Going forward, it's going to be about companies that can grow earnings and those companies that can generate market share growth, I think. And that's what we're focused on.
Damian Cilmi: When we discussed earnings growth in the past couple of years, it was often focused on the future and had a long duration, which some may consider a bit extreme. Where do you think the ideal point lies? Will it be in a longer duration growth again or in something shorter?
Katie Hudson: I think it'll be the middle ground. So, the companies that really benefitted over the last three or four years were those, as you call out those very long duration. So long duration, they don't even have any cash flow earnings.
Damian Cilmi: They have when discount rate zero, you know?
Katie Hudson: Yes.
Damian Cilmi: So, you can make your own value.
Katie Hudson: Exactly. That's exactly right. But you know, as we talked about that interest rate tailwind won't be there. So, it'll be companies that have genuine earnings, genuine cash flow and genuine earnings growth. I think they will be the winners going forward.
Damian Cilmi: Your major hypothesis is for a soft-ish landing in Australia's economy. You mentioned that population growth is a positive factor and highlighted some strong sectors, such as the lithium industry. As a result, you think that Australian equities are not too bad, and that the Australian economy is generally performing well in comparison to the rest of the world?
Katie Hudson: We believe that the Australian economy will fare relatively well. You're right to call out population growth. We're seeing net migration approaching 2%, which is a positive sign. We're starting from a good position in terms of employment and national income, and we're benefitting from strong export prices for most of our commodities.
Australia is also well-positioned in the energy transition. We're the largest exporter of lithium, which has become a huge industry for us. We're also a significant natural gas exporter and have substantial copper deposits. All of these commodities will play major roles in the energy transition. So, from a relative perspective, Australia looks okay.
What's interesting is that the small caps I manage tend to be more exposed to Australian companies, they tend to be net importers.
Damian Cilmi: So, in the local economy, in a sense.
Katie Hudson: Yes. They have a much bigger exposure, from an earnings perspective, to the Australian economy. So, counterintuitively, relative to where valuations sit, they should fare relatively better. And one of our other macro themes is we think the Australian dollar will head north. If that's the case, the small caps should perform better as well, because they tend to be net importers.
Damian Cilmi: Good, very good news for travellers as well. Looking ahead, are there any positive leading indicators that instil you with confidence?
Katie Hudson: The relative position of the Australian economy is one to definitely call out. I think we're largely through the interest rate cycle, so from that perspective, we are late in that stage. What was interesting is that the boards and management of companies in Australia were probably a little more confident than we expected them to be. You know, they've had their balance sheets in great shape, most companies have travelled through COVID better than they expected. And , I think there's a willingness to invest and grow and start to do M&A and get back on the front foot again. So, there are definitely some lead indicators there that I think are cause for optimism. Australia is feeling the pressure from an economic point of view but navigating reasonably well given the circumstances.
Damian Cilmi: And being in the small cap space, you would probably see IPOs, which virtually ground to a halt over ‘22. Is that looking a little better in 23?
Katie Hudson: Yes, with the market holding up well, there are some companies starting to do M&A and undertake capital raisings and , we're starting to see the lead indicators of some IPO activity, which is non-deal roadshows coming into the diary.
Damian Cilmi: Very busy then. I can imagine.
Katie Hudson: Absolutely.
Damian Cilmi: So just wrapping up, you said that many of the conditions were around volatility, a lot of uncertainty as well about hard or soft-landing, interest rates nearly finished, or there's still more to go there. There's a lot of different opinions out there. And I suppose within that vacuum, if you will, it sounds positive for active management. So, do you think that we've seen “peak passive”, as some have called it?
Katie Hudson: Now I've obviously got a vested interest in this conversation, so I'm going to acknowledge that upfront. But it is interesting to think about the last 10 years; there's been really just a big beta play. You know, beta was the driver, and in that environment, there's not much value attributed to alpha. And I think that when you have a strong beta environment, I think it does give rise to passive index. And we've seen that obviously over the last 10 years. But you think about going forward; beta is going to be much lower in a low growth environment. There's been a lot more volatility. I think the directional bet is not one way as it has been.
Damian Cilmi: It could be a bit sideways as well as a market.
Katie Hudson: Absolutely. So, I think that is a really good environment for active management, for stock selection being important again. And I wonder whether we may see that active management and people trying to access alpha, in a lower beta environment, may actually step up again.
Damian Cilmi: I imagine it's been an interesting reporting season. It's kept you on your toes and hopefully portfolio's all in good shape and you're excited about the years ahead.
Katie Hudson: Yes. Thank you. Well, we're pleased to say we, we had a really good reporting season from a performance perspective. But from our investment lens, we're looking over the long term and finding a lot of opportunities in this volatility.
Damian Cilmi: Excellent. we'll leave it there. Thanks for coming in, Katie.
Katie Hudson: Pleasure. Thanks Damian.
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Damian joined Praemium in 2018 as Head of Investment Managers & Governance. His prior roles include Senior Investment Analyst at Netwealth and Senior Research Manager for Sandhurst Trustees, and was previously a Private Client Advisor.
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