Nothing to see here

Skyrocketing gold prices, exploding data centre investment, commodity scarcity, increased geopolitical tension and defence spending; investment themes maintaining momentum and support for high valuations over 2025 were diverse. 

Undoubtedly the most important has been the determination of central banks to keep the world, and most importantly governments, awash with liquidity/borrowing capacity, particularly in the US. 

Asset price rather than production driven economies fear nothing more than leverage working in the wrong direction, collapsing the asset prices which leverage built. 

Future sustainability will be determined by whether incremental borrowing can create sustainable income and profit rather than continuing to fuel disproportionate asset price growth and unproductive spending. 

The valuation discipline which we do our best to employ is nothing more than insisting on reasonable connections between asset prices and prospective income. The trick is in determining when current profitability might not be providing a terribly accurate indication of sustainable profitability, either on the high side or the low side. The inflation in wages and prices currently evident seems to us a necessary part of restoring the balance between profits, wages and asset prices. 

Whether a generation of central bankers who’ve been happy to tolerate runaway asset price inflation yet panicked at any sign of inflation in the value of the goods, services and wages which must support them can comprehend that financial stability might require a period of time where wage inflation exceeds asset price inflation remains to be seen. 

While governments work hard to convince the population there’s nothing to see here and it’s all under control, we’re a little more inclined towards an investment paradigm in which protecting capital will become tougher, profit growth will be challenging, and governments will be forced to take more than they give. Whatever way you cut it, the last decade has been a pretty good one for equity investors and trees don’t grow to the sky.

As regulators and governments intervene ever more aggressively in the economy, the interim ASIC report into the operations and governance of ASX Group provides some food for thought. One can imagine that the management team at ASX aren’t stoked with the conclusions. Other than insufficient capability, a rotten culture and poor governance, things are going swimmingly. 

Fortunately, such problems do not afflict ASIC, the RBA or government. Harry Hindsight has always been one of the world’s best analysts, perhaps because things are a touch easier in retrospect, however, even with this benefit we struggle agreeing with many of the committee’s conclusions. Undue focus on financial objectives over the past 20 years contributing to a number of serious issues in the past 5 years seems at odds with a 5 year period characterised by the addition of lots of employees and cost. 

Between 2018 and 2025, employee costs more than doubled to $242m, with an average salary cost of more than $200k across nearly 1,200 employees (up from less than 600 in 2018). It did not lead to better outcomes. The link between the number of committees, compliance and IT staff and the effectiveness of a company seems to be tenuous at best, and quite possibly a contrary indicator. 

The Jeff Bezos 2 pizza rule; meetings should not have more people than can be fed with 2 pizzas, is adhered to by few. 

Whether companies, governments or the United Nations, there remains little evidence for more staff being a reliable answer to fixing problems. Nevertheless, placating upset regulators means doing what they say, which means costs are likely to rise even further. 

Once added, costs have a habit of being very difficult to remove. More than 120 reports into governance, culture, capability and risk management since 2020 have enabled consultants to feast at the ASX dining table. There will no doubt be some dessert.

Marketplace businesses such as ASX are fascinating and good businesses. They have a strong tendency towards oligopoly or monopoly structure across sectors such as real estate (ASX: REA), cars (Carsales ASX: CAR), payments (Visa NASDAQ: V and Mastercard NYSE: MA). Effectively connecting buyers and sellers is a seemingly straightforward but vital value proposition. 

Fragmenting marketplaces is generally bad for customers (buyers and sellers) as it’s vastly more efficient to meet in a single place, yet the natural tendency of regulators. Innovation, on which the ASIC report bemoans ASX performance, is an interesting concept for marketplaces. Performance of public financial marketplaces across the Western world over recent decades has been anaemic. 

Listed entities are flat to down, IPO’s abysmal and capital raising lacklustre, albeit the ASX fulfilled its most important role (providing equity capital to businesses needing it) admirably after the GFC when it was most needed.

Market value traded relative to market size has continued to move in the wrong direction as passive investing has taken hold. Prices are set on far less legitimate volume, meaning price discovery is necessarily inferior and more volatile. 

