May 2019 Investment Report

June 20, 2019
Investment Updates

Ethical Partners Australian Share Fund - As at 31 May, 2019. Unit price, Investor Class $1.0175, APIR code EPF9951AU. During May 2019 the Ethical Partners Australian Share Fund returned 1.45% versus the S&P/ASX 300 Accumulation Index of 1.75%, underperforming the market by -0.30% (after fees). During the month the Fund benefitted from overweight positions in NIB Holdings, CSR Limited and Medibank and holding no position in Macquarie Group benefitted the relative performance of the Fund. Key detractors for the month included Link Group, Graincorp and Clydesdale Bank.

There is no doubt we are in a market where there is an abundance of risk taking, facilitated by global central banks providing a perceived backstop for markets by way of ever cheaper money. In this environment money has been most attracted to equities that are exhibiting (revenue) growth and highly geared equities that can pay a yield. The equity of other lower growth or cyclical industrials has lagged and some are now attractively priced based on through the cycle asset valuations. We have built as large an active position in the remaining decent value opportunities as we can. Our investment process does not actually allow investment in any company that has zero or negative operating cash flow as these businesses are dependent on favourable markets to keep them afloat until they become self-sufficient by making a profit. These stocks are currently soaring and the Fund’s short term performance has suffered in part from not owning them. We are comfortable (but not complacent) however knowing we have invested our clients’ capital in businesses that have existed through multiple cycles.

In these newsletters over recent months we have been saying that the team had found some excellent opportunities to own businesses that were trading at discounts to our valuations due to short term cyclical factors and market sentiment. These positions included building stocks, health insurers and banking stocks in particular. Having positions in these companies meant that the investment team was looking through the short term noise and focusing on the medium to longer term franchise value. While we are the first to say that we did not pick the federal election result, and do not invest on that basis, the surprise result in mid-May had the effect of refocusing the market (very quickly) back on the medium to long term value inherent in these businesses (made up of sensibly managed assets, industry structure, competitive dynamics, debt position and brand value).

The Fund underperformed the benchmark in the first half of the month as investors sold many of these companies (domestic builders, banks, health insurers) down to levels that reflected the perceived difficult outlook. This was followed by a period of strong relative performance by the Fund into the end of the month. Prior to the election some of our companies were trading on less than six years’ forward (bottom of the cycle) earnings and for others the discounted future cash flow valuation assumed negative growth into perpetuity. When the market was forced to consider that the current circumstances would not likely persist forever, many of these companies experienced a significant boost in the share price to reflect the changed near term outlook even though nothing had changed in terms of the long term ie: companies’ management, assets, industry structure, competitive dynamics, debt position and brand value.

Specifically, health insurers were facing a world under a predicted Labor Government win whereby their premium growth would be capped at two percent for two years. The market had been fearful of constrained profitability during this term but had ignored the longer term attributes such as the rational market structure, strong capital positions, constrained capital positions of unlisted peers and the vast amount of preparation the health insurers had done prior to the proposed new regulatory regime. According to the strong post-election rally, none of these factors were being valued in the relatively cheap valuations for these quality stocks.

Likewise, in the building sector the negative new flow around domestic house prices had resulted in some extremely cheap valuations that reflected the market’s belief there would be a severe and lasting downturn. Analysts had been rushing to lower their forecasts but had missed the more consolidated building materials market (which helps achieve higher margins), the lower dependence on apartment building (versus the more resilient detached housing starts) and the stronger renovation and commercial markets as well as the net cash balance sheets in some companies.

Not all of our positions went our way however with three significant negative events impacting Fund performance during the month:

- The Fund holds a position in Graincorp which fell sharply after Long Term Asset Partners, the entity who had previously submitted a non-binding offer for the company, walked away from the bid. The company also reported their half year result during the month which was impacted by poor harvest volumes and derivative related losses. The company has however progressed its own demerger plan for the Malt business and progressed the divestment of its bulk liquid terminals business. It is evident from our analysis that the Malt business will be able to take all of Graincorp’s corporate debt (excluding trade receivable and working capital related debt) potentially leaving the Grains business (new Graincorp) with no debt and a recently executed derivative contract that ensures positive cash flow each year. With the shares trading in the low $8 range the valuation of the Malt business alone can support most of the share price. The Fund has recently added to its position.

- TPG Telecom shares fell after ACCC announced that the proposed merger of TPG Telecom and Vodafone would be blocked on the grounds that the merger might stifle competition in the mobile phone market. While the Fund had sold part of its position in the strong share price run prior to the announcement, we still had an active position. The ACCC rejected the merger because they felt that TPG would have been a disruptive fourth mobile services provider. TPG’s mobiles business however only envisaged capturing 5% market share and was to offer a data only service in selected suburbs close to the CBD. The companies are challenging the decision and our view is that the merger, if successfully challenged in court later this year, would create a strong third player. With TPG trading in the low to mid $6 range there is very little in the price for the possible merger and the Fund retains a position.

- At the end of the month Link Group provided an earnings update which, at the midpoint of its estimate of this year’s operating profit, was 10% below market estimates. The share price declined by around 30% following the downgrade. This is a disappointing outcome but we believe the stock has over-reacted because, on our estimates, two thirds of the change in earnings were one-off in nature. While the stock may not recover quickly it is now trading at a significant discount to market and remains a high quality diversified business. The Fund has since added to the position.

Looking forward we are more cautious given the elevated market levels and investors’ behaviour but we remain confident in the Fund’s domestic cyclical and agricultural exposures given relative valuations and the general ambivalence of investors towards these sectors. We also continue to avoid stocks that are being priced off revenue multiples (ie: no earnings) or companies that have negative operating cash flows

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