It’s just a flesh wound

“Look you stupid bastard, you’ve got no arms left!”
“It’s just a flesh wound!”

Many investors are feeling a little like the black knight after the past few weeks. Savage reactions were the order of the day as the pools of capital chasing the incremental piece of news grow ever larger, while those prepared to stand against the momentum grow ever smaller. Earnings calls and result presentations increasingly seem a quaint relic, as quantitative processes and the fundamental investors which increasingly mimic them, seek answers to the same few questions; Beat or miss?, What’s the guidance?, and How was trading in the first six weeks? The multiples, margins and long-term commodity price forecasts which underly the valuations and price targets which brokers happily feed into the databases of the quantitative price setters are increasingly just back-solved numbers to justify ongoing momentum chasing (in both directions). It is perhaps nostalgic to dwell on the underlying industry and business fundamentals driving earnings, rather than just accepting the most recent data point as the base for extrapolation, however, we feel business value must run a little deeper than a few banal data points. The ten, twenty, thirty and fifty percent changes in the value of a business, which have become the norm on the back of a few month’s earnings performance, seem to imply every positive or negative development is perpetual. These savage price moves undoubtedly have progressive impact on investor and company behaviour. Unlike the black knight, when faced with the prospect of losing arms and legs, most will choose to try and run for perceived safety.

Reporting season returns (1 August - 31 August)

Themes worth exploring

While extracting broad themes from results season is perilous and many share price drivers were stock specific, with often polarised performance for businesses operating in the same sector, there were a number which we thought provide some context for the durability of earnings;

• The undercurrent of the domestic economy, like many others around the world, is one of policy settings which have thrown the real economy (in which productivity and living standards are the value drivers) under the bus in favour of supporting an artificial and asset price based one driven by volume growth (immigration) and credit growth. Companies with revenue linkage to asset prices are invariably experiencing more buoyant revenue conditions. This has been the case for many years.

• Government intervention continued to loom large as free markets fade into the background. Being on the right side of government favours matters. The dominant employer, often the dominant customer and regularly oscillating between feast for some companies and famine for others, trying to find method in the madness is simultaneously lucrative and frustrating. Rational economics doesn’t normally provide the right answer.

• Consumer facing businesses were generally enjoying improving conditions as lower interest rates had begun to ease cost of living pains. While sensitivity to interest rates will always be high in Australia, given high personal indebtedness and the immediate flow through of interest rate changes to borrowing costs, the savings picture and overall health of Australia households is always trickier. Savings rise with asset prices. When someone borrows money to purchase a house or shares, it creates a corresponding deposit in the account of the seller. When asset prices rise vastly above wage levels, savings probably aren’t coming disproportionately from wage and salary income as many assume. This is the process that has created much of Australia’s household wealth and its inequality, and also provides the comfort that household balance sheets are in good shape and bank lending against outrageous house prices is so safe.

• Numerous companies raised the parlous state of operating conditions in Victoria and the worrying incidence of crime, particularly around illicit tobacco. The web of incentives is complex, however, as a lesson in the unintended consequences of government intervention and the importance of well-designed incentives, the message is clear. Where regulation, bureaucracy, poorly designed schemes (NDIS), tariffs and taxes create vast potential for profit, in this case tobacco excise, bad behaviour will fill the breach. As Charlie Munger famously quipped; “Show me the incentive and I’ll show you the outcome”.
• The fruits of productivity efforts are not readily discernible. Cost performance across most companies was mediocre. Evidence of technology improving cost trajectory is negligible. Substituting labour for an ever increasing bill from a technology company isn’t productivity gain and it generally ships Australian based profits to the US. As always, CBA (ASX: CBA) produced some excellent data in advance of the productivity summit, highlighting the extent to which the picture on employment and tax revenues doesn’t quite align with the AI enabled vision of the future peddled by technology companies. Paying no tax and employing few people, the economic payoff is not flowing to many. As the government contemplates tax measures which penalise high revenue, low margin businesses employing many, and supporting (supposedly) smaller businesses with lower revenues but sometimes stratospheric margins, technology companies remain adept at controlling the narrative.

