INVESTMENTS | Market COMMENTARY
Domestic equities: A focus on fundamentals
“In the short run the market is a voting machine but in the long run it is a weighing machine.” – Benjamin Graham
25 July 2022
The recent rise in bond yields has made for a difficult environment for equity investors and a reminder of the inherent volatility in share markets. This is why we adopt a patient approach to our equity market investments and focus on long-term fundamentals.
When markets are falling, it is very easy to become backward-looking and reactive, to the ultimate detriment of investors. Tell-tale signs are when asset managers let portfolios drift from their established principles and processes in response to short-term market noise. There are some signs of this now in the ESG investment community, with growing accusations of greenwashing and proliferation of products that don’t always meet investor expectations. Having a singular focus on ethical investing, guided by our Ethical Charter provides a stable lens through which we view the world.
However, the Ethical Charter alone can’t do the work of building successful portfolios – we rely on robust investment processes and an experienced team of investment professionals to pick the best opportunities from our ethically-screened universe. Nonetheless, our portfolios’ short-term performance has not been immune from the broader market pressure. Many of the better-performing ASX companies over the year were in the carbon intensive resource sector which we are underweight, while our long-term overweight to smaller innovative companies has detracted from recent returns. Another way of stating this is that markets are currently ‘voting’ for resources and against smaller growth-oriented companies.
Having a singular focus on ethical investing, guided by our Ethical Charter provides a stable lens through which to view the world.
Fund positioning and current themes
The rationale for avoiding fossil fuel companies and non-renewable resources requires little explanation – it is core to our beliefs. Ethical investing differs from some ESG approaches by explicitly incorporating ethical beliefs and purpose into the investment decision-making process. ESG focuses less on beliefs and often references the concept of risk to justify decisions in sectors or stocks that we fundamentally wouldn’t invest in because of their detrimental and sometimes irreversible impact on planet, people and animals.
One of the issues with the ESG approach is that it leaves the door open to investing in things like coal and tobacco should the fund manager change their risk-return assessment - a position often at odds with the ethical beliefs of the end investor. For this reason, we try to be as upfront and transparent as we can about what we will and won’t invest in. Sometimes these positions put us at odds with market sentiment, however, we have found over time and throughout market cycles that fundamentals prevail and we have not compromised long-term returns for ethics.
When we look across our funds’ one-year performance, we find our funds with greater large-cap exposure have outperformed those with greater smaller-cap exposure. Our exposure to smaller capitalisation stocks differs by fund; our Emerging Companies Fund invests exclusively outside the ASX100, our Australian Shares Fund is broadly invested across market caps typically 60% ex 100 weighted (inc. NZ), while our newly launched High Conviction Fund is more oriented towards established mid and larger capitalisation companies.
While small caps have underperformed over the year, historically our ethical approach pushes us outside of Australia’s largest companies and we have found some of our best value adding opportunities through focusing on this part of the market and in sectors such as healthcare, information technology and renewables.
Ethical investing differs from some ESG approaches by explicitly incorporating ethical beliefs and purpose into the investment decision-making process.
Weighing up long-term returns
It’s the reality of equities investing that long-term performance is accompanied by short-term volatility, including the potential for negative returns. This volatility, or risk, can be thought of as the price for receiving typically more attractive returns compared with cash over the long-term. Below we compare the performance of our flagship Australian Shares Fund (Wholesale) over several time periods with its benchmark, the ASX300 Accumulation Index.
| AS AT 30 JUNE 2022* | AUSTRALIAN SHARES FUND (WHOLESALE) | S&P/ASX 300 ACCUMULATION ^^ |
|---|---|---|
| 3 MONTHS | -18.0% | -12.2% |
| 1 YEAR P.A. | -17.3 | -6.8% |
| 2 YEARS P.A. | 8.8 | 9.4% |
| 3 YEARS P.A. | 6.8% | 3.4% |
| 5 YEARS P.A. | 7.9% | 6.8% |
| 10 YEARS P.A. | 12.7% | 9.1% |
| SINCE INCEPTION P.A.^ | 12.4% | 9.1% |
^Inception Date (Wholesale): 23/01/2012.
^^ Benchmark is composite S&P/ASX Small Industrials Accumulation Index until 12 August 2019 and S&P/ASX 300 Accumulation Index thereafter.
Even after absorbing the disappointing returns of this year, investors who had placed their money in the Fund, 2, 3, 5, 7 or 10 years ago would have received attractive absolute rates of return. Furthermore, in a relative sense, for any investment period greater than 3 years, investors would have received a superior return to the ASX300 Accumulation Index.
This analysis of course obscures the peaks and troughs along the way - the shorter-term intervals when returns were disappointing.
