EDITED TRANSCRIPT
Lukasz de Pourbaix (LDP): Today we'll be talking about the recent reporting season, some of the key observations and portfolio implications. I'm pleased to be joined today by our leading portfolio managers within the Australian business. It's been quite topsy-turvy reporting season. How are you all feeling?
Paul Taylor (PT): I think it's been a reasonable reporting season. The market is in a buoyant mood, but we did see some big moves up and down. When companies beat, they went up a long way and when they missed, they went down a long way. I also see this as another reporting season where it is about individual companies to me, it's less about macro. It’s more about individual companies even in sectors. For example - Coles and Woolworths. Coles had a good result, very strong whereas Woolworths had a weaker result, very weak. Overall, I think the market is in a pretty buoyant mood and I thought the results were reasonable.
Zara Lyons (ZL): I thought the interesting thing was that the financial sector had very strong earnings growth through the period. However, the returns delivered in terms of share price weren't as strong as say the materials or mining sector where they had earnings downgrade through reporting season but actually outperformed by 9%. So, we saw this sort of bifurcation there between earnings versus share price returns.
LDP: What's been driving that out of interest? What's been impacting the fact that you've got some of these companies where maybe earnings aren't as strong, yet the share price is rebound?
ZL: I think, specifically for the banks and material sector, you saw some optimism around anti-involution measures of the Chinese government potentially cutting down some of the loss-making miners. Then on the banking side, you saw solid results buoyed by very strong credit performance. Because of the easing cash rate cycle, we're seeing both a little bit of credit growth but also a good benign credit scenario.
PT: Markets are probably also looking for, or waiting for, rotation between the sectors, aren't they? Banks have obviously had a fantastic run. Resources have been out of favour for quite a while now, and I think the market's sort of looking for it. We've had a couple of false starts.
ZL: False starts, definitely.
PT: It'll be interesting to see what happens now, but the market is looking for that, waiting for that as well.
ZL: Absolutely. You did see some runs with lithium players through the period; gold took its foot off the pedal earlier in the quarter but then has brought back during the last couple of days. So, you're seeing those stocks in those two sectors performing well.
LDP: Obviously they're very important for Australian investors given resources are such a big component of the market. James, in terms of the mid-cap part of the market, that's been going from strength to strength. What are your key cases? A little bit different compared to the large-caps?
James Abela (JA): Very strong. There has been a lot of growth in mids and smalls, but the sentiment shift has also been quite significant. Resources have seen significant upgrades but also multiple expansions. Consumer was good, technology was good. I think just the breadth of where things are quite good now is has grown through this reporting season. People who were worried about consumer, people who were worried about resources, people worrying about costs and productivity - all of that has come through and people have delivered good margins, delivered good positive outlooks. So that's probably what's happened.
The sentiment shift has been quite dramatic and like Paul mentioned; a lot of the reactions were very significant. A lot of stocks are up 10 to 20% in small caps - in autos, resources, retail. That was because either there was fear or there's just more confidence as has come through. It's quite symbolic of where the market's headspace is. It is definitely optimistic. It is definitely momentum. It's definitely more positive and constructive and the market's more looking at the top line rather than bottom lines and margins and all the fine details. As long as the management teams are looking at positive top line and growth, then the market is being very supported.
LDP: Is it a similar experience in the large cap part of the market as well?
PT: I think so. To follow on from James, it really is a growth related. The market's looking for growth, so we did have a few of the bigger companies deliver strong top line growth. The market got excited about this and maybe that's also due to a belief that they can get on top of the costs and really, in this sort of environment, you can deliver growth.
LDP: One of the key themes was this divergence where you've had clear winners and clear losers. You mentioned Coles and Woolworths earlier. We saw Coles do very well and Woolworths obviously sell off on the back of reporting season. Is that a common trend now where it feels like it's very much stock by stock rather than sector by sector? Where in a macro driven market, you're getting these real individual stock dispersions?
PT: I think you got to. Zara highlighted the rotation people are looking at is banks and resources. I think when you delve into the sectors, it's then about very much about stock specifics. Now, and this doesn't always happen, Coles is significantly outperforming Woolworths at all levels. They're gaining share, growing sales, they're also developing good distribution so they're taking costs out, and they're getting on top of any shrinkage (theft) within the stores. So, they're winning at both the revenue and the cost line, which the market will reward.
LDP: That rotation between resources versus financials has been a topic of debate for some time people have been waiting for. Zara, do you think that this is a structural thing or do you think it's a bit of a false dawn again?