Price is the theme du jour

At a stock level, one theme remained pervasive. Investors love rising prices. When it comes to driving profit growth, price always dwarfs volume. Barriers to entry, market power, network economics, high return on capital and the myriad of other terms which investors attach to companies perceived as ‘quality’, are long-winded ways of asking the same question. Can a company raise its prices? Much as Microsoft Excel allows analysts to ignore economic reality and forecast above average price rises into perpetuity, economic reality has an uncanny knack of choosing a different path. Determining whether a company has pricing power which it hasn’t yet exercised, or has pushed pricing too far, will always be a crucial element in determining value. Even for companies without control over pricing (anyone selling a commodity or operating in hyper competitive industries), determining whether prices are above or below sustainable levels is crucial. Inflection points in a company’s fortunes often have a great deal to do with inflection points in pricing.

James Hardie (ASX: JHX) and CSL (ASX: CSL) stood out as the two large cap stocks with the most savage share price reactions, and from our perspective, price was probably key to both. Over many years in their key North American market, James Hardie worked hard to use its strong fibre cement market position to drive cost advantage over competitors and ongoing market share gain versus inferior forms of siding. Recent years have seen far more aggressive price increases, as the incoming CEO sought to drive earnings and margins. While US housing market conditions have been tough, and tariffs have impacted business and consumer behaviour, potentially complicating the assessment of the impact of price increases, sharp volume falls in the most recent quarterly result and the evaporation of market share gains versus vinyl siding raise the spectre of price having been pushed too hard. Add a wildly overpriced acquisition of Azek and lots of debt to fund the acquisition and the damage to shareholders can be severe. Unsurprisingly, continuing to raise selling prices remains core to their strategy. When you’re on a good thing…

James Hardie - North American fibre cement sales

In the case of CSL, issues are perhaps more complex as investors try to determine whether the growth which has driven its extraordinary long-term success can be re-captured. Failure of high profile R&D projects, the over-priced acquisition of Vifor, the increasing bureaucracy which has necessitated significant restructuring costs and demerging Sequiris in an effort to simplify the business have all contributed to loss of confidence, however, it is the Behring business which remains the key value driver. Gross margins well above 50% are not generally the sign of a business with depressed profitability. Over the years, the plasma fractionation industry has done an excellent job delivering both the new indications and marketing them, which prompts doctors to prescribe more (driving volume growth) and upgrading formulations to drive price per gram higher. The industry, and CSL in particular, also delivered ongoing yield, product expansion and collection improvements which meant more revenue per litre and lower cost per litre. Shareholders have grown accustomed to retaining the economic value of both price growth and productivity gain, hence CSL’s exceptional long-term earnings growth. Losing tenders for contracts such as the NHS in the UK raises the spectre that the supply/demand imbalance, which has for many years been tilted in favour of fractionators and cemented the all important pricing power, may have some risk in the other direction. Whether this risk to price trajectory eventuates, ensuring demand remains ahead of supply will always and everywhere be key to pricing power. While much is made of the relatively low earnings multiple versus history, the low tax rates which are so often a feature of global businesses able to shift profits into low tax jurisdictions, mean multiples of operating profit are considerably higher than post-tax profits. Like technology businesses, it often surprises us how the sustainability of extracting excessive economic rent while paying little tax attracts so little investor attention.