Whilst we typically expect a higher degree of volatility from investing in smaller capitalisation companies, through deep research over time we have been able to identify highly attractive opportunities that have delivered returns well in excess of the broader market.
The outlook for small caps
As shorter-term investors head for the exits, we are seeing attractive opportunities in the smaller capitalisation part of the market. After trading at premiums for much of this decade, small industrials are once again trading at discounts to large industrial companies, making this a buying opportunity for investors with specialist expertise in this part of the market.
Focusing on the technology sector, a wide gap has opened up between the multiples for large and smaller capitalisation technology companies. As fundamental investors, we’ve struggled for some time with the valuations applied to larger cap technology companies in Australia and have largely avoided this part of the market in recent years.
IT valuations
When we look at smaller cap technology companies, we think it pays to be selective and we are looking for useful products with recurring earnings, attractive returns on investment and scale or customer advantages. Apart from the ethical issues involved, we remain unconvinced of the economics of buy now-pay later companies, which appear to be highly capital intensive and untested over a full credit cycle. Neither have we been attracted to the economics of pure play eCommerce in niche markets or lumpy hardware revenue streams. The sell-off in these kinds of companies seems to be justified where there isn’t evidence or at least tangible progress towards a sustainable business model.
On the other hand, smaller cap software and marketplace companies with value-adding products have many of the attributes we seek and some of these are currently available at historically attractive valuations with well-funded balance sheets. For example, billing software provider Gentrack has a currently depressed margin but a history of positive free cashflow generation. With over NZ$100m of revenue, it should be capable of generating a 20% EBITDA margin - yet it trades at with a market cap of around only NZ$150m.
Smaller cap software and marketplace companies with value-adding products have many of the attributes we seek.
Resources and inflation hedges
Top-down concern about inflation has been one of the dominant influences on recent markets and driven significant divergences between sectors, most notably in favour of resource-oriented companies which are seen as a hedge against inflation. However, as the current inflationary environment evolves, we should expect a more nuanced ‘weighing’ of the fundamentals of companies and sectors to drive their values.
While resources have benefited from initial concerns over inflation, some of this has been factored into their share prices already. In terms of the underlying commodities, it is often said that the ‘cure to high prices is high prices’. Current very high rates of return on equity in the mining sector, in particular, seem unlikely to be sustainable in a slowing growth scenario.
As the current inflationary environment evolves, we should expect a more nuanced ‘weighing’ of the fundamentals of companies and sectors to drive their values.
Over the long-term, high commodity prices also incentivise additional supply - or in the case of fossil fuels, they can help to accelerate the development of green alternatives. Some of these companies, such as NZ renewable energy providers, have underperformed as the market views them as more akin to bonds, which are worth less in a rising interest rate environment. But we think the opposite: companies we hold in our funds, like Contact Energy, Meridian and Mercury, benefit from increasing energy prices, have relatively stable cost bases and a significant opportunity to re-invest for growth in new sources of renewable power.
The insurance sector also stands out to us as attractively valued, with revenues that are relatively defensive to a slowing economy and an inflationary environment. As interest rates rise, insurers receive an enhanced return on their invested capital, whilst higher rates also decrease present value of their future liabilities. Our Australian Shares Fund has positions in both Suncorp and IAG, which we expect to benefit from these trends.
Equities outlook
At the time of writing, Australian equities have corrected to levels which lead us to deploy some of our cash holdings into selectively attractive situations based on our fundamental investment process, and overall returns to Australian equity investors from here look fair to us relative to other asset classes. As the market moves from ‘voting’ to ‘weighing’, we expect less influence from top-down macro trends and more focus on the fundamentals of individual companies. And if economic growth falters, we see our portfolios being positioned relatively defensively in companies that offer productive goods and services in a sustainable fashion.
Mike Murray, Head of Domestic Equities
*Total returns are calculated using the sell (exit) price, net of management fees and gross of tax as if distributions of income have been reinvested at the actual distribution reinvestment price. The actual returns received by an investor will depend on the timing, buy and exit prices of individual transactions. Return of capital and the performance of your investment in the fund are not guaranteed. Past performance is not a reliable indicator of future performance. Figures showing a period of less than one year have not been adjusted to show an annual total return. Figures for periods of greater than one year are on a per annum compound basis. The current benchmark may not have been the benchmark over all periods shown in the above chart and tables. The calculation of the benchmark performance links the performance of previous benchmarks and the current benchmark over the relevant time periods.
This commentary may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, Australian Ethical accepts no responsibility for the accuracy or completeness of, nor does it endorse any such third party material. To the maximum extent permitted by law, we intend by this notice to exclude liability for this third party material.