Today’s topics

• State of play and portfolio positioning
• Direct equities valuations and growth

Summary

Our portfolios are positioned defensively, and today we discuss why that is. We look at both the diversified portfolios and our direct equities allocation.

Normally, in our daily notes, we like to show an “iconic graph” of some economic or market variable, and add some bullet points to discuss our thoughts, before moving on. But in the first half of this note we’ll use mainly words to summarise much of our recent writing. That will help keep the note length “readable”, but it is also because the second half of the note has a lot more graphs and worked examples.

Because of that approach please ask us or your adviser for access to prior notes on anything that piques your interest.

State of play

Equity markets fell modestly overnight, with bond yields slightly higher. Commodities remained generally strong across the board, and credit spreads remained exceptionally tight.

Market momentum

Market momentum remains strong, and in our view, is too strong. The graph below depicts the real returns in logs, for Australia and the US, over long periods of time. The basic idea is that the trend line captures the structural drivers of growth, with deviations above or below the set of common factors that produce growth indicating potential over (under) valuation.

In this instance, we feel things are bordering on euphoric.

Recent conversations

We’ve shown (increasingly often, of late!) the

Factor premia/market premia

• Compression in equity risk premia (equities)
• Negative excess bond premia (credit)
• Term premia returning to positive territory (government bonds)
• Fundamental PE models suggesting equities are expensive
• Foreign inflows model (equities, sentiment more broadly)

…and the above market momentum model (which is by far the simplest of those models), all of which suggest that the market is on the expensive side.

Idiosyncratic

We can add euphoric indicators like the

• Establishment of SPACs (blank cheque acquisition vehicles, “whatever you buy is fine with me”)
• The rise of the Robinhood traders (“what did I just buy”)
• Speculative activity in crypto markets (Dogecoin, which is a known joke, by which we mean an actual joke, as in, created in jest for good humour by the authors, with a now-immense ascribed market value)
• Popular investing strategies like ESG creating a mismatch between the value of the manager and the value of the underlying assets
• The bankruptcy of high profile firms (Grensill, Archegos) and the implied mismatch of leverage/credit/counterparty risk and due-diligence

And those bankruptcies are happening with markets at or near all time highs. Normally, that’s the sort of thing that starts to creep out when the cycle has turned.

We can add the macroeconomic pull forward of demand in recent months, including

• Retail sales prints
• Automotive sales prints
• Housing sales/new home sales data

Those are pretty clear cut indicators of data that cannot be sustained, and most market commentators don’t expect them to be, but the share prices of companies and the valuation of equity markets more broadly, seem to imply that they can. We’ll cover this idea in the second half of this note.

We can add the evolution of market narratives to our discussion.

Narratives

Consider that at first, during the darkest days of COVID (Apr-July 2020) and its impacts on the economy, we could constructively argue for higher equity prices (and risky assets more generally) because of very low interest rates and accommodative monetary and fiscal policy. We could also argue that the companies thriving (tech stocks and work-from-home beneficiaries) were big enough and impactful enough to drive the market with their sustained earnings growth.

But now we have the reverse narrative, which is that value stocks are capable of supporting the market, and that higher interest rates reflect the assumed higher growth trajectory for the economy, which supports corporate profits. Ergo the opposite narrative is being used to support still higher valuations.

And, whilst both paragraphs read in a manner that seems perfectly logical, they can’t both be right. Either the market was cheap then or is expensive now.

In our view the addition of a “fresh” narrative to the mix, namely that higher corporate tax rates and prospectively higher wage and input costs will prove deleterious to corporate profit margins, suggests that listed companies should not be automatically assume those economic gains will accrue to them.

Conclusions

Bonds

We expect US yields (10 year treasuries) to eventually reach 2.5%. In the interim, this will be negative for bonds (proportionate to their duration) which is why we are 4% underweight fixed income relative to our strategic weights.

Equity

We expect higher bond yields will negatively impact growth stocks, but also some of the value stocks (like the Banks, as those higher yields move mortgage rates up, which should reduce housing and loan demand).

We expect that the higher yields, in combination with the higher corporate tax rate and the higher input costs (prices, wages), will weigh on equity market returns, which is why we are 4% underweight shares, split relatively evenly across domestic (Australian shares) and international (developed and emerging) equities.

REIT

We expect that the mix of all the above will also weigh on property, as an asset class, but here we are thinking specifically of REITs, which tend to underperform when rates are moving higher (as property is a levered long duration asset). We are 3% underweight.

Growth v Defensive

At the portfolio level this equates to a 7% underweight to growth assets. You might initially think that this doesn’t sound all that large. If the above is even broadly correct, it does suggest that the equity market is vulnerable to near term correction of 15% or more. Wouldn’t a larger underweight make more sense?

We would suggest “possibly”, however the way we manage the peaks and troughs of economic and financial market cycles is gradualism. If the market put on another 5-7% from here, we would likely sell down another 2%, taking our underweight to 9%, and so on. Euphoric markets can be explosive in the later stages of their lifecycles, and you don’t want to get “run over” by the very momentum you initially identified.

The overweights are alternatives and cash, and both will act as funding vehicles during market sell-downs.

Market timing

We should note that the “trying to take some of the froth off the top” approach to portfolio management means that we are likely to lag the benchmark in the interim. That’s another reason for our caution in how much of an underweight we run. Being right, but early, is close enough to being wrong and so it’s a delicate line to walk.

We are comfortable letting some of these exuberant returns go in the interests of preserving capital on the way down, and we will rely on our strategic weights giving us enough of a market exposure to provide acceptable returns in the event that we are wrong.

