Originally published by UBS Asset Management
"Day in, day out, day in, day out Chaos and carnage around me"
— Postman, Living Colour
Key positions were caned for quite minimal reporting season "misses" (as the sell side would say). None were immediate thesis violations. It isn't entirely surprising that some of our favored stocks stumble relative to consensus given our process includes buying stocks that become oversold due to unenduring disappointments. The overwhelmingly thematic driven market of recent years has ensured market darlings have continued to have upgrades extrapolated while neglected and unloved industrials have lagged further.
While capital management announcements by both AMP (AX:AMP) and Suncorp (AX:SUN) disappointed, trading at about a 25% discount to the market on depressed earnings is too much to ignore. We are communicating with both companies and still believe the discount to intrinsic value will close over time. Post results management meetings and discussions over time with a range of players in domestic general insurance continue to highlight the material move higher in pricing. Caltex (AX:CTX) showed what a company, even when facing secular headwinds, can achieve by focusing on its key competencies and exploiting the strategic value of its assets. James Hardie (AX:JHX) has uncharacteristically mis-managed production in the face of strong demand growth. However we expect the path to a sharp improvement in returns to have only been delayed rather than erased.
Underweights were more material detractors in August. These stocks are not remotely on our investment radar. Very few have been discussed during portfolio meetings as even on our extended watch-list. These stocks operate in a range of fundamentally unattractive industries and are generally over-earning compared to what is sustainably normal, yet remain relatively overvalued. The largest impacted included:
Small cap discretionary and staples, including those selling products popular with Chinese consumers (-12 bps)
Mining contractors and smaller miners
(-18 bps)
Bond proxies (-20 bps)
Gold (-21 bps)
What all have in common is thematic momentum. The clearest story revolved around fading confidence in US growth (and inflation) which has seen yields (which determine bond proxy prices) and the US$ retrace. This has spurred metals (including gold which also rose due to geopolitics) prices and relative confidence in emerging markets. These have combined to support the broader mining universe in particular.
This theme has seen speculators along for the ride. The involvement of speculators has recently been highlighted by the Chinese Steel Association itself and by an analysis of trading on the Dalian Commodity Exchange by UBS investment bank. Iron ore futures (remembering China consumes near to 70% of all iron ore) trade on this Chinese exchange and are a material driver of pricing in the space. This analysis showed that retail investors (that is not iron ore consumers like steel companies) comprise over 70% of volumes, the average holding period of these futures is less than 5 hours and 0.004% saw physical delivery. Clearly this market is artificial and has almost no relationship with fundamental supply and demand, yet remains highly influential in determining prices.
Two other stocks that reflect the challenge we've faced over recent years are South32 Ltd (AX:S32) and CSL Ltd (AX:CSL). Since the beginning of the recent mining bull run at the end of 2015, S32 has returned 180%. In the last fiscal year it has returned 94%. During both these periods, it was one of the very best performers amongst all miners. Its attractions have been a strong balance sheet (courtesy of a generous spin-off from BHP Billiton Ltd (AX:BHP)), relatively easy efficiency gains given the businesses were neglected in the larger conglomerate and clean leverage to commodity prices. One slide in their presentation pack however exposed its and the entire sector's true driver.
This shows that despite all the efficiency gains and capital management announcements, without $1.9b in gains from commodity price increases, EBIT of $1.6b would have actually been a loss of almost $250m. Recall that this covers 12 months when commodity prices had already bounced sharply from levels in late 2015. And as we've shown previously, these commodity price moves have been the result of a machination involving massively unexpected demand stimulus and clumsy supply side rationing by the Chinese government.
A recent poll in the US showed that 6 out of 10 Donald Trump voters would not stop supporting him no matter what he did. CSL seems to be the Donald Trump of the Australian share market. Early in 2017, CSL announced an earnings upgrade due to competitors being temporarily out of the market. While this appeared to be a one-off, the share price extrapolated this gain forever and the share price quickly rose about 15%. For a company representing almost 4% of the market, this is a huge move. By the end of the fiscal year the stock had risen another 20%. However when the company reported this month the critical growth outlook guidance included an improvement in its flu business from making losses, thereby forecasting 12–16% growth. Excluding this recovery in flu, the growth in the core business is expected to be almost zero. While either of these growth numbers were materially below consensus expectations (of over 20%) and despite trading on a multiple near 30x, the stock didn't budge and remains up almost 30% this year.
The market is very forgiving of stocks with momentum and a track record of delivery, regardless of the, in some cases, very specific and unsustainable drivers. Unsurprisingly such groups of companies trade at material premiums to intrinsic value. Our portfolio construction and risk management (relative to benchmark and peers) decision regarding these names is how much client capital to sacrifice covering these strategically overvalued stocks. This depends on the level of overearning and overvaluation, and the conviction in other stocks. Right now both are extreme, and for that reason portfolios remain materially underweight bond proxies and mining. While we have always been very aware of the relative risk exposures of our portfolios, we admit being surprised by the continued almost exclusive outperformance of our underweights. However this has clearly been driven by both the inflation of single factors driving earnings and or multiples. This precarious situation will end and our clients will not be exposed when it does.
"Well I hear their shouts and cries
Well I laugh at the gut when they try to surround me
They won't take me alive"
— Postman, Living Colour