Shrinking to greatness, the key to unlocking value

Emma Fisher

Airlie Funds

We are living in extraordinary times, and it's fair to say it's been a very interesting start to 2021. Uncertainty prevails globally, yet markets are ripping back towards all-time highs. I recently sat down with the team to discuss the stocks that drove our outperformance in 2020, including Mineral Resources and Wesfarmers, as well as providing an update on the opportunities in Australian banks. 

In addition, I gave my outlook for markets in 2021 and explain why we see value in companies that are "shrinking to greatness"  through the intelligent rationalisation of their assets, including one player in the financial services industry that should reward investors in the year ahead. 

You can watch or read the full interview below.  


The fund has performed well over the December quarter and the calendar year. What were the key drivers of that performance?

From a top-down perspective, one of the drivers of the outperformance over 2020 was the fact that we have tilted the portfolio towards those businesses that have really conservative balance sheet. 

Now, I feel like I've been banging on about balance sheets for a number of years and to be frank, though up until now, it hadn't really been the kind of environment where balance sheets were a very big differentiator. Companies had very easy access to financial markets. Credit was widely available. Interest rates have been really low. Now that works until it doesn't, and in March it stopped working, globally. And what we saw over 2020 was a really dramatic recapitalisation of a lot of Australian companies, often at substantial discounts to the prevailing share price, which had already been hit by the equity market drawdown.

So, we saw some permanent value destruction as a result of these recapitalisations. So, by having this really strong balance sheet focus, we were able to go into the crisis with the portfolio positioned towards companies that had stronger financial positions. And we were able to avoid a lot of that value destruction. 

From a stock-specifics perspective, Mineral Resources was our best performing stock over the 12 months. This time, last year, it was our biggest position and we really benefited from the increase in iron ore prices, that has been driven by Vale having missteps in terms of getting their production back to the level that they had before the tailings dam's disaster, as well as unprecedented or unforeseen demand coming out of China. We still like mineral resources as an investment. It's got a great mining services business. It also has lithium earnings that aren't contributing much today, but we're starting to see an uptick in lithium pricing as a result of this demand for electric vehicles coming through. So, we think that business could be contributing a lot more to earnings in the future.

Other strong performers for the portfolio, I should say, over the last 12 months have been the retail sector. So, our holdings there include Premier Investments, Nick Scali, Wesfarmers. I was listening to a podcast, actually, and it's not related to investment, but a lady on the podcast described it as: 

“We've all been stuck in Australia and we've been self-soothing our anxiety by buying stuff”. 

And I think that's definitely what we've seen over the last 12 months. Australians spend a lot of money overseas when we're allowed to. And when we're not allowed to that money gets stuck in the local economy, and a lot of it has found its way into businesses and particularly coming through the online channel. So, we've been beneficiaries, particularly Wesfarmers. So Bunnings, we've all been stuck at home. We've been doing DIY projects, tinkering around with our houses, and it's really brought to the fore the power of that business. It's got four times the market share of its nearest competitor. And so, that business has really benefited.

Markets are racing back towards all-time highs, despite underlying economies going backwards during the pandemic. Where do you see value in the Australian market in 2021? And are there sectors or companies that we should be watching?

The Australian market is heading back towards all-time highs. The US market is making all-time highs. And that's all against a backdrop of, I guess, really economic decimation for a lot of the global economies because of the pandemic. So, I think those two facts are quite interesting. It's telling you that investors are willing to look through the crisis, and really the driving force of that willingness has been this coordinated level of global stimulus, both fiscal and monetary. So, when we look at valuations, given the underlying weakness in global economies and very high starting point valuations, we are feeling cautious. This has been the market that we've been living in for the last few years, has been ever declining cash rates, and then the relative attractiveness of the dividend yield of the Australian market, in particular, has pushed people into equities.

So, we've seen this dynamic play out; the market has felt expensive over the last few years. But I think what's new and what's really changed, not only, I guess, besides the negative economic indicators, is euphoria. It feels like euphoria is back and we're starting to see these things, these pockets of speculative excess that you usually see towards the top of the cycle. I can give you any number of examples, but we all read the news, the price of Bitcoin, share price of Tesla, things like that. So, I think that's really interesting because that's been an ingredient that's been missing in this market for a number of years. What it means, I don't know, but it's got us feeling pretty cautious.

I think in the Australian market, the segment of the market where you can see that exuberance coming through most clearly is the tech sector. 

