Sept 2022 Quarterly Update

October 20, 2022
Investment Updates

We continue to apply our process of focussing on attractive valuations, balance sheet strength, durable cash flows, proven management and of course very strong sustainability credentials. Given the ongoing capital market volatility, combined with an increasingly opaque economic outlook, we feel this will continue to serve the fund well.

Reporting Season: Balance Sheets to the Fore

We have long considered ‘reporting season’ as a litmus test for our understanding of a business' earnings profile, as well as opportunities and risks, and the August 2022 reporting seasons was no different. The fund outperformed during reporting season led by key overweight positions delivering pleasing results, including Qualitas, Pinnacle, McMillan Shakespeare, Super Retail and A2. Our process is driven around bottom up research and stock picking and we note since the inception of the Ethical Partners Australian Share Fund (EPASF) we have performed in line or better than the market in 8 out of 9 reporting seasons up to and including August 2022. Perhaps the key theme in our view from the reporting season period was the role of capital management. We wrote in the June 2022 Quarterly about the importance of balance sheet strength in our process and furthermore noted that the rise of funding costs had yet to permeate through the broader market. Whilst this still looks to be in its infancy as a concern for Mr Market we did see some interesting trends emerge as a tailwind for our portfolio, particularly through August, driven by capital management.

A number of our better performing positions during the period were those with strong balance sheets and solid business models that were able to deploy excess capital to bolster shareholder returns. Some examples include McMillan Shakespeare, which announced a significant capital return and a fully franked off market buyback,  A2 Milk announced an on market buyback during the August results, whilst Australian Clinical Labs announced a 41cps Fully Franked Dividend (which was akin to almost 10% of the Share price at the time). We will continue to prioritise strong balance sheets as our process demands and we expect this to remain a tailwind for performance over the period ahead.

Bear Markets & BHP

By no means here are we picking on the "Big Australian" but we note as a well held business on the ASX, with a weighting of over 10% of our benchmark, we think it is important to consider how BHP has historically behaved during tougher markets (the fund has no position in BHP). The conclusion is somewhat obvious but we feel this risk is being overlooked at the current juncture, BHP being a global growth proxy and price taker is a late stage cyclical and typically underperforms the broader market in the second half of bear markets, at the point where economic downturns shift from fear to reality. Below we consider the most recent 3 bear markets (excluding COVID given how short and sharp the sell-off was):

1.     GFC. Over the first 6 months of the bear market BHP outperformed the broader market by 12%. Over the subsequent 6 months BHP lagged the market by a similar quantum.

2.     2011. Over the first half of this sell off (broadly 7 months), BHP outperformed the broader market by 2% but, then lagged for the following 7 months and didn’t actually trough until 10 months after the broader market.

3.     2015. Over the first 6 months of this bear market BHP beat the index by 0.5%, but, as the Yuan devaluation and global growth concerns gathered pace BHP again underperformed in the second half of the bear market, lagging the index by 30%.

Turning to today, over the first 9 months of CY22 to the end of September, BHP has outperformed the falling market by almost 20%, just as the Yuan looks to be under pressure and global growth concerns start to play out. Based on our investment process we do not see through the cycle value or an attractive risk/reward equation in the resources sector at present. In the above analysis BHP can be viewed as a proxy for the broader resource sector, and we see significant risk of the above pattern again playing out and are positioned accordingly, being underweight Resources at the current time, with the majority of the sector trading above our through the cycle valuations.

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