Head of Australian Equities
The Australian equity market had a steady quarter, with the S&P/ASX 200 Index (Total Returns) falling 0.4%. Australia lagged global markets, which generally performed well. Local economic data was weak, with the June quarter GDP release showing a record 7.0% fall. The August company reporting season was another key focus and delivered earnings around 20% lower than the prior year, albeit somewhat better than expected. The Australian Government 10-year bond yield fell 8 bps to close at 0.79%. Commodity prices were generally improved, including for iron ore, base metals and gold. The AUD also strengthened against the USD. Looking at performance by sector, Information Technology (+13%) was strongest, followed by Consumer Discretionary (+9%), A-REITs (+7%) and Materials (+4%). Energy (-14%) was weakest, followed by Utilities (-8%) and Financials (-6%).
The vast majority of the portfolio’s underperformance was due to its energy holdings, including overweight positions in Origin Energy (-25%), Woodside Petroleum (-17%) and Ampol (-17%). As noted above, Energy was the worst performing sector for the quarter, which was somewhat puzzling given a steady spot oil price and some improvement in oil futures. We continue to view current oil prices as unsustainably low and hence see significant value amongst our energy holdings. Very strong performance from hyper-PE technology stocks, to which we have no exposure, was the other main detractor from performance (costing approximately 40 bps). The key names were Afterpay Touch Group (+31%), Xero (+12%) and NextDC (+24%). Needless to say, we continue to view these stocks as extremely expensive. The three stocks mentioned have a combined market capitalisation of more than $40bn and only one of them made a profit last year – Xero with $3m. Our decision not to hold Fortescue Metals Group (+24%) also contributed negatively, with the stock highly leveraged to a very strong iron ore price.
Many of our out-of-favour value holdings performed well over the quarter. Our overweight position in Boral (+20%) was a key positive contributor. Whilst delivering a weak financial result in August, the market reacted positively to some early strategic commentary from the new CEO and an equity raising is looking increasingly unlikely. The company subsequently announced major changes to the Board, giving further evidence of support for an aggressive turnaround. Our overweight position in Nine Entertainment Group (+28%) performed very well. Whilst current earnings are being impacted by a weak advertising market and structural issues in traditional TV, its digital platforms are growing quickly, cost discipline is strong and it will eventually benefit from a cyclical advertising recovery. Our overweight position in Healius (+18%) also contributed positively, following the earlier sale of the Medical Centres which improved the strategic focus of the company and significantly strengthened the balance sheet. The company’s pathology division is also benefiting from the uplift in COVID-19 testing, with the government announcing a 6-month extension to its funding regime during the quarter.
Reporting season overview
We have written extensively regarding the absence of any change in market leadership during the recent bear market and subsequent recovery. Last quarter we highlighted that, not only had there been no change in market leadership – the market had in fact seen a further significant expansion of the valuation differential between the most expensive and cheapest stocks (as reflected in price earnings multiples). This has been most clearly seen in stocks that have any element of Tech aura but healthcare and other select industrials have seen also significant “premiumisation”. During August we witnessed one of the most interesting reporting seasons in decades as a fairly normal half year to December was in most instances decimated by a poor second half reflecting the impact of COVID-19 and associated lock-downs and disruptions (with full year market earnings declining ~20%). Given the record dispersion in valuations between stocks, the assumption would naturally be that the premium rated stocks enjoyed the best earnings outcomes and the cheapest the worst. This was not the case as illustrated in the chart below.
Tech stocks trading on average >50 times price earnings multiples
Yet EPS downgrades far worse than most other sectors
As can be observed, the market has seen some of the largest downgrades in the Tech sector which on average trades on price earnings (PE) multiples of more than 50 times. The other market sector to really struggle was Industrials (the GICS sector rather than the industrial market as a whole) which includes many premium rated stocks including Transurban, Sydney Airport and Qube Holdings. Healthcare fared somewhat better than the market although the sector was also significantly impacted. Whilst recognising that COVID-19 has brought about an exceptional set of circumstances it seems to beggar belief that many of the most expensive stocks have the largest profit downgrades but have generally sailed through from a stock price perspective. The value in these premium stocks lies largely in the outer forecast years but analysts seem to have less ability to forecast even the shorter term than for many other stocks, giving us little confidence as to their ability to forecast the longer dated earnings necessary to justify current (excessive) valuations.
It has been of some encouragement during this quarter to see a selection of the value names performing well, often despite shorter term earnings travails. Corporate activity has begun to play a role in some instances too (e.g. Boral and Healius). Notwithstanding this, it has again been a challenging quarter for those investors with a strong valuation focus as valuation spreads for industrial stocks have remained exceptionally wide.
The PE multiple spread between the most highly rated quintile of industrial stocks and the cheapest quintile is the key pillar in the underperformance of value, although it is not the only one. The valuation spread has recently traded in a three to four standard deviation range from the twenty year average. Most investment professionals acknowledge this extreme divergence between growth and value but have tired of calling the end of an extraordinary cycle for growth investors after having had a few too many attempts already! Taking a “neutral” view on value at the time of a one standard event might be sensible but when it is a three to four standard deviation event this seems unduly cautious!