Despite the diverse products and services, geographies and revenue sources of the healthcare sector, CSL was not Robinson Crusoe when it came to painful reporting season returns and price cycles moving in the wrong direction. Pathology companies and private hospital operators have had far less success in either retaining hard won productivity gains or being compensated for rising wage costs across large employee bases. Despite years of declining margins and strong evidence on the benefits of pathology in early diagnosis and healthcare cost savings, the Australian government remains firmly in squeeze mode. Perhaps a hangover of price gouging during COVID and the lack of a Chairman’s Lounge in which politicians can enjoy a chardonnay and avoid the general public while waiting for a test, price pressures show no signs of abating. As profitability in the sector disappears (Healius (ASX: HLS) continues to make no profit at all), there will be no choice but to thrust more of the cost on to patients in the form of private billing, should price pressures continue in the medium term. Perversely, should healthcare companies eventually diversify revenue streams away from the government, there is little doubt they would become far more desirable businesses. As wealth is increasingly in the hands of the demographic consuming most of the healthcare services, this seems highly likely in the longer run. As cautionary tales on both genuine diversification being tougher than it looks and the ongoing wanton value destruction through M&A, both Ramsay (ASX: RHC) and Sonic Healthcare’s (ASX: SHL) efforts in global expansion have managed to expose themselves to exactly the same price squeezes from governments in varying geographies, depressing economic returns and share prices for extended periods. At least in the case of Ramsay, new CEO Natalie Davis has diagnosed the problems and is seeking to address them. Without a price signal to support the addition of new or brownfield hospital capacity, capital continues to retreat from the sector. The good news is an ageing population assures admission growth and improving capacity utilisation of operating theatres (the revenue generation centres of hospitals). The economic path to reclaiming lost pricing power is well trodden. Reasonable multiples, enormous underlying asset value and slowly improving economics leave us confident in strong and durable economic value despite a pace of improvement which does not currently please the quantitative investors.

Shocking economics

Like hospitals, despite equity markets awash with capital and stratospheric asset valuations everywhere, capital has not sought a home in electricity generation. AGL (ASX: AGL) and Origin Energy (ASX: ORG) results revealed diverging profit paths and a still problematic path for power generation. The draft Nelson review of the National Electricity Market (NEM) diagnosed problems and recommendations which bear little resemblance to those we’d perceive. A deep and liquid derivative market has, in our humble opinion, been the solution to creating substantial investment in no industry ever. It is obvious that potential developers would like a long-term commitment on electricity volume and price to underwrite reasonable returns on a solar or wind project. The incentives to be on the other side of the transaction are less clear. Households, or governments using taxpayers money, are the ones expected to shoulder the risk. Government has shown a propensity to artificially hold prices down, reducing the pool of revenue and profit available to fund investment in generation. AGL’s balance sheet has around $1.4bn in onerous contract provisions which will reduce its cash earnings for some time to come. Add $1.7bn in rehabilitation provisions for coal fired power stations which will be incurred in the next decade, $3bn of debt and capex of some $500m per annum to keep ageing coal fired power stations running in the meantime, and it’s not clear that AGL is in a financial position to underwrite or build too much new power generation. While Origin may be a better position, given strong cashflows from APLNG and a successful investment in Octopus Energy (which doesn’t build generation either), it still needs to digest the loss of earnings from the Eraring power station. New investments for both AGL and Origin are in battery projects which profit from volatile pricing and a shortage of generation capacity. When investment needs higher prices and voters have been told clean energy will deliver lower prices, the landscape becomes tricky. That high-energy using and relatively commoditised sheds with little in the way of job creation prospects (also known as data centres) can become some of the most sought after investments is perplexing. If the word data centre was substituted with aluminium smelter, enthusiasm for investment would probably wane a little. In a recent meeting with Bill Oplinger, CEO of Alcoa (ASX: AAI), he noted that the long-term power price contract Microsoft (NASDAQ: MSFT) signed at Three Mile Island in the US to underwrite its data centre was at roughly 3 times the power price an aluminium smelter would need to achieve to underwrite reasonable economics.

The excess profitability which technology companies are enjoying after years of exercising their enormous pricing power allows them to justify investments and contracts which those without rivers of gold would not contemplate. History has not shown the best investments are made when companies are awash with cash and looking for the next big growth opportunity. Equity markets are making large wagers that this time is different.

Margin magic

Interesting case studies on the maturity of product pricing and the resultant runway for further price and margin gains were plentiful. Our always cynical view on the value of M&A has been firmly challenged by Seven Group’s (ASX: SVW) turnaround at Boral (ASX: BLD). Under Vik Bansal, the combination of strong price rises and strong productivity gain has seen margins explode. If one wants an illustration of the importance of price versus volume, the charts below are as good as any. Despite enormous margin gains, levels are still below those of global peers such as Martin Marietta, and like a large number of hard asset businesses, pricing is still not justifying investment in new quarries. The realistic view of Seven Group’s prospects which didn’t coincide with analysts' unrealistic view saw the stock price struggle. Business performance remains difficult to fault.