Direct equities

We mentioned earlier that we wanted to explore this dichotomy between what market participants (fund managers like ourselves, brokers, academics and government officials like the Fed or Treasury) have to say, and what the expectations that are embedded in stocks’ prices themselves have to say.

We’ll look at a few worked examples to try and bring this to life.

Sector performance

Firstly, let’s notice what areas have been performing well.

All you need to know about your equities manager’s recent performance is contained in this chart.

Defensive portfolios will be underperforming the benchmark, namely Utilities, Health, Staples. Cyclical portfolios (Materials, Discretionary, Financials) will be outperforming.

Our diversified investment portfolios, as outlined earlier, are defensively positioned, and, perhaps unsurprisingly, our direct equity portfolios are similarly defensively positioned.

We are long Healthcare, Utilities, Telecos, Industrials (and within Industrials, the boring defensive types like Amcor, as opposed to more cyclical industrials like Reliance). We are also overweight Energy, as part of our “reopening” play, but those weights are comparatively more modest, and in any case, all those sectors are towards the bottom end of the graph.

We will now take a look at some of those outperforming sectors.

Commodities

Pricing

Firstly, we don’t see the below commodity prices as sustainable. High prices are the cure for high prices (as supply reacts and demand contracts). But, we won’t go on about that here, we’ll just re-note our general stance. The key question, do company share prices reflect peak pricing into perpetuity?

Pricing and producers

Well, it sure looks like the share prices of steel and iron ore stocks are almost exactly following the commodity price trajectory. And you might think “well sure, it’s not surprising that they bounce up and down with the price”. But, it is if share prices shouldn’t reflect peak pricing.

WHC is a good example of that concept, where the daily correlation to the commodity price is extremely high, but it doesn’t exactly match size of the move. And that’s because investors doubt (quite rightly!) the sustainability of thermal coal pricing, and accordingly don’t want to pay peak pricing for the commodity producer.

Profits

Let us look at the net income history and forecast for FMG. The cyclical strength is clearly evident in the trailing 12M net income and consensus expectations quite rightly assume that FMG’s earnings will fall away (mean revert) as the iron ore price, currently at around $180/t, declines.

Trajectory

Now consider the following. Let’s extrapolate the current market cap of FMG forward at some acceptable rate of return, here let’s say 7% pa growth rate, for 10 years. We will then divide that market cap by a “market multiple” of say 20x to calculate what the company would need to earn a decade out to justify that share price growth. The red lines in the graph below connect this 10 year future net income number to current earnings, so you can see what kind of “implied earnings trajectory” is embedded in the market price. We take the log of the values for better visibility (exponential growth is represented as a straight line).

That way you can contrast a) actuals, b) street consensus income expectations and c) market implied income expectations.

We’ve got 3 red lines, which use a “market PE of 20x” to deflate the future market cap, and also a “historical PE over the past 5 years” which one hopes is broadly reflective of a typical valuation for the company, and lastly the current PE multiple. That way we’ve got 3 sensible values with which to frame our conversation.

If FMG trades at 20x earnings in 10 years, the trajectory for earnings looks reasonable. But commodity companies don’t tend to trade at 20x. They trade at closer to 15x, which is what the historical and current PEs are telling us.

And that means that FMG needs to maintain net income at peak levels over the next 10 years, to be able to generate a 7% pa return. That looks wildly unrealistic, to our minds.

Retail sales

Just like our US friends, we see Australian retail sales (top left) booming. We know listed retailers (HVN, JBH, NCK) are performing well, but surely they are not extrapolating out peak retail sales into perpetuity in their valuations, are they?

Profits

Well, firstly, here’s the HVN track record of actual net income (trailing 12 months) and the forecast consensus net income.

Note the cyclicality, and note that it matches up with the housing market booms. This makes good sense, you buy a home, you move in, you deck it out with stuff.

COVID was about not being able to buy services (haircuts, music concerts, massage, etc) and hence a bigger share of wallet (with government subsidies to boot) was left over to spend on stuff for the home (gadgets, new couch, new TV, etc). And HVN’s sales and income boomed.

You can see that brokers (the consensus estimates) don’t assume that those peak earnings will remain, and forecast a return to normal. And note that net income hadn’t grown much in the years leading into COVID. Pretty flat, really.

Trajectory

Now let’s perform the same extrapolated earnings analysis (7% total return CAGR). The only way for HVN to meet the implied NPAT trajectory is if you value those 10 year out earnings at 20x.

But HVN doesn’t trade at 20x. Over the past 10 years consensus forward PE multiples have been above 16x for but a moment.

Using those historical averages (and also the current PE) suggest that HVN needs a materially acceleration in earnings growth to justify a return of 7%. And, if they broker consensus forecasts are correct, they will be 3 years behind on that acceleration, because earnings are forecast to fall back to “normal” levels, rather than growing, as they’ll need to to generate an acceptable return.

Hence to our mind, it sure looks like the retailers, just like HVN, are pricing peak sales activity into perpetuity.

We can make a similar case for the Banks, another sector we are underweight, in which current multiples (PEs at upper end of historical highs) are factoring in loan growth that we cannot see (or rather, see as “sustained” at current levels.)

We’ll probably write that up as a separate note, given this one is getting a bit long. But we can’t resist one more example.

PME

Pro Medicus Ltd is a health imaging IT provider. It’s been growing strongly, but the valuation of the stock is immense. We have the PME multiples shown below, a nice array to choose from.

Note what earnings need to do on the chart below to justify a “mature” market multiple of 20x in 10 years. They need to grow by a factor of about 10.

That’s a very tall order.

Mind you, if you want to put it on 100x 10yr NPAT (which is what applying the current PE would do to the earnings trajectory) well, that still looks like a tall order!