September 2018

Overall State of the Australian Equity Market

The Aug 2018 Reporting Season overall was relatively disappointing, with a balance of misses, when looking at the ratio of upgrades to downgrades – with 28 upgrades and 53 downgrades.

Domestic Cyclical and Defensive stocks were particularly disappointing, with a strong tilt to downgrades. Financials were also unsurprisingly weak, given the domestic macro backdrop of weaker house prices, slowing credit growth, and weak wage growth.

Structural Growth had a few bright spots, as did Resources, though reporting season tends not to matter as much as spot commodities for these stocks.

Looking ahead there are a number of macro headwinds seemingly converging on Australian equities that leave us a little mixed on domestic equities certainly, and incrementally favouring fixed income in this asset market.

Financials

The big story is Westpac lifting mortgage rates on its residential mortgage book. This is a de-facto rate rise for Australian households, which all but negates any requirement for the RBA to lift rates in lockstep with the Fed. Lower for longer in terms of the base rate seems to be the order of the day for the Australian cash rate.

House prices is an area of concern for domestic investors. Resonant’s view is more of a gradual dribble down in real terms, rather than an outright collapse, given reasonable population growth and a lack of
supply in urban areas in particular.

In Asset Management, results were a little downbeat, as the industry grapples with margin squeeze, index investing, and the persistent low returns delivered by hedge funds and alternatives. In addition, potential regulatory change looms large.

Insurance had pockets of success, though we note the initial enthusiasm around expanding insurance margins when Suncorp published results was quickly dampened when other equivalents such as IAG failed to follow through. Notably though QBE announced earnings above expectations.

Resources & Emerging Market Sentiment

The continued struggles (real and perceived in some cases) in Emerging markets in the face of protracted US Dollar strength, continues to weigh on our Resources sector, through the risk preferences of investors, firstly, and secondly their perspective on what this might mean for Emerging Market driven demand for our raw materials.

Resonant remains constructive on certain select Resources names, without being aggressively positioned one way or another on the sector overall. We also believe that many of the US Dollar related headwinds are coming to a conclusion. Our sense is that while select problems exist in certain jurisdictions (Turkey, Argentina, and to a lesser extent South Africa & Brazil), the exposure elsewhere is nothing like the Asian financial crisis for instance, so repercussions should be limited. In addition, we feel that US inflation is less likely to spike than some commentators would suggest, so we actually think rates may not shift as aggressively as the market is anticipating, and US Treasury bond yields could come off.

In terms of specific names three stocks to struggle over reporting season are Origin, Rio Tinto and Fortescue Metals. Origin’s performance relates to a dampening of expectations around 2019 earnings, and a very specific earnings quality issue, while Fortescue is a function of the grade of Iron Ore they currently export and the increasing discount this product fetches on the market.

Technology Disruptors

Perhaps the greatest theme of our age is the earnings potential of technology and software. Software solutions, particularly in recent years, have become cost effective to the point that integrating these solutions into your business becomes a mandatory proposition. For equity investors, it is more of a case of gauging fair value for these high margin, high profitability businesses, and at what point we start to trim these names in the face of stratospheric valuations. Some examples of stocks that have performed strongly in reporting season include WiseTech (WTC, logistics management software), Appen (APX, language and social technology for companies), Altium (ALU, printed circuit board design).

Stratospheric valuations are justified in terms of the potential for these businesses to 1) bolt on earnings through acquisition 2) be acquired themselves 3) grow their revenues on a relatively fixed cost base to hit the bottom line directly.

That said, Resonant is weary of overpaying at this mature stage for Australian tech names, even though fundamentally we like the story and we see significant upside to margins and earnings as adoption of software solutions becomes essential for cost management.

Telstra and Telcos

Changes in the competitive structure of the Telcos sector has been a key development.

Telstra’s result was in line, no better, but the stock has rallied on the back of the actions of TPG, in securing a merger with Vodaphone Australia, which investors speculated would mean the end of the aggressive price competition in the mobile market.

We remain skeptical. TPG’s CEO has never been conventional or predictable in his approach, and it would seem unlikely that he would settle on a cozy oligopoly in the medium term. Telstra’s earnings profile is ugly looking forwards as the NBN roll out continues, and regardless of today’s yield, looks horrible in tomorrow’s yield. We think this looks unlikely to change dramatically in the future.

“Quality” Stocks

Quality stocks were the big winner this reporting season. This would appear at odds with the performance of low Volatility strategies, which have fared terribly. What this suggests is that when seeking out defensive assets, investors have sought out fundamentals (stable earnings, revenues & ROEs, low earnings accruals, strong balance sheets) rather than technicals in assessing the ability of the company to withstand a tougher equity market environment.