ZL: That's the million-dollar question! I guess a $65 million question. I think there's a couple more rate cuts coming. What we've seen historically is that banks have outperformed during RBA rate cutting cycles. If you can tell me we're at the end of the rate cutting cycle, I could probably tell you when we think banks might Peter out, but obviously investors really want miners to work. I think we're only about a year or so into this rotation into banks versus miners and we still haven't seen the end of earnings downgrades in miners. But as we know, the stocks tend to run ahead of the changes in earnings and look forward rather than backwards.
PT: I think the miners have probably got valuation on their side, which is what investors are looking at.
ZL: They do.
PT: Then maybe, well the banks in particular, are at the more expensive end of their range. We've had a few things in terms of some more stimulus from China as Zara pointed out. We've had a couple of mine closures which have got people excited on lithium. Rare earths are performing really strongly as well. So, resources do have good fundamentals, and gold is just performing well because of the gold price but also good production as well. So, I think they've got valuation on their side over the banks. But a couple of times that's happened and really hasn't followed on.
LDP: James, the consumer is another area of focus for a lot of people. There’s been a lot of noise around consumer sentiment. We've talked about for some time now - cost of living pressures etc., but yet the consumer seems continues to be fairly buoyant. How have you observed this?
JA: Consumers was pretty strong across the board, particularly in autos and furniture. The perception is that the consumer is already expecting the rates to go down so they're already starting to change their spending habits and starting to spend on things that they maybe enjoy more. It's a little bit more discretionary rather than staple like cars, fashion and furniture - those things are now starting to lift up. Temple & Webster had a good result for example, which is furniture based. Eagers Automotive had a good result, which is autos. The breadth of consumer as well has been pretty broad in terms of companies that have done well, but then sectors that are doing well too.
Touching back on resources, that sector comprises 20% of the mid - and small-cap index. It is driven by gold mainly, but too by rare earths, copper and others. Resources has definitely become a lot more topical in mid- and small-caps whereas the last time that happened was the last gold rush or the last lithium bubble when it got to that sort of level as an index.
PT: Technology's probably the growth angle as well.
JA: That's where there’s growth, mainly offshore.
LDP: It hasn't all been positive. Healthcare has been one part of the market which has lagged a little bit. I mean any sort of observations there in terms of the healthcare sector more broadly?
PT: I know within healthcare, hospitals are obviously doing it tough and at the moment, the top line is not growing as much. The costs that they've got, particularly nursing as well as non-labor, mean they're going up much faster than revenues, so you're getting a bit of a margin squeeze or improvements in that sector aren't necessarily coming through in margin. Hospitals have been doing it and there's a lot of hospitals, private hospitals, that are not making money at the moment, which is very unusual. They're probably doing it tough.
ZL: Conversely, the private health insurers perform quite well through the season in terms of delivering earnings growth and also share price returns because of lower claims utilisation essentially. So that's been a very strong tailwind which possibly may persist. It seems that the consumer has been more inclined to spend on furniture and auto rather than the knee replacement that you might need.
PT: The largest healthcare stock, CSL, which did have a weak result. They've done a few structural things. But fundamentally, they had a pretty tough result, dramatic reaction to that one.
ZL: They did announce that they were looking to spin-off an asset, Seqiris, as well as potentially launching a share buyback in September. But I think they've faced some cyclical headwinds as well as potentially some structural challenges. That one went up 10% in July and then down 25% in August.
LDP: Where do valuations fit in? Is the market focused on valuation or are they still just focused on growth?
PT: I think it has been all about growth so far and I think that it's interesting. To a certain extent in Australia, we have a lot of quant funds and the quant funds are looking for upgrades and that growth, so they're buying stocks without linking it back to valuation or if someone disappoints, they sell it without worrying about valuation as well. That probably creates some opportunities when you get those indiscriminate moves - that does create opportunities. I think it will always come back to valuation in the longer term, but it doesn't have to in the shorter term. So maybe some of the quant funds can drive it in the short term, but eventually it has to come back the other way and that's when they really have a tough time. It moves on valuation.
LDP: Zara, how do you manage those two aspects of managing growth versus valuation in this environment?
ZL: I think it is quite challenging. We saw the market increase by 3%, but earnings actually went backwards. So, you are seeing that wave of liquidity and the weight of money from the index buying really pushing things. I think you just need to keep a calm head and think about the fundamental opportunities that present themselves during these market dislocations or rather stock specific dislocations. It's very much sector by sector. As James already mentioned, technology performed very well, delivered strong earnings growth and then you saw other sectors like materials deliver earnings downgrades but still perform well because of the hope that we're at the bottom.