Whilst Seven Group were reporting the history and trying to stay realistic about the future, Seek (ASX: SEK) was daring investors to dream. Whether one calls it depth, yield, or premium products, these terms are code for higher prices. In the path laid by REA (ASX: REA), Car Group (ASX: CAR) and many other ‘marketplace’ businesses, improving price trajectory is about working out who can pay more and making sure they do. Identical services doesn’t mean identical prices. The ‘everyday low prices’ and ‘down, down, prices are down’ which makes food retail so competitive don’t quite apply. The remarkably similar looking ad for your used Porsche or house in Point Piper commands a vastly different price to the 2010 Hyundai or apartment in Sydney’s outer west. Like CAR and REA, underlying volume growth in Seek’s market has been negligible. As the illustration highlights, improving volumes (should they eventuate) might help, but price will help more. As wages move higher, the value proposition for effectively delivering high quality candidates is high. We’re pretty sure Seek is well on track in the quest to find out who can pay more.

Another on the list of well received results was Qantas (ASX: QAN). No prizes for guessing the key earnings driver. Ensuring its domestic market position remains firmly entrenched has never been more important as respective margins illustrate. Aggressively managing capacity utilisation and price is driving strong profitability. International flights not so much. The government seems a little less worried about airfares than healthcare and energy prices. Chardonnay anyone? Guiding towards further increases in RASK (revenue per available seat kilometre) for 2026, with domestic again better than international, was all investors needed to know.

Having been in the doldrums for a while, lithium and rare earths stocks took off. While the US Department of Defence agreement to underwrite a floor price (albeit also sharing in the upside) for the key rare earth elements in permanent magnet production (NdPr) to facilitate the expansion of MP Materials magnet, capacity was the event which lit the fire and enthusiasm quickly spread. Trading at nearly 6 times tangible assets, Lynas took the opportunity to raise $750m. In an industry in which processing capacity should be relatively commoditised, the return on capital expectations for the mine (Mt Weld), are high. While undoubtedly one of the best rare earth mines outside China, assuming commodity prices move to a vastly higher plain because of a deal to ensure security of supply for US defence applications is a fair leap of faith. Similarly, news of a crackdown by authorities and shutting of lepidolite capacity in China provided the fuel to declare lithium and spodumene pricing had hit bottom. While not necessarily disagreeing with an assessment that lithium prices are below long-run sustainable price levels, it is another matter altogether to revise long-term prices to chase rocketing share prices. Predictably, this is exactly what happened. In asking the CEO of one of the major lithium producers whether anything had happened in recent months which would justify changing a view on long-term commodity pricing, he wasn’t equivocal; “No”.

Market outlook

Enthusiastically embracing current market valuations requires far more of an eye on momentum than valuation levels. It is equally accurate to observe that caution on valuation has proven unwarranted and unrewarding of recent years. “Empty headed animal food trough wiper”; “I fart in your general direction” is probably how the Monty Python crowd would phrase it. The savage price moves currently characterising the market can similarly be viewed through different lenses. On the one hand, high valuations and high volatility suggest an unusually risky environment. On the other, potential for short-term gain can be remarkably large, given the extent of price moves. Investors in Life360 (ASX: 360) are feeling pretty good about themselves as market capitalisation moves towards $11bn before a profit has been registered. Nevertheless, as believers in valuation discipline and fundamental anchors, we’d suggest it’s not a time for high speculative appetite or aggressive financial leverage.

ASX200 firms trade on a 12-month forward PE of 19.7, which is 33% above the 25 year average

Bond markets continue to send sharply different signals to equity markets. The expectation that money supply will remain unconstrained and will continue to find a home disproportionately in asset prices rather than the real economy is more than valid if your lens is focused on the past couple of decades. A wider lens gives a different picture. Losing arms and legs is funny in the movies but less amusing in real life.

ASX200 dividend yield less 10yr govt bond yield

Learn more about investing in Schroders' Australian Equities.