Why the bull market persists
The four reasons for current performance— being overweight mining, underweight bonds, owning better-run businesses, and some recent investment stars losing their lustre — is a scenario with more to run.
In the context of the Sir John Templeton quote “… Bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria …” we are clearly still in the optimistic phase.
The 2017 year highlighted how optimistic equity markets are, and January continued in the same vein. All ASX sectors provided good returns, apart from Telcos which saw Telstra derate as it brought its dividend back to a more sustainable level and TPG and Vocus derate as acquisition accounting and a renewed focus upon the need for organic investment saw shareholder’s that had hitherto cheered the M&A roll up, organic capex light strategy of the prior few years, baulk. Only interest rate sensitive sectors such as Utilities, Property Trusts and other Financials did less than 10% returns, with most ASX sectors producing 10%+ returns, and Energy, IT, Materials and Healthcare doing 20%+ returns.
There were two major drivers to the stronger sectors on the ASX. Stronger global growth, and a reversion from the lower prices and subsequent lower levels of investment in recent years, saw commodity linked (BHP, RIO, AWC, ILU, S32) and Energy (WPL, STO, ORG) names all buoyed. The second driver was that globally, and to some extent in Australia, liquidity which continued to be fuelled by global central bank asset purchases nurtured ever higher multiples for “growth” stocks, seeing A2Milk, Lynas and Wisetech Global, and their ilk, lead the ASX300 performance tables for the past year.
The two year long rally in commodity prices, and the ongoing reticence of management and boards to materially raise opex and capex after the malinvestment of the last cycle sees free cashflows reaching record highs. The resources sector last year produced almost $30b in free cashflow, and this year is not expected to be much shy of that. The outcome in 2017 was close to double the best year seen though the commodity cycle boom of a decade ago; stronger for longer, indeed. Similarly, at current prices the Energy sector is forecast this year to produce free cashflow more than double the best year of the prior decade, albeit with returns on investment still at poor levels. The difference between the sectors to our minds continues to be that the Australian equity market hosts world class minerals companies, with little to no debt now in the case of the majors, but third quartile energy producers which still have material (albeit reducing) debt loads.
One other impact of central bank policy in driving asset prices higher has been the impact upon households, with wealth increasingly concentrated in the few and wages growth being negligible for the many. As weaker consumer discretionary names have found, this is a potent mix for their profits. We remain wary of many of these companies, especially those still bearing significant debt, given we believe discretionary levels of consumption in Australia remain well in excess of mid cycle levels.
This in turn raises a problematic scenario for many domestic, retail based REITS. After many decades of building a global empire, and several times adroitly changing corporate structure (without ever ceding control) to reflect market mispricings, the Lowy family have sold. The signal should not be ignored. When bidders for retailers now in administration (Oroton) suggest they will only proceed should rents be materially reduced, joining public calls to the same end by significant tenants such as Premier Investments, and Woolworths needs to raise a provision for Big W leases it cannot economically exit, underlying tenant demand is clearly not as strong as many may wish it to be.
Ian Narev presents his final result as CEO of CBA having assumed the role in 2011 when profits were $6.5b and leaving in 2017 with $10b in profit. There may have been and may yet be a high price to be paid for that profit growth, with $500m in operational risk related provisions already raised, albeit this equates to several months of the higher profit base. On balance, he has clearly done an exceptionally good job. The banks are not on high multiples, and so long as margins hold it is difficult to make a case that they are expensive. Earnings have a downside bias, given that even through the past five buoyant years for credit growth they have not had a year of greater than 5% eps growth, and stocks have rarely outperformed the ASX through recent years whilst being subject to negative earnings revisions.
Most M&A (more than 80% by number of transactions, and far more than that by value) destroys value, and the damage done often dwarfs a few months of profit. Examples abound through time, across sectors, and recent write offs suggest the practice remains as a standard operating procedure. In 2014 Telstra, for example, took full control of the video streaming company Ooyala, created several years earlier by three Google alumnus. Last month, Telstra announced the complete write off of the $500m investment. In less than two years, Wesfarmers have turned a $750m acquisition in Homebase into a $1b write down. Orica have made a $200m acquisition in recent months which will follow a similar path. RIO and BHP, and the energy names in Australia, all invested poorly through the past cycle, however they are in crowded company and it continues to be misplaced to see this as a sectoral quirk. Very few companies can point to M and A as being a source of value accretion through the past cycle, and those that would have done so (e.g. Vocus) usually find the experience a relatively fleeting one. We are most comfortable with stocks in the portfolio where we feel the prospect of organic growth means that the likelihood of paying for goodwill is reduced.
For reasons outlined in this commentary, we continue to be most overweight the Mining sector and its long life, low cost, lowly geared constituents, albeit at levels well below where we were a year ago, and we are still most underweight bond sensitives such as Infrastructure and REIT stocks. Portfolio performance in the past couple of years has come from these two positions, but also meaningfully from owning better run industrial companies with cashflows matching earnings, and further aided by the fall from grace from some of the investment stars of the prior few years. We believe all four of these themes have further to play out.
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