Prepare to get lucky

“… You never know how things are going to change. You’ve got to be ready when they change. And you have to be prepared to get lucky…”.
- Scott Bessent – United States Secretary of the Treasury

The first half of 2025 has seen constant change for investors. A risk free rate constantly hovering within a 4 and 5% band hasn’t impeded ongoing strength in equity indices, including in Australia. This continues to surprise us given multiples, especially for industrial stocks, which are now at stretched levels, and we have just left the third year in a row of no earnings growth for the market. While July provided a modest change from the common drivers that have propelled market performance this year, revenue growth above all else continues to be the gold standard as the driver of returns for equity investors. It feels as if we are in a post CAPM world.

Investors have sought refuge from change and the attendant seismic shifts in pricing securities in different ways. 

My learned colleague Mr Conlon last month highlighted how equity yields decoupling from bond yields may make more sense if it is accepted that governments tacitly, in deed if not word, show little intent, or capacity, to repay the bonds they have on issue. The more the prospects for any change arising from this month’s economic reform roundtable are emasculated, the more such a view is validated, even if remaining unpalatable for those preferring free markets. Of all the ways we foresaw increasing government involvement in commerce when we produced our dirigisme presentation two years ago now, the prospect of fiscal imprudence accelerating AND equity markets rerating whilst earnings decline for three years in a row, was one our imagination did not countenance. Hence our characterisation of investors living in a post CAPM world, where revenue growth has seemingly displaced a risk free rate as the most important anchor for equity market prices.

New themes and old

The nature of this environment of change has prompted several market themes. In some cases, reflecting government expenditure and policy, these are new. Defence and security, both physical and digital, government tariffs and government investment bastardising the cost of capital for commodity producers, margin pressure for those competing with governments for labour, and deglobalisation. And in some cases it is merely repeating the tried and tested – energy and gold – in the face of declining fiat credibility. In yet others, such as the impact upon financial services, while interchange reforms in the Australian market may in the short term impact upon loyalty scheme promoters more than financial institutions, the full impact of increasing government intervention spawning the commercial changes we are witnessing, may yet to be seen.

Whilst any government encouragement towards a productivity agenda may be slow to come, there is little doubt the market remains keen to reward those few companies looking to self help. 

This can take several forms – often headcount reductions is the most visible form. And it remains true that little of this has happened, especially among larger companies on the ASX in recent years. Another form of productivity however, can be just as powerful for investors; improving the return on assets, through more disciplined capital allocation and working capital policies.

Brambles (ASX: BXB) is a classic case of the latter. Brambles’ profits in recent years have improved, but far less cashflow. There is little doubt this has been a management focus; on a call with a Brambles board member two years ago, he highlighted how he had little yellow sticky notes on his computer screen highlighting the three areas of focus for every company he was involved with. The focus for Brambles was “Cash; Cash; and Cash”. The appointment of new CFO may have assisted this intent being put into effect, but either way the market performance linkage to Brambles improving cashflow is undeniable.

The asset productivity challenge

Other companies in our portfolio have, we believe, similar latent value potential should the asset productivity challenge be accepted. Ramsay Healthcare (ASX: RHC) has a strong domestic asset base, where current returns are poor. The putting into administration of their major competitor, a significant new board addition to Ramsay, and the urgings of the Health Minister to Health Funds to address the current blockage of insurance premiums going through to health providers to an appropriate extent are all recent factors which buoy our optimism to this end. Private hospital operators claim this blockage has cost them $1b in foregone revenue; the redress thus far this year has represented a small make good, of approximately 25% of the loss, but the issue is on notice and to the extent the government wishes to effect change in hospital admissions, it is aware that much remains to be done.

The change in asset productivity need not always be a consequence of government policy, as is the case at Ramsay. Aurizon (ASX: AZJ) is one such example; a long standing holding which has greatly disappointed the expectations of both us and the market – for one major reason: capital allocation. It’s not through lack of earnings or cashflow; in fact, relative to a starting point of a decade ago, revenues have stayed within a 10% band, and EBITDA and EBIT have been even tighter. Operating cashflows have also been strong and reasonably consistent. Partly, this strength is due to our misplaced expectation that coal volumes could fall materially through that decade (although we still expect them to fade through time). And exposure to coal volumes doesn’t seem to be a deterrent to investors in itself, as a casual observation of the Dalrymple Bay Infrastructure share price would confirm.