LDP: James, I chatted to you at one stage, and you gave me a good overview of some of the drivers in the market. Momentum was an interesting one where, particularly in the Australian market, it is a quite strong factor. How does that play into your world?
JA: The overall valuation of the market is not that high. It's around 20 to 21 times, but the earnings are double digit earnings growth, which is quite high. If you look at resources that have come up a lot, the earnings have come up a lot and the multiples have come up as well. So that's a cyclical growth. Then you've got structural growth in tech and consumer tech and those multiples go from 15 to a hundred times nearly.
The range in valuations is very, very wide. But what's interesting now in this reporting season is a lot of momentum has come to those what I call in-betweeners or more average stocks. A stock like Harvey Norman is a good performer, but it's at an all-time 10 year record high in the share price because the property's worth more because the search for yield is on. The franchisees are doing a lot better now. The volumes in the stores are now doing well. Franchisees profit and the actual property is worth a lot more. That stock's gone from $4 last year or nearly $3 to over seven today. Resource stocks as well. Some of them are up 40, 50 to a hundred percent. Consumer names as well.
So, a lot of these in-between stocks, either cyclically good stocks or consumer stocks that are all right are up 30, 40% just because there's a lot of valuation give or a lot of valuation that can move from stock. 15 times to move to market average at 20 times doesn't seem like out of the realm of norm, but a lot of stocks that were in-betweeners and kind of ok have been lifted upward.
There's a lot that the breadth of earnings drivers which is also leading to the breadth of valuation drivers where you've got your structural growth and cyclical growth. Then, sentiment shift has led the market higher in mids and smalls. The breadth of valuation now is quite large and there's not a lot of very low valuation stocks anymore. A lot of things have just moved upward, but they're moving up with earnings and then some have gone with duration, building durations long, so let me give that a high multiple. Then duration in terms of quality is also the market's confident, but now also momentum because the market's positive about the market overall and the strength of the market and the breadth of the market. Quality and momentum is really dominating the market right now and that's really what happens in the buoyant, confident, long-duration mindset market that we are in today.
PT: One of the other things we saw as well was growth. You've eventually got to turn that growth into leverage and that's the thinking. It doesn't have to be in one. One of the real standouts for me in terms of one stock we own quite a lot of is SEEK. SEEK has been the top line, has been growing for the last few years, but the bottom line hasn't grown. I think the market got a little bit sceptical: ‘why is the top line growing?’ But the bottom line staying flat. We're investing, which is fine, the market will put up with thats for a little while, but they want to see it eventually come through. This actual result was they had a stunning stock performance because finally they had growth top line growth, but it came through in the bottom line as well. So, I just say that because I think the market's happy for growth, but I think it's got to eventually come through.
LDP: Has there been any material shifts in your thinking in terms of how the three of you respectively are thinking about your portfolio positioning? Has it cemented the views you already had or has anything changed?
ZL: This reporting season was one of the key reporting seasons where everyone talked about AI and how that was going to change the business, not necessarily change the business model, but the investment being made for AI and the potential for it to change the business model. Take out costs, convey benefits to the employees, convey benefits to the customers, and one hopes, convey benefits to the shareholders. So that's been a key line of interrogation with the companies. That's a good point to get a sense of where that's going. Clearly, they're making the investment now, but no company has come out and quantified what the potential benefits are. So that's another thing to bear in mind.
There is potential for operating leverage coming through, particularly in the banks which are very big spenders in technology and incrementally spending more in the AI piece and financial services, banks, insurers, even Zip talked about the number of benefits that they have that may be able to etch out from using AI from all sorts of things like HR, legal and compliance, call centres. There was a number of different avenues that were called out by the companies that I spoke to.
LDP: An interesting point because just on that, before we get to the portfolio element, there is obviously a lot of headline news around AI more generally and obviously some big companies globally benefiting from that thematic as well. Do you feel like from an Australian perspective, in terms of these companies you’re looking at, do you think it's a structural thing in terms of that this is really going to be part of how a lot of companies operate having AI involved in some shape or form?
ZL: I believe so. I certainly think they're all at least dipping their toe in the water to get a sense of how it can be used responsibly within the businesses. Yes, I think there is definitely scope to expand even within our own business there's opportunities.
