December mid-year reflection
We look back on the first 6 months of the financial year, FY-20.
Our optimism with respect to your equity portfolio found new validation this week, with the announcement of a takeover offer for CML Group (CGR) at a 25 per cent premium to recent trading. CML Group is the 3rd largest position in most client portfolios (5 per cent of Australian shares), with First Samuel clients owning 20% of the company. In a recent equity raising, we increased our stake by 15%, gaining further exposure to what is an undervalued company. The entire team have worked closely with the company over the past year in a range of merger and acquisitions discussions.
The company exhibits the clear characteristics of a First Samuel investment: a real business, with good growth, reasonable value and options for future value creation. Through being able to identify these qualities, First Samuel has generated outperformance over the past 13 years.
During my first CIO presentation, I noted that Emeco, Healius, CML, Paragon, Challenger, MMA Offshore, Cardno (Intega) all represented positions with these qualities. They remain core positions, and constitute one third of your portfolio. These positions have grown by 7.2% since June 30, outperforming the market, and contributed +2.7% to your Australian Equity Portfolio.
After further research, I am confident that Worley and H&E Limited (HT1) can be added to this list, although they are broadly flat.
Part of identifying these companies involves patience. And this patience is often rewarded with specific events such as a takeover (including Aveo Group & CML Group) or high impact financial results from a company, such as those recently presented by Emeco.
It is worth noting that our companies are often mentioned in dispatches regarding potential mergers and acquisitions. This is by design, not just good fortune. The reason others, often private equity or industry competitors, see value in such positions are the same that we do.
First Samuel continues to invest based on simple metrics;
We love buying companies that grow;
- Those growth expectations can be "long-dated", and to be frank, have some “fog” that lays between the present and the future. Your positions in Emeco at very cheap levels in the past, and positions in TZ Limited and Carbon Revolution today would be good examples.
- However, we remain aware that markets often (dotcom bubble, pre GFC, mid 2016 and late 2018) pay for growth at any price. At such times avoiding these stocks protects clients' wealth like few other strategies.
- In the next six months adding more growth stocks will be a priority.
We don’t mind buying companies with solid asset backing, even when they face short term constraints, difficult conditions in the markets they operate, and when they are undergoing short-term turmoil.
- The price we pay facing these headwinds so to speak, is that the market is often more concerned with these short term headwinds than company’s long-term prospects. The market price of these companies can often reflect this. Stocks that are broadly flat or down in the first six months would include Southern Cross Media, Coronado Coal, Pact Group and the uranium producers we hold. They have reduced your portfolio value by approximately 2.6%.
- When our research indicates that these headwinds are likely to persist for an extended period, we will sell such positions. As the new CIO, my tolerance for headwinds that are likely structural rather than cyclical is limited.
We don’t buy expensive stocks with moderate growth. Instead, when the market presents limited opportunities, we hold cash or gold, waiting for these stocks to “go on sale”. In addition, we own several unlisted, illiquid investments.
- The short-term cost of these holdings can be high, especially as they represent one third of the portfolio. Excluding the write-downs anticipated last week, they contributed -0.6% to the portfolio, instead of rising with the market.
We don’t assume that what is happening today can be extrapolated forever. The price of any commitment, including buying stocks, cannot only make sense if current conditions need to persist forever.
- The stable attendant, carriage maker, Australian car manufacturer and the internal combustion engine parts maker may all agree. Forever low interest rates in yield and property stocks, forever non-existent bad debts in banking, are examples where we refused to entertain the “things will never change” mentality.
Surrounding the core positions, we buttress the portfolio with larger or more defensive stocks that makes sense, both individually as well as what they add to the portfolio as a whole.
- BHP, QBE, Boral Limited, Origin Energy and 360 Capital, which together represent one sixth of the portfolio, are examples of this and have outperformed the market. They have contributed +1.2% to total returns.
And finally, we aren’t waiting for a crash. We are conscious that persistent discussions of “expensive markets” and cash holdings can appear akin to be a jeremiad (a long, mournful complaint or lamentation). When any stock at any time represents good value, we will buy more. We have a long list of stocks, and a list of prices we are willing to pay.
The market and your Australian Equities Portfolio
Ongoing reductions in global and Australian interest rates drove a “melt-up” in the market of 5.2% since the 30th of June.
No excuses. Your Australian Equities Portfolio remained relatively flat. A reasonable question remains why, with all of the good news in the previous section, did the portfolio not keep up?
Apart from the drag of cash and illiquid holdings as discussed, broader market growth was driven by further rises in already expensive growth stocks.
What we have seen in FY-20 thus far is a continued decay in earnings expectations, which is at odds with valuations that continue to climb and are above historical averages.
Is there evidence the strategy is working despite the numbers? We suggest there is. Results in the broader market are consistent with the structural positioning of the portfolio.
The +5.2% increase in the ASX was very narrowly focused. CSL alone contributed 20% of the market’s performance. CSL is now twice as expensive per dollar of earning or per unit of growth than two years ago, and we try to avoid expensive growth, regardless of the momentum in such names.
Avoiding the assumptions of permanence anywhere was rewarded as the big 4 banks went backwards – they lost more in capital value than their dividends provided. A similar theme emerged with property stocks which were flat. There was no hiding place in the big miners either with concerns surrounding global growth seeing miners BHP & RIO going backwards.
An area of the market which did rally was the consumer names in anticipation of positive impacts of tax cuts and consumer spending. Evidence suggests it was a mirage at best, and Christmas trading is likely to confirm our analysis. Consumers are heavily indebted, and looking to de-lever rather than spend more, spending per capita is going backwards in real terms.
Some brief notes on the market as a whole and how we are positioned, rather than discussions of individual stocks or levels of cash.
Simple math suggests that when we have very low interest rates and high stock prices we should expect increased volatility (see chart below). Small changes in interest rates, or expectations surrounding geopolitics will continue to feature heavily. When volatility is high expensive growth stocks tend to underperform.
Source: IRESS, First Samuel
With respect to the global macroeconomic environment, renewed optimism around trade and global growth has seen markets moment upwards towards the end of December. It is likely that with further progress around trade and positive global economic data that we will see equity markets strengthen. This could also lead to a strengthening in bond yields and commodity prices. We are positioned for such an outcome.
Any movement in rates will create volatility, and any sense of rising yields in general are more favourable to portfolios with a “value” bias relative to a “growth” bias. As such we may see the September rotation we saw into value stocks continue. This is in addition to the benefit rising yields may have for specific companies whose revenues are tied to long-term investment returns, such as QBE and Challenger. On the domestic front, the reporting of 1H-2020 results at the end of February/early March will be crucial to share price performance and in framing the outlook for companies for the financial year ahead (FY-20).
As evident with the news from CML this week we remain confident of the outlook for your portfolio. Working with companies, finding new companies with good value prospects for growth, and strengthening the fundamentals of the portfolio will remain the clear objective.