Why today’s market favourites could be tomorrow’s also-rans

Zigging and zagging have been the story of 2020. The equity market zigged higher, then zagged sharply lower as the health and economic ravages of COVID-19 became better understood. Only for markets (if not economies) to zig again globally and in Australia in response to stimulus. What to make of this from an Australian equity perspective? Which areas of the market have zigged and zagged the most and now (net of this volatility) provide most opportunity?

Tech insiders make hay while they can

We have spent quite some time detailing our views of the listed technology stocks on the ASX in prior monthly commentaries. Suffice to say that, outside of a GICS classification, in several cases they share little in the way of operating characteristics with their large US peers that have driven that market’s performance. We cannot find an ASX listed technology stock where insiders are buying, and can point to plenty where there is voracious selling. We remain with the insiders when it comes to assessing the sustainable, fundamental (as opposed to market) value of these companies.

Gold glitters as currencies are debased

The biggest zigger outside of technology has been materials, which has outperformed in Australia in both the downturn and then the market rally, led by gold and iron ore. The negative real-yield-spread correlation with the gold price has been tight for quite some time – and the more stimulus is applied, the tighter and longer-standing that correlation becomes. Inflation, deflation and any other factor that has been nominated as a correlated link through time doesn’t appear to us to consistently hold. It may be as simple as gold is, as it ever was, the “anti-fiat”; the more currency is debased, the more the relative attraction of gold, well, glitters. 

When all developed world currencies are being debased simultaneously, gold climbs to an all-time high, as indeed it has done.

However, as with many factors at play in the market right now – and as my learned colleague Martin Conlon is fond of pointing out – while this correlation may continue to hold, it tells you nothing about what the absolute value of gold should be. After all, gold continues to be a negative yielding asset (zero coupon less holding costs). There is little doubt that monetary policy is the driver for the direction of the gold price rally, and we do not anticipate a reversal in the direction of monetary policy any time soon.

Iron ore wins when value trumps volume

Apart from gold, iron ore has been the stand out commodity, driving the materials sector while also zigging this year. As always, relatively minor supply disruptions (or additions) have led to outsized price movements in the face of relatively steady demand over the longer run (as Glencore have shown, over 50 years demand has been tightly correlated with population growth). Four years ago, when the price was a lamentable US$30 per tonne, the prospect of iron ore spending the better part of this year above US$90 per tonne was remote. Especially given demand continues to be driven by China in the face of what would have been then unimaginable geopolitics.

Having lived through the “stronger for longer” era a decade ago, both producers and investors are now wiser. Producers are far more considered in capacity additions in the face of high prices, figuring that having committed the commercial equivalent of seppuku once per decade was enough. And investors, while riding the momentum wave (Fortescue is now the best performing major stock on the ASX over a year by some margin), have shown far more restraint in leaving price to book multiples at less than half the peaks achieved through the “stronger for longer” era, reminding management that these businesses indeed ought to be managed for value, not volume.

This is a lesson needing to seep into some other areas of the market. The BHP diaspora (from that era) that has morphed into senior positions at Orica through the past five years seem to have brought with them BHP’s since discarded volume over value focus, replicating the disappointing shareholder returns from that era. Amid an industry that locally in IPL, and globally through Mosaic, Nutrien and Yara, is preaching return on assets as a corporate focus, rather than growth in productive capacity, Orica remains the recalcitrant outlier.

Were it to focus upon leading prices, as should be expected from a market leader in a manufacturing business, all industry participants would benefit. However, both instinct and incentive remain overwhelming countervailing forces to this eventuating.

Banks pay the price for negligent lending

Financials, especially the major banks, have zagged this year, underperforming as the market fell and then again as the market rebounded. In points, all of the Australian market underperformance year to date is net driven by financials, with insurers joining the banks as poor performers. The only real variable at play for banks is forecast loan losses; volumes remain tepid and margins benign, and costs relatively flat.