PT: It's quite exciting when you think about it. We all started by saying the market's in a buoyant frame of mind. To me, AI is a contributing factor. We don't really know how much, but we know the likelihood is it's going to be positive and significantly positive. So maybe that's just part of the mindset of the market maybe.
ZL: Well I know the newspaper headlines focus on labour reductions, but I actually think what it's more likely that it's upskilling your labour rather than it being a replacement.
LDP: The productivity issue, which has been an issue for some years now, I think it's a relevant one and topical as well. So, in terms of when you wrap all that up from a portfolio perspective, whether it's AI or whatever it may be, some of these thematics coming through, has it changed in terms of the shape of your portfolio where you are taking risk, where you're not taking risk? Has anything changed or has this reporting season really just reaffirmed your views on the market?
ZL: I haven't made any major shifts through August. It's like drinking from the fire hydrant, really getting all the information and I think it's important to distil it all and work that through it. But I have had occasions where I've trimmed names where I've lost a little bit of conviction and or concern that there's more of a structural shift going on in terms of market share loss, but also added well just before reporting season. I added to Cochlear for example, which has a new cochlear implant called the Nexus, which has potential benefits to improve hearing outcomes for both the recipient as well as for the surgeons implanting the implant. That's a two to three year type story, but that's one name that I've added over the last quarter.
PT: From a sectoral perspective, we talked about consumer discretionary, I've added to that. I think with interest rates coming back down and the consumer already being relatively buoyant, particularly for Australia, we've still got reasonable population growth. So even without an individual buoyancy, you've got demand coming through. I have added a little bit to resources as well. That's probably more the subsegments of resources. I’ve taken a little bit away from healthcare and consumer staples. I've stayed strong in technology and we've talked about some of those stocks, so probably just added a little bit to consumer discretionary in that sort of area.
JA: I’ve added to consumer resources too, then added defensives, pure yield or very low growth value type businesses, moving more to where there is growth, where there is opportunity for companies to grow top lines and companies that are low growth. I think below 5% growth is going to be very far out of where the market is for the next 12 months and they're unlikely to perform well. So really going where there is growth and certainty, but then also keeping a balance with things that are going to do well if things do slow down a little bit. But the majority of the portfolio is still towards that growth angle and tilted more towards that slightly during this report season.
LDP: If you had to pick the one thing that you're focused on at the moment, either positive or negative could be either in terms of the market, what's the one thing you're focusing at the moment and you think investors it's worth them focusing on over the next coming period?
PT: Probably looking for who does have the growth, who is investing. To get the growth, often you've got to invest in who has been investing. There is a lot, when you think about all those different areas, there is a lot of growth out there, but it is in pockets. We spend a lot of our time talking to individuals, it's not just about sectors. Like I said, Coles is significantly outgrowing Woolworths. They're not just better cost performance. So, even in a sub-sector for a fund manager that's doing well is going to be growing strongly. One that's not, maybe is not growing. It is about spending time. You want to be on top of the individual stock, you want to look at the trends, but then you want to look at which companies are delivering, you want that fundamental bottom-up approach to which companies are delivering the growth. I want to put the caveat on that, it's not just financials growth or resources growth, it is actually which company is doing it within that sub-sector or something.
ZL: I'm looking closely at the companies that have made big acquisitions and trying to understand how that shifts the dial for those companies. Also, looking at the leverage that was implied because there are a number of companies that made acquisitions. The street got confused about where the consensus estimates may have over or under egged the potential earnings impact of those set acquisitions to the businesses. So, I’m really trying to get a handle on that dynamic to see what the potential is for synergies or otherwise, or the risks for leveraging issues. It feels like we are seeing more of that at the moment.
PT: We've seen Santos and Domain for example do this. Another stocks currently is Lynch, there's an offer for it to be taken out by a private equity firm as. So, you are seeing a bit of that.
JA: I'd say growth certainty. I think it's a very quality momentum, cheerleading market and in that, you've got to be careful of the risks. So that's complacency, CapEx and competition - that's typically where that paradigm starts to slow itself down. Complacency of management, complacency of investors, etc. But then competition can start to emerge too. If returns are too good or valuations are too good, eventually competition comes in either capital or genuine competition. I think that they're the things you've got to keep in mind. For CapEx, because as things get more growth orientated, people do start to spend more and then as that competition starts to lift, you need to increase your CapEx, which means the returns eventually fall. If returns fade, then valuation should eventually follow. It feels like this is a very good quality momentum type market, but I think they're the sort of concerns you need to have in your mind as you continue to follow this growth trajectory that the world is on.