The financial stability of Aurizon through this period is the good news. The bad news is the capital allocation policy has destroyed much value, with the 2022 acquisition of OneRail for (net) $2b yet to generate anything like an acceptable return. The chair of Aurizon is due to change this year; an external appointment (given the value destroyed with the OneRail acquisition, not just at the time of acquisition but also subsequently through its poor operational performance) would be preferred. With this change, one could anticipate management change and again an external appointment would be likely. In the interim, while some financial engineering solutions have been proposed to improve Aurizon’s market performance, as always our strong view remains that the preferred path is the harder one; focus on improving the operational performance, and should that be achieved, market multiples always seem to self correct, usually more rapidly than anticipated (with Brambles being a case in point). 

Each of Brambles, Ramsay and Aurizon had the same latent asset; in Bessent’s parlance, Brambles shareholders got lucky in that asset being realised; and holders of Ramsay and Aurizon have to be prepared to get lucky.

Consequences and questions

Change in government policy has knocked into the commodities sector this year in several ways. US Tariffs, ostensibly targeting the Chinese dominance of refinery production in rare earths and energy transition metals, have had unintended consequences, adversely impacting capital flows into the sector which continues to trade at low multiples despite producing strong cashflows. Investor scepticism as to the capital discipline of miners also remains high, given myriad poor transactions including an aborted but disliked large acquisition proposed by BHP (ASX: BHP), a transaction with similar characteristics completed by RIO (ASX: RIO) with the Arcadium acquisition, IGO’s (ASX: IGO) disastrous acquisition of Western Areas and more recent Kwinana lithium refinery write-down, and others (eg the South32 development and subsequent write-down of Hermosa). Somewhat offsetting this capital destruction, governments have provided capital to the miners on favourable terms as part of this new regime. The US government provided $250m to assist in the development of Hermosa and the Australian government invested $50m into Liontown (ASX: LTR) to assist in the development with the Kathleen Valley lithium mine, as part of the $15b available to the National Reconstruction Fund to invest on behalf of Australian taxpayers. Just like companies, governments have given up on their harder functions; Economic Reform Roundtable be damned, we’re going with tariffs and subsidies.

Amid the weakness in the basic materials and energy sectors, notwithstanding the strong demand that can be expected from increased defence spending and the energy transition, one sub sector has stood out as performing strongly. 

Gold has outperformed every major geographic MSCI index this year, as the abandonment of fiscal prudence by western world governments in recent years, coincident with an era of benign globalisation ceding to great geopolitical competition, has created a perfect storm for the commodity price that glitters. Notwithstanding this fiscal and geopolitical impetus, the vexed question for the investment case for gold equities remains two fold. One; what long run gold price is used to value the security ? The answer through the past year has been simple; higher. The best retort to this was put by a famed global investor who noted the question with respect to the investment case is; “Why?”. Gold does well in times of fiscal recklessness; why ? It always has; why ? It’s a store of value uncorrelated with fiat currencies in terms of fiat and geopolitical stress; why ? And so on. Ultimately, it’s hard to answer this with any confidence; and in turn a cost curve based approach to the long run gold price, unlike most non precious metals which are otherwise subject to industrial substitution, becomes somewhat moot. We have no direct gold exposure in the portfolio, which has hurt performance through the past year, albeit the second question for an equity investor in gold remains critical. Even in a strong gold price environment, investors in Newmont have enjoyed significant share price appreciation; in contrast, the performance of Northern Star has been as volatile as it has been relatively modest, whereas Greatland Resources (ASX: GGP) joined the ASX with much fanfare in recent weeks but has been a poor market performer since listing. Operational performance has determined the investor experience in owning a gold stock as much as the commodity price movement.

Meanwhile, in the finance sector

Another change for investors announced during the month was the RBA’s proposed reforms to merchant card payment costs and surcharging in the Australian market. Whilst this has some implications for financial stocks, it mostly (and adversely) affects the smaller payments players. It also has material potential implications for the loyalty schemes operated by supermarkets and, especially, airlines. The proportion of the valuation accruing to the two listed airlines arising from loyalty programs, ultimately funded from interchange fees, has risen materially through recent years, but may be about to hit some turbulence. Given the RBA was focused upon benchmarking to the European precedent for interchange fees, it is interesting that we can see little evidence of European airlines having loyalty schemes afforded any meaningful market value.

One other important consequence of Dirigisme globally, is that government debt as a proportion of total debt in an economy has only increased, and will only increase. 