Given the current extremes might this be the turning point for value? Of course no one knows but if it is not the turning point it is likely to be exceptionally close. It is not only the extreme valuation differentials that give us this confidence but also what we observe with the movement of mandates in the market. It may be interesting to debate how far PE multiples might expand further under some circumstances or how Tech can continue to disrupt – but for investors perhaps this debate is of limited value. The money has largely moved already! It is not only growth portfolios that have benefitted from these trends, it is across the spectrum – growth, index, style neutral and ESG portfolios are often well represented in the same names given the index weighting and popularity of these stocks. Portfolio correlations are likely to prove to be exceptionally high when the cycle turns. In gambling terminology, “all the money is on red”. As George Soros once noted; “profits are achieved by discounting the obvious and placing capital in the direction of the unexpected”. Current investor positioning could not be further from this principle.
With the extreme underperformance of value it is understandable that there is so much focus on the question of when the turn might come. However, we think there is a far more important question that investors should be focused on and which receives almost no attention. And that is this – what is the potential size of the opportunity when value turns? If this opportunity is outsized then the debate around whether a three or four standard deviation PE multiple spread provides sufficient encouragement that a turn might be within immediate sight, pales into insignificance. There are a number of ways one might seek to address the size of the opportunity;
- A review of MBA’s rolling 3 year performance (alpha) highlights that the deficit is currently as large as it has ever been (this is a fairly similar picture across our value peer group). That is not to say that the deficit cannot expand further but there is strong encouragement that the differing market conditions that have created these deficits over time, do reverse. Given that the 2015 deficit only had a short-lived recovery during 2016 before continuing on, we are of the view that the recovery is likely to be at least as meaningful as we saw post the GFC and then also during 2014.
Performance relative to benchmark suggests significant upside
- The forecast alpha of our portfolio (over 4 years) is the highest on record and indicative of numbers well in advance of those suggested by the chart above. The forecast alpha assume many of the valuation excesses currently reflected in the market unwind. Clearly not everything is going to occur as forecast; nor will the changes occur simultaneously. Nevertheless, the potential upside for value fully reflects the current extreme dislocation.
- The outperformance of growth relative to value has been extraordinary (US data highlights that this is both the deepest and longest drawdown for value in ~60 years – and by a huge measure) and a comparison of the performance of the two styles is very useful in informing the potential upside for value. Over the past decade growth has outperformed value in approximately two thirds of monthly periods. Looking at the S&P ASX 200 style indices shows that over the 3 years to September growth has outperformed value by 14.8% p.a. and over 10 years by 5.2% p.a. MBA also creates our own style indices as a check using averages of suitable managers and we derive similar numbers. These numbers highlight an exceptional period for growth which is reflected in the +3 SD difference between the PE multiples of the highest rated stocks and the lowest rated stocks.
Most investors acknowledge that the value style is deeply out of favour and has very significant upside when conditions improve. However, given the extended “hibernation” that value has been in, investors are fearful of calling the turn in advance of it happening. Inevitably the question is, what is the catalyst for a turn? History teaches that predicting catalysts is usually fraught with difficulty. Do we know today what precise catalyst turned the Tech Bubble or brought on the GFC? In the end excess valuation folded in on itself as it always does. Are we at that point now? When Apple is capitalised at more than the whole of the FTSE 100 or Tesla (having never really turned a profit) is briefly capitalised at nearly US$500bn after having traded in a price range of $44-$502 over the past year – we think we might be close! However, that is not really the point – value has in many ways become a niche strategy in the face of all-conquering growth. This leaves so much upside for the strategy when performance does turn that the timing thereof is largely inconsequential. “All the money is on red”, and the when the turn comes it will be very significant.
 Reports of Value’s Death May Be Greatly Exaggerated – R. Arnott, C. Harvey, V. Kalesnik and J. Linnainmaa. Research Affiliates Publications August 2020
Maple-Brown Abbott Limited (MBA) ABN 73 001 208 564 AFSL No. 237296 is the responsible entity of the Maple-Brown Abbott Australian Share Fund, Maple-Brown Abbott Sharemarket Fund and Maple-Brown Abbott Australian Geared Equity Fund. Before deciding whether to acquire, or to continue to hold, an investment in the Maple-Brown Abbott Share Fund or the Maple-Brown Abbott Australian Geared Equity Fund, investors should obtain the Product Disclosure Statement, available at maple-brownabbott.com.au, by calling 1800 034 402 or from your adviser and consider whether the product is appropriate for your circumstances. The Maple-Brown Abbott Sharemarket Fund is closed to new investors. This commentary contains general information only and does not take into account individual financial circumstances. Any comment we make about individual stocks are intended only to explain our approach to managing funds and are not recommendations intended to influence anyone in making an investment decision. An investment in any of the Funds does not represent an investment in, deposit with or other liability of MBA. It is subject to investment risk, including possible delays in repayment and loss of income and principal invested. MBA does not guarantee the return of capital, performance of any of the Funds or any specific rate of return.