Our analyst, Joseph Koh, has benchmarked our assumption for losses to all of the large observable credit loss events through the past decade, across countries and loan classes. Given its dominance in the asset base for the banks, the loan loss assumption for mortgages is the critical assumption. Our 50bps loss assumption on the mortgage book remains well above previous peaks in Australia and other countries such as the UK, albeit well below the more extreme losses incurred in the US and Ireland a decade ago. This is the price of negligent lending practices increasingly through the past decade: while near term EPS benefited as loan to income ratios escalated to levels 50% higher than those seen in Canada, the UK and the US, the sustainability of the earnings base (and social licence) for the Australian banks was always compromised.

In toto, our valuations are predicated on loan loss assumptions of more than A$60bn for the Australian banks this cycle, approximately 50% higher than consensus assumptions. This reflects 10% of current Australian loans having repayments deferred, with further (and further) extensions of these deferrals increasingly unlikely, given the moral hazard assumed by the banks in doing so. Even with our projected level of loss, the banks are not expensive relative to many stocks on the ASX; however, among the lessons of the past decade are that realised losses have been without exception far larger than modelled in a recessionary environment, and that large misconduct penalties inevitably also arise in those circumstances, compounding the loss for shareholders. 

We remain wary of the siren song of bank valuations at the beginning of a downturn.

Retailers zig while REITs zag

Of course, that expected downturn is driven by the Australian consumer, with expectations that the job losses of 700,000 already seen in the economy (on a base of 13 million employed) will be increased as the JobKeeper program (currently extended to 3 million people) unwinds. Almost one in every four Australian workers currently receives JobKeeper. Not that it is immediately hurting retail; all of Kogan, The Reject Shop, Temple and Webster, Beacon Lighting, Adairs and Motorcycle Holdings have reported terrific sales outcomes through recent months. Retailer share prices have, as ever, reflected the current trading conditions, although the landlords are not being extended the same courtesy. Each of Scentre Group and Vicinity Centres, the larger retail REITS, have had a rotten 2020 in terms of market performance, with the zagging of the former compounded by its higher level of gearing.

While the increased use of online shopping is a given outcome in a post COVID-19 world, it is equally unlikely that shopping centres (or for that matter, office blocks) cease to serve a valuable function. 

The question that needs to be determined is what sustainable decline in turnover will be experienced by these landlords arising from a reduction in turnover experienced by the tenants (even if to date that experience is mixed, given the long list of winners detailed above) and a reduction in rent to sales ratios.

As with many fixed cost businesses, property rentals are very responsive to changes in capacity utilisation; our property analyst Daniel Peters has highlighted that in the last recession in Australia, vacancy rates in the office sector in excess of 20% led to 70% reductions in rents. With department stores and discount department stores struggling for profitability, if not sales, it is likely that large amounts of space could become vacant in these centres in the coming years. The assumed reduction in revenues for the landlords is clearly an elastic number but one which is critical in determining their value, as indeed is the case for other assets with similar fixed cost characteristics, such as infrastructure, especially where retail is an important revenue driver (as in the case of airports).

How we are positioned

Market prices globally and locally have largely recovered well ahead of economies, sending multiples to record highs. Ironically, the biggest sources of cashflow on the ASX in deriving multiples – still the banks and major miners – remain on the lowest multiples. Clearly, hope is being valued with more fervour than experience; the promise of growth remains more prized than the delivery of cashflow. This has now extended well beyond what can be explained by any relationship with lower bond yields in themselves driving multiples higher, and of course, it ignores the hit to earnings ultimately expected by the reduction in the Australian workforce from 13 million to 12 million.

At the moment politics, through stimulus both monetary and fiscal, has zigged to the extent it is transcending the expected zag from the decline in earnings across all sectors on the ASX bar materials for the 2020 financial year. Of course, the human drama arising from this zigging and zagging will remain enthralling (have we reached peak fear? has the market run too hard?). However it has little to do with investing when looking to buy the best value, sustainable cashflows available to investors on the ASX.

What is sustainable, however, among the ziggers and the zaggers, amid the interplay of geopolitics, commodity prices, domestic employment and consumption, and lending practices, is that, ultimately, long run cashflows transcend hope in driving valuations. Our portfolios remain positioned accordingly.

Written by Andrew Fleming

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