We don't own any of these stocks and that's really because our investment process, as I've mentioned, focuses on the balance sheet and a lot of these businesses are loss-making. So, because they're loss-making, they're really reliant on the equity market window always being open to them to sort of fund the dream when they need to raise capital. Now, March and April told us that that's not a foregone conclusion, that that will always be available.

And then the other part of our process where these companies typically fail is valuation. We're now paying EV/sales multiples in line with what we saw in the tech bubble in the year 2000. We've got a precedent there that buying the dream at every expanding EV/sales was not a road to creating long-term value for shareholders. So, we've avoided, it's hurt us, I guess, in terms of performance this year, but none of these loss-making businesses, I should say rather, fit our investment process.

What we do like, opportunities that we're always looking to put into the fund are asset rationalisation plays. 

These are businesses that are typically shrinking to greatness. It's interesting, there's a lot of financial research and literature that proves out the fact that companies that grow their assets slowly tend to outperform. And it's a little bit counterintuitive. I mean, we probably think that businesses that go out and acquire and grow their asset base really fast are likely to have really high increase in share prices. But actually, the opposite is true, because a lot of that activity tends to destroy value. So, we're always looking for businesses that are shrinking to greatness, spinoffs, things like that, asset sales that can unlock value for shareholders.

So, two businesses we own that fall into that category in the portfolio, the first is TABCorp. So TABCorp have a cyclical wagering business and a very high-quality lotteries business with pricing power, pretty steady volume growth, high margins. So, we see the investor base for these two businesses as being pretty different. We think that when new management comes on board, they could look to divest the lottery's business. And then, that business would immediately re-rate to a higher multiple. Because those investors that have a lower cost-to-capital like pension funds, for example, would love to own the lotteries earning stream unattracted to that cyclical wagering business.

The precedent in the market over the last year has been on Iluka Resources. Iluka is a commodities business, but within the business, they had this royalty stream. So, last year now, they spun off the royalty business. It immediately rerated to a higher multiple, and actually both businesses have done pretty well since then. So, that's unlocked a lot of value and we think that's the path that TABCorp management could go down.

Another business in the fund in a similar vein is Healius. So Healius used to be known as Primary Health Care. They had a medical centre business, so GPs, a pathology business, and imaging. And the medical centre business was really the problem child. It soaked up a lot of CapEx, and the balance sheet of the group as a whole was very highly geared. So, it had never passed our investment filter. However, last year they actually sold the medical centre business.

So, they sold the problem child. They use the cash to pay down debt, and now the balance sheet is in great shape. So, the net of that is that they're left with most of their earnings coming from pathology. As we know they're printing money in COVID testing at the moment. They own Laverty, for example. And we really liked this industry structure of the pathology industry. So, we think it's less capital intensive, their balance sheet's better. They can grow earnings from here and buy back shares as well. 

So, that's another one that we like in that thematic of shrinking to greatness. But, I think broadly with the market where it is, you really have to be quite selective about where you see value. There's no sectors that scream as having absolute fantastic value.

Emma, how is the portfolio positioned in the banks? Has your view that the big banks will be facing an increasingly challenging environment in 2021 changed at all?

Yes and no. I think when we look at the banking sector as a whole and we zoom out, the issue for the banks that's really hampered their valuations has been this declining return on equity. And that's been structural. If you go back pre GFC, the banks were making a 20% return on their equity in aggregate, and today they're making 10%. So their profitability has halved effectively. The drivers of that have been, firstly, they've been required to hold more capital, so that's not going away. And then secondly, structural decline in net interest margins. And the real drivers of that have been competition in mortgages and lower interest rates. So, because we don't see those factors abating, we don't necessarily think the banks deserve a wholesale re-rate beyond what we've seen in the December quarter.

That said, I think the most positive part of the story that's changed looking forward is credit growth. So, the banks are a play on the Australian economy. The Australian economy looks to be recovering, and particularly Australian property looks like it's set to have a pretty good year. So within that, we own the Commonwealth Bank and we own Westpac because we think the most positive part of the bank story is housing growth. So, we think you want to own the two banks that have the biggest mortgage books. Within that, the Commonwealth Bank we think is a phenomenal retail brand. It's got the best tech, and it does have surplus capital that could be coming back to shareholders over the next 12 to 18 months. And Westpac, we just think it's too cheap relative to the others.