‘Innovation’ has consisted of fragmenting liquidity across ASX and Chi-X (now Cboe), forcing participants to invest heavily in technology to ensure ’best execution’ for no discernible benefit (total ASX trading, clearing and settlement fees cost investors about $200m a year or a little over 1 basis point of value traded), and a race for ever faster execution which has required data centres, fibre optic cable and huge investment to cope with increased trade volumes (not value) in order to allow high frequency trading (HFT) firms to extract large profits by unnecessarily intermediating trades. HFT firms continue to hoodwink regulators by arguing that narrower spreads indicate improved market efficiency. If these ‘innovations’ don’t fall into the category of solutions in search of a problem we don’t know what does. 

Whilst not wanting to defend ASX performance on technology, as it has been abysmal, ‘innovation’ has equalled increased complexity, and increased complexity has seen higher cost and more scope for failure. While few market developments in the past couple of decades have been positive, we continue to believe ASX is a very good business, public markets are vital and the plumbing of Australian financial markets as efficient as almost anywhere in the world. 

Across nearly all businesses, management teams able to discern which technology developments genuinely improve customer experience at an acceptable cost and which are just adding further to the spaghetti of technology complexity, making them hostage to technology providers and consultants, will remain an important differentiator of success for years to come.

Effective technology spend is also front of mind in assessing another of the major themes of 2025, Artificial Intelligence, its impact and the value of the data centres which facilitate it. The enthusiasm of governments and investors to sponsor large industrial sheds full of servers, piping hot processors and the associated pressures on electricity provision has surprised us. 

Telecommunications infrastructure has been the backbone of the internet and vast amounts of productivity gain over recent decades. It has not been an overly lucrative market for investors. The world has provided the backbone on which US technology companies have extracted the returns. 

Announcements of yet more MW of data centre contracts with the same mega-cap tech giants seem to us to confuse volume with value. Volume equals lots of capital expenditure, value is the extent to which fairly commodity assets are expected to deliver excess returns. 

Much of the excess return provided by property assets over the long-term has been through appreciating land value. The greater the building value relative to land the higher the proportion of depreciating asset value. Data centres seem to be very expensive buildings housing rapidly changing technology. The quantum of the return on capital, and more importantly, its durability, remains uncertain. 

AI and data centre spend continues to move vastly ahead of the revenue models to justify it, not a traditionally sound business case. When profit forecasts assume both more lucrative returns than other forms of property ownership and a never ending stream of property development profits, as is the case with Goodman Group, all wrapped in earnings multiples higher than the rest of the of the property sector, optimism still seems the prevailing sentiment.

While gold prices have been front page news for most of the year, it is only in recent months that silver, platinum, lithium and others have joined, seeing commodity enthusiasm intensify. As believers in the scarcity and value of high-quality commodity projects and real assets in a world of ever more plentiful fiat currency, yet more comfortable when we are finding value away from the crowd rather than following others over the cliff, we find ourselves at a crossroads. 

Using the Bloomberg Commodity Index as a benchmark, the case for commodities remaining attractive versus financial assets looks sound. Beneath the surface the picture is more complex. Designed as a diversified index based on economic significance to the world economy, energy and grains are 50% of index weight, with gold and silver a little under 20%. 

The Goldman Sachs Commodity Index is even more skewed towards energy, at more than 55%, with precious metals a little over 5%. The reason the broad commodities complex still looks attractive is straightforward. 

Large, deep and liquid markets in important commodities such as oil, grains and livestock have seen little in the way of either recent or long-term price inflation. 

Commodities far more influenced by financial investment demand have now seen quite a lot. This is not a story of strong global growth and broad strength in commodities. Valuations have become increasingly bifurcated and universally attractive valuations are no longer the norm.

Perhaps the simplest way to express this divergence is through the ratio of gold to oil prices. Other than the brief COVID induced oil price collapse, gold has never been more expensive relative to oil. More durable measures of valuation such as price to book are moving into elevated territory for nearly all gold miners. 

