Strength in the market has been driven by multiple expansion in sectors where earnings growth is tepid and yet multiples are already high; we suspect the early bloom shall wilt and they may be prone to derating as the year progresses.
Equity markets were again extremely strong in January, increasing by more than 6%. A good year’s returns in a month; the third time this has happened in the past four months. We continue to believe that while 2023 earnings should continue the strength seen in 2022, dominated by ongoing strength in commodity producers and the banking sector, these earnings are likely well above mid-cycle levels. We also believe that multiples for many growth names on the ASX, which have led the market’s performance through this most recent rally, continue to remain unduly aggressive and hence subject to downwards pressure. The likelihood of interest rates heading back to the extremely low levels seen in recent years is minimal, given the difficulty in seeing inflation breaching the 2% threshold continuously referred to by the Chair of the Federal Reserve, and again stressed in the January Federal Open Market Committee meeting minutes.
What earnings shall prove temporary?
The great Liverpool manager Bill Shankly was often credited with the quote “Form is temporary, class is permanent”. And so it can be with companies as well. On the ASX, REA Group, owner of realestate.com.au and some other, much smaller businesses is a great example. Twenty years ago, when first listed, it was in loss, albeit modest loss. It lost circa $5m in EBIT over three years before striking a maiden profit, and continuing to grow ever since, fully funding itself from internally generated cashflows along the way. Its current EBIT, in excess of $600m, is now greater than the combined profits of all of the traditional media forms – television, radio and newspapers – in Australia. At a $17b market capitalisation, the multiple attaching to REA now is high, but there is little doubt that this is a class business, with a very strong market position. Qantas, by way of contrast, is seemingly being run with the intent to celebrate a record profit to coincide with a retiring CEO, with prices being lifted and costs being pruned, in each case to unsustainable levels. Questionable class, albeit strong form. In a market of extremes, where either or both profits and multiples continue to be at levels rarely seen across many sectors, discerning what is form, rather than class, is a critical judgement required of equity investors.
In the banking sector, earnings are currently boosted by two material trends which we expect to revert, to a greater extent than the market. A perfect storm attaching to net interest margin expansion has seen revenue per share currently at its highest level seen in many years; market consensus has this continuing at this elevated level, which would appear to us to be a scenario, but the best possible outcome. Equally, bad debt expenses have trended lower and lower in recent years until they have now reached zero; while market forecasts are for this number to revert, there is no scope in forecasts for any further bad news as is likely to occur in recessionary conditions, should they occur. The impact upon the bad debt line of recessionary conditions is open to argument; but to assume this expense to be zero through all future forecasts appears ambitious, and again reflective of a scenario, albeit the best possible one rather than the most likely scenario.
The importance and fragility of forecasting structural as opposed to cyclical or ephemeral trends can also be seen in the retail trade numbers in Australia. Total retail trade is still well above the trend line that had been established over 50 years using the ABS data. Even though the rate of change is slowing, and in some cases reverting back to the trend line, conditions for retailers in aggregate are still buoyant. So long as employment markets remain strong, this will likely continue to force the RBA’s hand. In contrast, online retail trade as a proportion has given up much of its COVID bounce, such that it is now back to 2020 levels. The new paradigm of retail has proven illusory, and share prices of many online retailers have followed suit. While there is little doubt that Australian online retail sales will grow as a proportion of total retail sales through the medium to longer term, the aggressive projections attaching to extrapolating the momentum experienced through the 2020 to 2021 period failed to be realised. Kogan’s current share price of $4.60 is a long way from the $25 seen in late 2020; its performance has followed online share of industry sales, which in recent years has proven to be more form than class.