I don't think after the rally that the banks have had over the last quarter, I don't think value looks obvious. It really is capturing the incrementally more positive outlook for the banks. But as I said, we're happy to own the two mortgage banks in the fund.

One of the other big drivers of the Australian market return in the December quarter was resources and high commodity prices, particularly iron ore. Is there still upside in the majors given where prices are?

Yeah, it's a good question. I always think that forecasting demand is impossible. Although I would note that demand out of China is running very, very strong at the moment. But, what is easier and I think more important to focus on is supply. So, supply really drives the big inflexion points in any commodity price. Particularly over the last few years, we've seen in iron ore. And it's good to focus on supply because you can typically see these large projects coming, and you can see them coming years in advance. So, the iron ore market is interesting because it's very heavily held. There's not many players, the iron ore seaborne market, 70% of the production is in the hands of four players, RIO, BHP, Fortescue, and Vale. And when we look at their production profiles for the next few years, there's no one that's really bringing on incremental tonnage. Vale is really struggling to get back to the level of production that they had before the tailings dams disaster.

So, we don't really see a wave of supply coming in the way that precipitated the end of the commodities supercycle back in 2013. So, we actually think that the risks remain skewed to the upside while demand is running strong from China. And certainly when you look at consensus expectations, for every month that iron ore prices are above $150 a tonne, again, the expectations, they're too low that are embedded into the share price.

The other thing that I think is different about this commodity cycle is that the management teams have really been cowed by the sins of the last cycle; the acquisitions at the top, the heavy CapEx. This cycle, I think management teams really understand the bargain that they have with shareholders is CapEx discipline. And so these businesses are phenomenal free cash flow generators, and a lot of that cash is going to come back to shareholders in the form of dividends and capital returns. So, we own BHP and as I said before, we own Mineral Resources as well. So, we're pretty happy here to own iron ore exposure in light of what we think are pretty favourable supply side dynamics over the medium term.

Last year was a volatile one for almost all Australian companies. Is there a stock you own that has navigated 2020 particularly well?

So, the stock I would nominate in that vein would be Credit Corp. But before I get into Credit Corp, so typically in a business cycle, in the end of a business cycle, it can be a really phenomenal investment opportunity for the number one player. And typically in our fund, we're usually looking to invest in the number one player in the industry. And normally what happens in a recession, you get the number two, number three, the weaker players, they're disproportionately impacted, and often some of them have to exit the industry. We didn't see that this cycle really at all. And part of the reason for that has been the fiscal stimulus. So, the government's effectively socialised a lot of losses. It's really only been Virgin that was allowed to go to the wall. So, it hasn't been a typical business cycle in that sense. The one company where we have seen the full effects play out has been for Credit Corp.

So Credit Corp, their core business in Australia, they buy purchase debt ledgers from the banks. So typically the banks, when debt is past due, they impair it and then they on sell tranches of debt that they haven't been able to collect. Credit Corp and a number of other players will buy that debt typically for between 15 to 25 cents to the dollar of the value of the debt, and then now turn around and try to collect it from the person that owns the debt. So, they'll typically collect maybe between 30 to 40 cents back. So, they'll make a return on that.

Over the last few years there has been a number of entrants that have been pricing very aggressively. 

So, with that 15 to 25 cent range, they've been pricing up towards the top of that range. And that has meant that Credit Corp have to take a step back and say, "We don't think we can generate a good return on that pricing”. Now, what's happened is during this crisis, those businesses that were aggressively going after those books, their assumptions have proven to be too aggressive. They've both breached their covenants and had to repay the debt and they're really hamstrung going forward.

So, one of them has sold a very large book of debt to Credit Corp at a pretty substantial discount, 40% discount to the value of the debt in their books. So basically, they're a distressed seller and Credit Corp has potentially been able to buy those assets at a very attractive price. But importantly going forward, you now have the number one player with the lowest cost to collect losing two competitors that comprise 33% of the market. So, that market share is up for grabs. 

And we think the industry will be a lot more rational on pricing going forward. So, that's one that we like in the portfolio that, it's had a wild 2020 from a share price perspective. At one point, it bottomed down at $9. It's ended the year at $30, but that's one that we like going forward.

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Emma Fisher
Portfolio Manager
Airlie Funds

Emma has over 10 years investment experience, with roles in investment research at Airlie, Fidelity and Nomura. She holds a Bachelor of Commerce (Liberal Studies) from the University of Sydney.

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