That is the case independently of what happens with consumer debt levels, where Australia stands alone with this being at all time high levels; the US, for example, has seen this drop from 100% of GDP to 70% since the GFC. With the largest institutional banking franchise in Australia, both of these trends – greater government borrowing and a fully leveraged domestic consumer - should relatively see ANZ (ASX: ANZ) well placed. However, having sat idle for several years as the retail bank aggressively under performed from a starting position as the smallest of the four major banks, ANZ has through the past year found itself frozen from participating in Commonwealth bond primary issuance due to unresolved disputes with the Commonwealth and its agencies, arising from rate rigging allegations levelled against its institutional bank. As a consequence of this and two other institutional bank snafu's, all bringing regulatory and market opprobrium, ANZ has suffered significant additional capital impost, and an impaired market position directly impacting upon revenues as well as costs. As Yes Minister would put it, this is most unfortunate. The Board needs to own the group’s position in the eyes of Commonwealth agencies, especially given its initially timid rebuke of senior management (a 10% reduction in incentives was proposed in 2024). This benign response was consistent with the Board’s meek reaction to the retail bank losing material share, especially through proprietary channels. In this context, the incoming CEO, Nuno Matos, has some work to do on culture as well as operational performance. Early signs are that he is cognisant of both of these issues and resolute in addressing them. 

The reward for ANZ shareholders should he succeed could be material; it is the only major bank trading at a price to book level lower than historical norms, reflecting its poor recent operational performance.

In contrast, CBA (ASX: CBA) has only tepidly underperformed through the past month, while remaining the highest multiple bank in the Western world (and remaining the stand out in the sector in terms of operational performance). NAB (ASX: NAB) has had a well publicised management change, which has somewhat unfairly tarnished the new CEO whilst glossing over the fact that proprietary retail performance in both deposits and lending has been weak for several years. Westpac (ASX: WBC) has arguably as much opportunity in prospect as ANZ, and has laterally hired several well regarded executives. However a year after the appointment of a new CEO, it has little in the way of financial performance or market share change to show for its efforts. Overall, the sector remains priced for higher growth than the sluggish levels produced at an underlying level in recent years, and absent a strong productivity agenda we struggle to see how it can grow earnings at a faster rate in coming years than it has recently. Apart from ANZ, where hints have been given that this productivity opportunity may be embraced but the full intent of the new CEO is not yet articulated, the major banks are mute on an aggressive productivity agenda.

The Macquarie wildcard

The wildcard in the sector remains Macquarie (ASX: MQG), which continues to see two pronounced trends in operational performance. The rise and fall of the contribution from the commodities and global markets segment of Macquarie has been spectacular. In 2018, it made $900m of $5b in net profit contribution from operating groups (pre tax and incentive payments), or circa 20% of the group’s profit. This grew exponentially until 2023, with its circa $5b in profit growth being more than all of the net profit growth for Macquarie as a whole since 2018. Since management changes following the 2023 zenith, more than half of that growth has unwound, and it has flowed straight through and represented almost all of Macquarie group’s overall profit decline since that time. While the contribution of the departing executives has been downplayed consistently through all of that period, the impact of the rise and fall of the commodities and global market segment upon overall profitability for Macquarie has been as striking as unforeseen (in both directions) by the market. 

The fact that this segment is still seeing earnings decline and yet producing profits well above 2018 levels is why we continue to be wary of forecast group profits.

The other segment of great interest within Macquarie is banking and financial services, as much because of its status as the low cost, technology driven disruptor in the retail banking market in Australia as because of its own operating performance. BFS is growing its revenue (driven by home loans issued through the broker channel) at a faster rate than any of the major banks, fully funded by deposits (which again are growing at a faster rate than any major bank). And yet last year it reduced its employment costs by 13% and headcount by 15%, which was attributed to the business having spent several years improving its technology platform, which now allows a harvesting of the operational leverage from that investment. For context, the BFS segment’s headcount at 2025 year end was 3,100 and the amount spent on technology was disclosed as $600m; this investment allowed the group to grow its market share by 1% to 6% of the mortgage market and attract more net flow than some of its major bank peers, which boast headcounts and IT spend literally multiples of Macquarie’s investment. It seems inevitable that this cannot last, and that the incumbents will need to respond with productivity initiatives to respond to the challenger, which is only accelerating its disruption of the market.

Market outlook

As governments have increasingly intervened in economies and capital markets, capital has crowded into simplicity, taking multiples for ASX listed equities in the globally chosen favoured sectors ever higher. Revenue growth as a thematic has been the single greatest driver of relative performance, although gold securities, led by Newmont, have given it a close run through the past year. Just as CBA was driven higher by seemingly inexorable forces, which in fact did reverse to some extent in July, the best prospects for alpha amidst full multiples and anaemic earnings growth for the market as a whole probably no longer lies in the chosen, favoured, simplistic sectors/factors. Even if the government through its economic reform roundtable has no appetite for reform (quelle surprise), companies prepared to embrace operating and capital productivity may yet offer the best prospects for return. This will especially be the case where it is driven by an ethos of simplifying and focusing upon improved operational performance, rather than one sponsored by financial engineering. Where boards and management are prepared to exploit this opportunity, in Bessent’s words, shareholders should prepare to get lucky.

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