While these returns are inextricably linked to commodity prices, and returns will be strong for almost every gold company on the planet at price above US$4000, when almost every gold company is trading at price to book ratios above 2, and many far above, investors are now envisaging an entire sector expected to deliver sustainable excess returns. 

For a sector where history has seen growing gold production rather than economic value as the prevailing raison d’etre, requiring regular capital raising from investors and reliable work for investment bankers, a future of 15-20% return on capital in perpetuity seems on the optimistic side. 

When Mark Twain characterised a gold mine as “a hole in the ground with a liar on top,” it was probably not wholly unjustified.

In looking for opportunity in energy and materials, a few cursory observations are perhaps useful. 

While overall materials valuations are now closer to historic averages, with gold now exerting significant upward pressure on these levels, undervaluation is no longer the norm. 

Strong recent share price performance has left the privileged assets of BHP (ASX: BHP) and Rio Tinto (ASX: RIO) commanding earnings and price to book valuations which, from our perspective, are neither excessive nor cheap. Sharp increases in the valuations of lithium miners have left the likes of PLS (ASX: PLS) and Liontown (ASX: LTR) requiring very optimistic long-term prices. Energy is perhaps the only remaining ugly duckling. Both Santos (ASX: STO) and Woodside (ASX: WDS) now trade at price to book multiples below 1. 

Unlike Pilbara (ASX: PLSN) iron ore or the Greenbushes lithium operations, Australian gas assets are not amongst the world’s lowest cost or best quality, leaving the logic for durable excess returns dubious. 

Nevertheless, these valuation benchmarks are reflective of an expectation of depressed returns in perpetuity. As the government looks to move forward with the East Coast Gas Reservation policy, the conundrum of promising lower prices when producers are struggling to generate acceptable returns on historic projects at current prices, looms large. Inducing new supply requires acceptable returns or subsidies. 

While satisfying domestic requirements could be managed by diverting and reducing export volumes, this confiscates profits from existing LNG producers and hardly instils confidence in the regulatory landscape. Free markets and low energy prices seem unlikely to co-exist in Australia’s future. Calls for lower pricing from large energy users such as Bluescope (ASX: BSL) and Orica (ASX: ORI), while not totally unjustified, should perhaps be taken with a few grains of salt. The choices of some countries to either use an advantaged energy position (US, Middle East) to simulate industrial production, or of others (China) to artificially reduce energy costs to achieve the same goal, leave other countries, including Australia, in an unenviable position. 

Understanding the source and durability of energy cost advantage seems increasingly important. Whether it is Rio Tinto’s ownership of hydro power in Canada and the aluminium cost advantage it supports, or the expiry of South 32’s electricity supply contract on its Mozal smelter in Mozambique and resulting write-off, plenty of profits can appear and disappear with changing energy prices.

Contributors and Detractors

Contributors

IGO (ASX: IGO) (Overweight) (+58.6%)

From the lows of mid 2025 spodumene prices have almost doubled. While valuations of commodity producers should be driven by long-term prices, given the short-term will always be volatile and relatively unpredictable, reality sees investors chase earnings and commodity price upgrades. 

While capital allocation for IGO has been fairly disastrous outside the acquisition of a 25% interest in the Greenbushes mine from Tianqi in 2020, the value creation in the good transaction has overshadowed the bad ones (Western Areas being an unmitigated disaster). 

While sharp share price rises have reduced valuation appeal in the sector, the 500ktpa share of Greenbushes production which IGO houses remains very attractively valued on a per tonne basis relative to the lower quality and higher cost exposures offered in other lithium producers.

Alcoa (ASX: AAI) (Overweight) (+60.1%)

In a familiar picture, the consistent and large supply addition in China over the past couple of decades, particularly in alumina production (the chemical process in which bauxite is transformed into the raw material for aluminium smelting), has exerted ongoing pressure on commodity prices, depressing profitability of all global producers. 

As a major and fairly geographically diversified global player in alumina and aluminium, Alcoa stands to benefit significantly should more restrained Chinese supply addition under the current capacity cap induce an improved supply/demand balance and higher prices. 