Mining retains an optionality that can create value, seen in very few sectors. Nowhere has that seemed to have been more pronounced than in lithium in recent years. All of Allkem, IGO, Mineral Resources and Pilbara Minerals have seen their market capitalisations multiply, between 3 and 7 times, through the past several years. But this growth in market value is dwarfed by their growth in cashflows, with multiples of next year’s EBITDA at current prices being between 2 and 3 times. And the quantum of profit now being generated by lithium names listed on the ASX is now extremely large; EBITDA this year of circa $15b is well above what any sector in Australia outside of iron ore and banking has ever produced. The lucky country remains blessed! Obviously prices are expected to decline from these lofty heights, but the geopolitical backdrop to the surge in demand for minerals which facilitates decarbonisation means that the magnitude and duration of prices staying well above cost curves remains tricky. The Inflation Reduction Act is doing anything but for lithium prices. China’s subsequent mooted ban on exporting solar wafer manufacturing technology only reinforces the likely ongoing escalation of the geopolitical tensions which have fuelled lithium prices in recent years, and price to book multiples have followed this price trajectory. Lithium has plenty of class but its form, so to speak, could not be stronger.
The market learned long ago not to capitalise the strong years in commodities, given first-hand experience in deep cyclical swings in profits in the past. For example, BHP last year produced EBITDA of US$22b in iron ore, and circa $9b in each of coal and copper. Capex was circa $6b and there was no debt, and yet after a stellar year,(and indeed several years) of market performance, the market capitalisation of the group is still only six times EBITDA. RIO and Fortescue are priced on even lower multiples after also enjoying several years of strong market performance. In contrast, ASX technology stocks continue to trade at much higher multiples than the US technology market. We continue to believe these multiples are prone to downwards pressure to the extent earnings continue to struggle to meet expectations; they are truly the mirror image of the commodities sector on the ASX. Strong form, but with class yet to be proven in most cases.
While many commodity prices have enjoyed a golden decade, the laggard mining names on the ASX have been in the gold sector, which has seen operational issues consistently hinder expected levels of profits from being realised, and alumina. The portfolio’s overweight positions in Alumina Ltd has consequently dampened relative performance. On the back of poor market performance, bids have emerged for scale producers in gold names in recent years, and despite ownership complexities, to the extent that Alumina continues to trade below replacement value it may also beckon such a fate.
Within materials, there is also a broader smorgasbord of opportunities outside of mining names, many of which have been dramatic underperformers over the medium to longer term. While sharing a broad industry classification of materials, the characteristics which drive the current investment appeal for these companies are often idiosyncratic. For example, Boral has performed well through the last quarter as the market anticipates the initial result delivered by the incoming CEO Mr Vik Bansal, and far more importantly the expected enunciation of refreshed group targets at that time. A focus upon reduced costs shall not be a new approach; the past six CEO’s have started singing the same hymn, but unfortunately few have finished the song. Recent quarters have seen real pricing power emerge in concrete in Australia after decades of industry ill-discipline, usually blamed upon Boral. The weather through the past half means this result is likely to be poor, but a case can be made that Boral has significant latent earnings capacity. As indeed can be done for Orica; the last time its customers were making profits of this magnitude, Orica was making more than $1b in EBIT. And yet the corporate ambition in Orica is now so tepid that after a poor decade of performance, EBIT of close to half of that amount is now seen as commendable and the trigger for full executive reward. We think that poor form and a lack of class won’t detach from the chemicals names on the ASX in the near term.
Bill Shankly said of football; “Football is a simple game based on the giving and receiving of passes, of controlling the ball and of making yourself available to receive a pass. It is terribly simple”. And so it is with equity valuations; it is a simple exercise, based upon forecasting earnings, applying a sensible multiple thereto, and in doing so, balancing the risk of those forecasts proving to be form (or temporary), or class (and permanent). Again, terribly simple; at least in theory! In practice, as can be seen across the larger sectors on the ASX – banking, retail, and materials including mining, lithium and building materials – rarely have both earnings and multiples on the ASX been at such extreme levels across many sectors. The opportunity for alpha is consequently rich, albeit more prudence and judgement than usual, in discerning the permanent from the temporary, may be required.
Please be advised that mentions of securities and sectors are for illustrative purposes only and not to be construed as a recommendation to buy, sell or hold. Past performance is not a reliable indicator of future performance and may not repeat. This commentary contains the opinions of the author and are subject to change without notice.