Amazing Strength
PUBLISHED
2022-12-14
Content
by Andrew Fleming - Deputy Head of Australian Equities
An amazing year in the equity market is rapidly drawing to a close, with much ado about nothing in the context of Australian equities given the ASX200 is almost exactly flat over the year. Strength in the local market has been buoyed by the highest earning and lowest multiple sectors – materials (notably resources), and financials. The ASX200 has been a beacon of calm amid cyclonic conditions for almost all other financial assets; Australian bond yields have moved from 1.5% through 4% to now settle at 3.5%, with the cash rate increasing commensurately; and elsewhere, equity market indices have reacted to the increase in the risk-free rate as might be expected with MSCI World down 10%+, Nasdaq down 25%, and more speculative assets such as crypto, of course, faring far worse again. The UK did the world a service in taking modern monetary theory seriously and trying it, which saw a prime minister last all of fifty days.
What lies beneath
Indeed, a flat index year-to-date belies a multitude of stories on the ASX. Within materials, an obvious driver of strong performance has been those stocks exposed to a strong lithium price, with all of Mineral Resources, Allkem, Liontown, and Pilbara Minerals having strong years, reflecting movements in the lithium price. Valuing these stocks is tricky in that the obvious surge in demand will ultimately be met with supply, but it is folly to suggest that the required incentive price to generate that supply is precise. As we have seen in recent years with metals with mature demand and supply profiles such as iron ore, relatively small changes in demand and supply can lead to outsized and prolonged changes in commodity prices. This has been the story with the only commodity to trump lithium through the year – coal – in terms of both commodity price performance, and in turn the market value of the producers.
Amidst other materials, copper is fascinating; the time to peak for global copper supply is now just 18 months away, and global stocks of copper are at their lowest level in two decades. Obviously, in bidding A$10b for Oz Minerals, BHP has made its views on the outlook for copper clear, and Glencore have projected a 50mt supply gap to 2030 and explicitly highlighted delays in new production at Vatera, so as to not disrupt prices. The copper price has dramatically underperformed most other metals through the past twelve months, however the outlook remains strong, driven by EV and renewable energy uptake. Finally, the worst performing metal and mining stock through the year has been Alumina. Idiosyncratic issues relating to the Spanish production within Alumina has exaggerated pressures on its market performance through the year. We continue to believe that these shall be resolved and given it continues to trade below replacement value (despite having most of its assets in the privileged part of the cost curve) we continue to have a significant portfolio holding in Alumina.
Concrete cancer
While materials have led the way, and many metals stocks have had a stellar year, not all components of the materials sector have done well. Building material stocks, for example, have had a dismal year, for disparate reasons. Adbri Limited is a price taker which enjoyed strong market performance when run by a former CEO who was obsessed with it being the lowest cost producer, and attacked opex and capex accordingly. In the ensuing nine years since his retirement, there has only been one year where capex has been less than depreciation This cumulative, material cashflow drag was funded by increased prices in markets such as Adelaide and Perth, to the extent that it invited imported clinker to enter the market. Resultingly, a logistical presence was established, such that demand and supply dynamics remain irreparably damaged. Yet again, a relatively small change in the supply and demand balance has had an outsized impact on price, albeit this time cement prices have been suppressed rather than bid up. While of course this ultimately led to suggestions that the business was being run unsustainably in the earlier period, we suspect that may be less the cause of Adbri’s current woes than more recent actions. An example of these is the payment of ever larger dividends paid out of debt, given the absence of free cashflow, which has now led to a balance sheet which is precariously placed. In contrast, Adbri’s nearest construction materials peer, Boral, which has also had earnings challenges this year, has a pristine balance sheet and a new CEO with a track record of reforming the operations of underperforming industrial materials businesses.
Win with NIM
Apart from materials and energy, financials have been the strongest performer through the year. Bank reporting season saw the landing of the much anticipated NIM boost, seeing underlying pre-provision profits rise between 8% (NAB) and 20% (ANZ). Interestingly, cost growth for the sector was circa 2%, well below global norms (the ASX-listed Virgin UK just announced 10% growth in wages and the German minimum wage has just increased from EUR 10.45 to EUR 12.00 per hour). As all of ANZ, CBA and Bendigo Bank saw negative credit impairment charges during the year, the sector as a whole had zero credit losses through 2022. As a whole, for a 10% return on equity for the sector this year the price to book at 1.7 times is high, albeit CBA distorts the sector metrics on both fronts, given its marginally higher ROE (12.8%) and much higher price to book (2.2x). While still priced at a significant premium to its peers, CBA leaves the year as the laggard of its major bank peers in terms of market performance. As an investor, the quandary remains what the longer term earnings implications are from the spectre of mortgage stress arising in an economy with no unemployment and 3.1% cash rates. As a mix, that is the definition of policy failure, which led to the remarkable apology from the RBA Governor during the month in telling Senate estimates “I’m sorry if people listened to what we’d said”. Because the RBA believes the Australian banking system is very low risk does not mean it should be accepted at face value.
The financial sector more broadly has enjoyed strong performance this year, with the banks’ performance being even bettered by the general insurers. This strength is led by QBE, which is enjoying the pricing leverage endowed through a significant hardening in global premiums. Both IAG and Suncorp have also outperformed, reflecting the same dynamics of accelerating revenues as premiums increase following several years of elevated claims. While we continue to believe the general insurers offer good relative value following several poor years of market performance until 2022, the banks remain fully priced as a sector and it is very difficult to expect their market performance to be strong in the face of declining earnings when credit charges start to emerge.
Agricultural seasons
Amid some challenges across other sectors, the agricultural sector continues to perform well. Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) forecasts of net cash farm income of A$31b in F2023 is similar in size to the banking sector’s profitability. Capturing these buoyant conditions through listed exposures remains tricky, however, with many listed names struggling to produce free cashflow even with the benefit of strong prices. The portfolio’s holding in Ridley has been counter to this trend, and while it, Graincorp and Nufarm have performed well through the past year, many others have underperformed.
Outlook
As Alice proclaimed when leaving Wonderland, "It's no use going back to yesterday, because I was a different person then." Three factors have permanently changed the outlook for equity investors in the three years since Covid-19 first struck. Inflation and the spectre of inflation have shaken complacency about the cost, and availability, of capital. The likelihood of seeing a near-term recurrence of the multiple divergences experienced through 2020 and 2021 that saw high multiple stocks be rerated to all-time highs (taking equity market indices with them) is low, given that central banks are relearning the universal truth that all actions, even profligate monetary supply, in conjunction with other actions, such as geopolitical tensions, prompt reactions, such as inflation. The importance of energy prices to the broad economy, and energy security, has been heightened, seeing a greater premium placed upon surety of supply at an affordable price. Finally, and connected to the first two factors, western world governments’ willingness to use fiscal policy to confront energy challenges and reshape undue economic dependencies has irrevocably changed. All these factors remain material drivers to our portfolio positioning, and in the main have aided relative performance this year. We suspect, however, that their greatest influence upon equity market performance may still be in front us.