Importantly, while Alcoa is a lowcost alumina producer, primarily through its Pinjarra and Wagerup refineries in WA, its aluminium assets are higher cost and therefore more leveraged to the upward pressure which rising power prices may exert on the industry (aided by data centre demand).

South32 (ASX: S32) (Overweight) (+30.0%)

South32’s assets across alumina and aluminium, copper and manganese are diverse and generally of good quality as management have continued to migrate the portfolio towards more attractive commodities and assets. The same issues relevant to Alcoa will drive profitability in its Alumar assets in Brazil (jointly owned with Alcoa), Worsley alumina and Hillside (South Africa) aluminium assets and are still the dominant commodity exposure. 

Along with manganese and Cannington (silver, lead, zinc) exposure inherited from BHP, the meaningful copper exposure through the 2022 acquisition of a 45% stake in Sierra Gorda assets in Chile and the potential from Hermosa assets across manganese, zinc, silver and lead in the US, leave South32 well exposed to commodities with solid demand growth prospects.

Detractors

Fortescue (ASX: FMG) (Underweight) (+17.8%)

As Simandou begins production in Guinea, coming months and years will determine whether this additional production in a relatively low growth steel market will exert significant downward pressure on iron ore prices. 

While Fortescue results have continued to impress with the extent of cost control and production consistency that has characterised the company since its inception, our view of value remains influenced by an expectation commodity prices will move down as supply increases. While iron ore valuations do reflect this expectation to a degree, Fortescue remains more operationally leveraged to this outcome.

Seek (ASX: SEK) (Overweight) (-18.9%)

As another marketplace company, Seek’s role in linking employment opportunities with suitable candidates offers great opportunity. While the winners in the race for supremacy are perhaps less obvious than in some other categories, particularly given Seek’s operations in developing Asian markets are less mature than in Australia, the value to employers of finding the best quality candidates is high, meaning the marketplaces which accomplish this most effectively will enjoy far more pricing power. 

Seek has been investing heavily in technology over recent years and while investors often prefer the strong cash generation phase over the investment phase, coming years will determine the effectiveness of this spend and whether customers are prepared to pay for the (hopefully) differentiated value proposition the Seek platform offers.

PLS Group (ASX: PLS) (Underweight) (+67.5%)

While the Pilgangoora operations of PLS are both well managed and appealingly simple (100% owned long-life assets), lower grades and higher costs relative to Greenbushes leave us surprised at the degree to which investors are prepared to pay a significant premium on a per tonne basis for company structure over resource quality. 

While long-term commodity prices in lithium remain perhaps more uncertain than in other commodities given the relatively immature nature of the industry and the likelihood of continuing strong demand growth from both EV’s and stationary storage, prices needed to justify current valuations are moving to levels which seem optimistic and imply very strong returns on invested capital.

Market Outlook

The assumption of abundant liquidity has deeply permeated the behaviour and expectations of most investors. Global financial crisis, COVID – whatever the problem, easy monetary conditions have been the solution. Tighter monetary conditions are not on the horizon. They were probably not on the agenda of the Weimar Republic in the early 1920’s or the Zimbabwean government in the 2000’s either. It will always be the unexpected problems that hurt most. 

Despite the able assistance of Harry Hindsight or the 4th or 5th viewing of ‘The Big Short’, we have struggled to identify the ‘catalysts’ which have given rise to sharp changes in market conditions historically. Given our inability to identify these ‘catalysts’ in retrospect, we don’t give ourselves a great chance of nailing them in advance. Momentum tends to continue until it stops. When it stops there will be a loud chorus of “I told you so”. 

As a result, whilst we can’t see the catalyst for sharp changes in market conditions, valuations suggest we should be prepared for them. Though aggressive current valuations and the relatively cautious approach to risk and importance of protecting the downside of this might be the bad news, the limited attention span of those chasing sharply rising prices and earnings momentum and the resultant bifurcation in valuations between the popular and unpopular is the good news. 

There remains plenty of opportunity for those prepared to diverge from the crowd and stay focused on long-term fundamentals rather than chasing the ones which abundant liquidity is pushing into the stratosphere.

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