During August 2019 the Ethical Partners Australian Share Fund returned -2.27% versus the S&P/ASX 300 Accumulation Index of -2.27%, performing in line with the market (after fees). Over the last quarter the Fund benefitted from overweight positions in the Industrials and Telecommunications sectors and an underweight position in Energy benefited relative performance. Key detractors for the last quarter included stocks in the Financial and Food and Beverage industry groups.
Even though the market fell during August our investment style remained firmly out of favour. Of the top thirty contributors to the S&P/ASX 300 Index return for the month our Fund owned only three of these companies. The other twenty seven were all not held due to the stock either not passing our investment process or due to excessive valuation. The value / growth divide we have spoken about widened further during the month. For example the WAAAX group of stocks that we referenced in last month’s report was up a collective 16% during August and added another A$6bn to the combined market capitalization of the five stocks. The total group is being valued at A$36bn and now equivalent to almost 1.5x the combined market cap of all of our ex-100 holdings. Who said irrational markets couldn’t get more irrational.
Other Australian listed tech stocks are seeing the inevitable founder sell downs, presumably into the hands of those who fear missing out of the next move up. One stock we marveled at is currently enjoying a market cap of almost A$4bn, having increased from A$95m five years ago. During this time the company has impressively increased annual revenue three-fold from $14m to $50m. But the market cap has increased by more than 41x. When two founders recently sold 3% of their holding they each netted around A$36m. This 3% is currently worth more than their entire stake was in 2014. Now, we aren’t saying that there is anything wrong with that success, simply that in our view, the market has overcapitalized the future opportunity in the valuation of 80x revenue.
It is in this environment that as a conservative value oriented fund we are investing and trying to beat the market. But there are some signs of fragility too, one being the postponing of WeWork’s proposed IPO amidst reports of its valuation halving from early 2019 estimates as well as Uber and Lyft trading -28% and -38% below their respective IPO prices earlier in 2019. The time for unprofitable companies coming to public markets may be passing.
Being able to identify the market environment is one thing and it is equally important to assess our own team’s own stock picking through reporting season. Of the 33 companies held in the Fund, 27 reported their results and we were satisfied with the business performance and our positioning in 22. Five companies reported results below our expectations. Looking at our portfolio objectively, of the 27 companies that reported results, 11 of our positions underperformed the market in the month while 15 outperformed the market (as well as Telstra that underperformed with the Fund being underweight this stock). 15 of our holdings raised their dividends year on year. We would generally call this a reasonable result with respect to stock picking. So why isn’t the Fund performance result better over the month? It comes down to two main reasons in our view:
1. Some of our larger positions underperformed, one of which we have now sold and one we have retained.
2. While the team’s hit rate of successful results / poor results is reasonable in our view, any mistakes are amplified in the current market environment. While mistakes are inevitable in investing, these are not being offset enough by other winning positions. This is in part due to broad market money flows continuing to chase high PE, growth and momentum names. That is, while we may be able to identify and position the Fund correctly in stocks that are cheap and have reported good results, these are simply not the stocks that the market is currently enamoured with. Even some of our best ideas and results are struggling to match the share price performance of companies that remain unprofitable and have negative cash flow. The reasonable results reported by most of our holdings, however gives us confidence to continue to hold our positions, with the knowledge that fundamentals do matter in the long term and when markets return to normality we are well positioned.
Another phenomenon we saw in reporting season is the domestic cyclical names where we have some exposure, outperformed global expansion stories and expensive defensive stocks in August. Stocks such as ARB Corporation (+1.5%), Nick Scali (+8.7%), Super Retail (+7.1%), McMillan Shakespeare (+17.9%), Smartgroup (+21.0%), Suncorp (+5.5%), Lend Lease (+19.3%), that are exposed to domestic consumer and property, outperformed. While some global expansion stories such as Brambles (-13.9%), Orora (-17.5%), Nearmap (-19.0%), A2 Milk (-20.9%), Blackmores (-18.8%) and Boral (-15.0%) fared poorly. Also stocks that had been preferred for their yield or supposed defensive characteristics like BHP (-11.0%), Rio Tinto (-9.2%), Telstra (-5.0%) and Insurance Australia (-4.3%) underperformed. This is the first reporting season in a while where we have seen this rotation. The reasons include all the measures that have been taken to support the housing market (removal of caps in investor loans, loan assessment and availability of credit etc), a return of confidence post the federal election and lower interest rates. Should conditions remain stable then in our view there is still inherent value in many domestic cyclical names.
We believe that at some stage the music will stop and value and fundamentals will return to being the factors that matter with respect to share prices going forward.
Ethical Standards Report received well
We recently released the Ethical Partners 2019 Ethical Standards Report and we have received a significant amount of feedback from CEOs, CFOs and Investor Relations teams. The responses have been encouraging and many companies have enquired about how they can improve sustainability policy and practice. The Report has been circulated to company Boards through CEOs and our team has had many follow up meetings with senior management including sustainability teams to progress ideas. Sustainability outcomes could improve as a result of this engagement and we will keep our investors apprised of progress. We have found this research and engagement to be an excellent way to further appreciate quality and depth of management teams and the culture in different companies.
