Ethical Partners Australian Share Fund - As at 30 June, 2019. Unit price, Investor Class $1.0249, APIR code EPF9951AU. During June 2019 the Ethical Partners Australian Share Fund returned 0.73% versus the S&P/ASX 300 Accumulation Index of 3.64%, underperforming the market by -2.91% (after fees). During the month the Fund benefitted from overweight positions in NIB Holdings, Helloworld Travel, Sims Metal and Commonwealth Bank and underweight positions in Wesfarmers, South 32 (not held), Challenger (not held) and A2 Milk (not held) benefitted the relative performance of the Fund. Key detractors for the month included Link Group, Nick Scali, BHP Limited (not held) and Inghams.
Financial year to 30 June 2019
Since inception of the Fund on 8 August 2018 through to 30 June 2019 the Australian share market delivered a 10.2% total return, including an impressive 19.8% recovery from levels reached at 31 December 2018. Among the various sectors the 50 Leaders outperformed (12.6%) whilst the Small (3.3%) and Mid Cap (2.3%) sectors underperformed. This performance differential is occurring in an environment where active management of equities is suffering unprecedented outflows and it is one characterised by the wide adoption of index funds that continually buy the largest stocks in the market with new inflows.
Within industry sectors the Resources outperformed (15.9%) strongly whilst Industrials (8.8%) lagged the market. REITs in particular (+15.9%) outperformed whilst Energy fell (-8.3%) over the period. While the market broadly trended higher this year it was a small number of stocks that contributed most of the returns. BHP Limited, Rio Tinto, Fortescue Mining and Newcrest jointly contributed around 55% of the total index points while another three companies, Transurban, Sydney Airports and Goodman Group, contributed just under an additional 20% of overall market returns.
It is well known that this is a market with some valuation extremes. What appears to be driving the strong market returns, in this low growth environment, is both the high price being paid for equities that demonstrate or promise growth as well as a high price being paid for equities that demonstrate perceived earnings or income stability. The chart below depicts that valuation spread between growth and value stocks within each sector are now at extreme levels.
Key stocks held in the Fund that did particularly well over the period include NIB Holdings, Telstra, Commonwealth Bank, Ramsay Healthcare, Insurance Australia Group and Medibank. Since the start of the rally in January 2019 the Fund has captured approximately 70% of the market’s upside.
The Fund underperformed the market in the period from 8th August 2018 to 30 June 2019 for three main reasons:
1. The Fund is underweight highly geared Industrials, Utilities, Mining and Technology companies that are not in our investment universe due to their balance sheet and poor cash flow or that fail the Ethical Partners Operational Risk Assessment (EPORA), our ethical screening tool;
2. We have been disciplined around valuations. As such the Fund has not benefitted from owning, for example interest rate sensitive stocks that are trading on very high valuations and are capitalizing record low interest rates. We also have an underweight in the Healthcare sector and zero weight in stocks like CSL Limited due to high valuations;
3. There are four companies that we owned that detracted the most from the Fund’s performance. These stocks included Ooh Media, Bega Cheese, Link Group and CYBG Plc. We sold Ooh Media during the period as the business was less resilient than we had thought and the significant acquisition it made did not deliver the expected benefits. We are still holding a position in the other three stocks in line with our view that their equity is trading cheap relative to the business prospects.
Like the Dutch, who in the Treaty of Breda in 1667, traded the island of Manhattan (longer term value) for an island in the South Pacific that grew nutmeg (shorter term populism), investors today appear to be selling enduring businesses that represent longer term value in exchange for companies that, in our view represent shorter tem populism and may, in the fullness of time, be worth a lot less than they are in today’s market. Specifically those companies that have high debt, no profit and zero cash flow in an era of record market levels and record low interest rates.
We are cautious on the equities market at present for the following reasons:
1. The market is now expecting 100% chance of a US Fed Reserve rate cut in the short term. This stands in contrast to December 2018 when the market had expected (with 80% probability) that the Fed would not change interest rates for the foreseeable future. The surprise rate cuts had a powerful effect. Today’s rate cuts are already priced in. The Bank of International Settlements indicated in its June 2019 Report that global monetary policy is quickly reaching the end of it’s runway; “But given the persistence of economic weakness and, even later on, an inflation rate stubbornly below objectives, interest rates have been kept unusually low for unusually long, and central bank balance sheets have ballooned. As a result, the room for policy manoeuvre has narrowed considerably”.
As the Fed hiked rates towards the end of December 2018 and markets fell away we saw value and opportunities in equities and invested accordingly. At December 2018 our cash percentage was low. Today we are finding less opportunities and cash levels in the Fund have risen.
2. There appears to be a high level of speculative money betting on rising markets and commodities. Take iron ore for example. The Dalian Futures contract is the main iron ore pricing mechanism and where the market takes its lead. Over the past six months the average traded contract volume was around 800,000 contracts per day. June 2019 saw only 3,100 contract settlements (0.4% of average daily volume), indicating that most of the volumes are not for delivery but for speculative purposes. The current contract is currently trading 3.5x normal volumes at 2,800,000 contracts on average, per day. This futures market activity has also prompted a response by Chinese steel industry associations trying to deal with a collapse in margins.
3. Locally there is an inordinate level of capital raisings in the most popular sectors. 60% of the total secondary market raisings this calendar year have been in REITS and Tech, two of the best returning sectors this year. This year has been the largest REIT capital raising in almost a decade but back in 2009 REITS were raising capital at an average of -10% discount to NTA whereas today they are raising capital at a 10% premium to NTA. We have not taken part in any of the $10bn of raisings this year.
We believe the risks are to the downside at the present time in relation to equity markets, with a particular emphasis on selected areas. That said however there are a number of areas that we feel are being overlooked including domestic cyclicals and consumer staples (food/agriculture) that will still yield reasonable future investment returns. The team is exercising caution in managing the Fund and while our conservative investment process will mean, in part, that performance may lag the market in times like these we believe that a disciplined approach will benefit our clients in the medium term. We remain focused on quality, enduring businesses and investing only in companies trading at sensible valuations that are not capitalising the current state of world affairs including record low interest rates.
Nathan Parkin, Investment Director
Matt Nacard, CEO
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