Commodities and SAA

Today’s topics

• Commodities (resource scarcity)
• REIT’s
• Iress (IRE)
• PEXA

Commodities (resource scarcity)

Earlier in the month we travelled to WA, to see clients and to present to end clients on our portfolio positioning and investment strategy.

Being WA, many questions were commodity centric, and we were pressed on why we aren’t materially long commodities given that a) high prices meant strong cashflows and dividends, which are self-evidently desirable attributes, and that b) the future of renewables meant a pretty clear structural demand for nickel, copper, cobalt, lithium (all the metals that go into electric vehicles, and windfarms, for example).

As such, our underweights, and firm conviction that high prices will be short lived, surprised.

Now we’ve tabled many graphs of a multitude of commodity prices, but, the below one is instructive for several reasons.

One, note that after a century of fairly accurate record keeping, commodity prices, in aggregate, are more or less at the same level as over a century ago.

That is a fairly modest real return, and vastly inferior to bonds, equities, and property.

You’ll also note that the volatility is fairly extraordinary.

As such the risk adjusted return from commodities, is not especially desirable.

So we’ve made a long run top down SAA-ish point against commodities. Trading profits, sure, but buy and hold, not so much.

But why is this way? Surely commodities, being finite, have a production peak that eventually means more scarcity, matched against rising demand, that should lead to higher prices. This is exactly what the electric vehicle / renewable energy transition argument is about – finite copper, finite lithium, increasing demand.

And the answer lies in human ingenuity. Just as advances in technology like horizontal drilling and hydraulic fracking rendered enormous amounts of previously uneconomic oil and shale reserves suddenly profitable, exploration and development of reserves in copper have kept pace with demand.

And this will very likely prove true for cobalt, nickel, lithium.

3 times in my career now I’ve stared down the barrel of an uncomfortable underweight to commodities, and twice previously emerged unscathed, and so we think it will be again on this 3rd occasion.

Note in particular the reserve estimate increase for Lithium, 518%, over the past 20 years. Rare earths are neither rare, nor located in especially difficult regions to mine.

You might say “well, why not attempt to market time the commodities more”. And the reason is because commodity downturns can last a decade or more, and that’s a long time to park capital if you are wrong.

But even that response isn’t quite fulsome enough. Because we do have some structural commodity exposure. Around 10% of the fund is in commodities, namely Alumina and BHP. We’ve not sold our BHP either, because it’s in there as a portfolio hedge. We’ve kind of hung on to it with our fingertips, given the enormous rally in both the share price and the specific mix of commodities that BHP produces.

That answer too doesn’t quite capture the full dynamic, as we are making a market timing call on the price of oil, for example, by noting a) that we think oil will likely settle somewhere near the ~$60/bbl mark, and that the listed Australian oil producers don’t reflect that level of spot pricing, and are thus cheap.

And of course none of that quite feels satisfying either, because the materials weight in the benchmark is closer to 20%, and as such 10% is quite an underweight.

REITs

This week we exited our position in SCP (Shopping Centres Australasia), viewing the stock as close to fully valued, and we’ve done so on the back of generally very good news across the REIT sector.

That news is the better than expected property valuations across both office and retail, where office booked modest increases to book value (Dexus +2.3%), and retail modest losses (Vicinity ~-1.2%). Both instances were above market expectations, and are a function of the reasonably robust net renewals rates, leasing spreads, and net absorption in the market.

The REIT’s are a reasonably priced defensive play, in our portfolio, with some additional upside to the ongoing normalisation in the economy (albeit periodically plagued by lockdowns).

Iress (IRE) [and ALU, CWN]

IRESS was a stock we farewelled, with the takeover interest of EQT first evident in the prior week hoovering of shares by Barrenjoey at a 30% premium to VWAP.

We now have no tech exposure in the portfolio, as we exited Altium (ALU) on the back of the tabled takeover by Autodesk.

There are no other tech names that are interesting to our process, at present, as we deem them all as extremely expensive.

Still, it is pleasing that we’ve had 3 names in our portfolio (CWN, ALU, IRE) find corporate interest, although it is perhaps less pleasing to give up some secular growth exposure.

PEXA

We were asked earlier in the week to table some thoughts on PEXA, which we share below, edited lightly.

Certainly interesting, at one stage we almost bought LNK to get access to the PEXA business, but couldn’t get comfort around the remainder of LNK’s assets. PEXA was valued at the time at around $2bn, and is now north of $3bn. In a way, that’s the totality of our view, a good asset, one we wanted to own, but at this price we’d have been selling our position, rather than looking to own it now.

Execution risk around the UK is going to be key – the Aussie business is excellent and well understood, however in our view, at 30x EBITDA the market doesn’t fully compensate the marginal buyer for that risk. Nor does it fully compensate for a slowdown in underlying housing activity. Usually, an IPO is designed to monetise enthusiastic market conditions, and is often associated with peak revenues coinciding with peak valuations. Conditions for AU & UK housing could convincingly be described as “enthusiastic”.

Key takeaways:

• Universally well regarded quality digital conveyancing & settlements solution
• First mover advantage and now incumbent monopolist in Aus
• Market saturation locally (80% share) • Opportunity is to replicate the business model internationally
• Loss making until recently, so no long track record of continuous profitability
• 30x EBITDA, 13x Revenue is quite expensive

PEXA has been chased for quite some time now, by various private equity firms, by Domain, and even a consortium attempt by CBA. Lots of eyes have been over it, and been keen to move forward with it. It comes to an end now with the IPO, although even within that, there is some good news. PEXA tried to float a while back, and had pro’forma numbers that it subsequently went on to beat. So, although it didn’t get up at that time, it created a strong sense of credibility with the market.

Key operating stats:

PEXA, being a cloud based digital business, is tabled as a SaaS business, with material operating leverage (as a platform, incremental costs are negligible, and hence top line growth flows pretty directly to the bottom line).

…and hence the SaaS like multiple (highlighted below, 13.4x revenues, 30.8x EBITDA).

Very much worth keeping the idea in mind that if interest rates start to go back up, secular growth stories on high valuations tend to underperform. The rates going up aspect also has a lead back into the business by slowing housing turnover, and hence digital volumes.