Letter to investors by John Abernethy


Looking forward in 2016

To start this letter, we believe it is essential that investors understand the current pricing of equities prevailing in world markets. Generally speaking, equity prices are justified, but there is more to investment decision-making than this.
Our view can be summarised as follows:
Today, it is fairly easy to justify current share prices in both Australia and around the world based on long term bond yields. However, being able to justify the price of an asset is not the same as justifying the purchase of that same asset at current market prices. The sustained period of low bond yields through which we have traversed for the last 5 or so years has resulted in share prices adjusting to a low return price point consistent with a low return cycle.
This letter, like many in the past, reaches a recurrent conclusion – Australian equity investors need to be patient, and remain cautious. For some time, we have asserted that there was no need for portfolios to be fully invested and that cash was an investor’s best ally – whether it be in $A, or more strategically, $US. Recently we foresaw increased market price volatility and suggested that cash was needed to access opportunities to trade markets, even though they do not present as particularly cheap.
To emphasise our view, we present the following charts which show that both the shorter and medium term returns from the Australian equity market have been dominated by yield. However, as we will see below, the performance and returns from the equity market belie the solid underlying growth of our economy.
The long sideways tracking of the Australian market suggests there is a developing opportunity in the Australian equity market. Poor returns from Australian equities will be corrected at some point. That is what free market systems dictate. Ultimately, risk capital must generate a return.
The charts show that the total returns from the Australian equity market, which have averaged just 4% per annum for the last nine years, are well below long term average returns. The Australian equity market over the last 100 years has generated average returns of 7% per annum compound.
The first chart below tracks the market return since late 2006. It compares the “price” return with that of the “accumulation” return (i.e. includes dividends). Over nine years, the Australian equity market has returned 50% and all of this return has come from dividends. The “price” return has been zero.
Market Return Since 2006
Figure 1. Market return since 2006 (June 2006 – May 2016)
Thomson Reuters Datastream
The next chart covers the last 23 months from the end of 2013. It shows that the Australian equity index has produced a capital loss over this period. Over the same period, the accumulation return (which includes dividends) is 3%.
Market return since 2013
Figure 2. Market return since 2013 (December 2013 – May 2016)
Source. Thomson Reuters Datastream
The above charts confirm that there has been no hurry to invest in the Australian share market. Indeed, Australian equities have been a poor investment except for some chaotic trading opportunities in 2007, again in 2012, and more recently the short rally in the March Quarter 2015 that took the market back towards 6000 points. Since April 2015 the ASX All Ordinaries Index has fallen back by some 12% or by about 7% including dividends.

Thinking about equity investment

Today, more than any other period in recent years, we observe that there is a heightened level of fear amongst equity investors. It is a confronting world outlook – with feeble economic growth, the risk of deflation, historic low interest rates, the slowing of rapid growth in China and the omnipresent risk of terrorist attacks. Markets are notably affected by high price volatility.
If you feel fear in the current environment, that is a natural response. Remember it is fear and greed that drive human behaviour in markets. But it is fear that is the dominant force. As Nobel prize-winner Daniel Kahneman says, “We typically fear loss twice as much as we relish success. That’s why it’s so hard to take a risk.” The fear of losing dominates short term thinking.
When fear is both heightened and widespread, it is sensible for an investor to stand back and observe proceedings with a logical eye. If neither logic nor common sense is helpful, then the default investment strategy should be to do nothing and wait.
Equity investment, as opposed to trading, is a long term wealth creation endeavour. It should not be short term focused, where success is measured by correctly guessing what the market thinks today or may do tomorrow. Shares or equities are the issued capital of perpetual entities. Most of the best companies will outlive all of us in some form. Indeed, it is important to understand that the best perpetual entities will invariably change, and their performance will be driven by smart human beings who rise to the top because they have vision and expertise.
Therefore we should not be coerced to believe that companies with fixable problems cannot have those problems fixed. Further, we need to understand that short term problems often present buying opportunities in good companies. Also, we should not be naïve and believe that today’s successes will be endlessly repeatable. That is a function of greed and will lead us to overpay.
Our aim is to invest in companies that have the basis and the attributes to grow for as far as we can see. If they grow, and therefore grow our capital, then they will support our needs into the future. Our investment focus must be long term, for our requirements are long term.

Economic growth and the Australian market

We noted earlier that the Australian equity market has delivered historically poor annual returns over much of the last decade. However, the performance of the index belies the underlying strength of the Australian economy. Further, the strength of the Australian economy is in stark contrast to the poor growth seen across much of the G20 where equity markets have been relatively stronger.
The following charts show the key elements of Australia’s growth – economic production, population, employment and trade. Each chart suggests that Australia has some unique growth characteristics that have not been translated into the performance of the share market.
The first chart plots Australia’s GDP and the market capitalisation of the Australian stock market since 2006. It shows that our GDP has grown from $1.27 trillion (2006) to $1.6 trillion (2015). Over the same period, the Index value has risen from $1.1 trillion to $1.5 trillion.
GDP vs ASX All Ords Market Cap
Figure 3. GDP vs ASX All Ordinaries Market Cap (March 2006 – December 2015 forecast)
Source. Thomson Reuters Datastream; Clime Estimates
A superficial review of the above might suggest that the Australian share market has performed in line with the growth in the Australian economy. It hasn’t: this is because the measure of capitalization includes the value that is generated from capital raisings and new floats. Since 2006, they have been unusually large.
Australian Equity Raisings
Figure 4. Australian Equity Raisings
Sources. RBA, ABS
Today’s index, which sits around 5200, correctly reflects that the Australian share market has not increased in true value (as opposed to size) since late 2006. The net new capital raised by Australian companies since 2006 is estimated at close to $400 billion. Therefore, the lift in market capitalization is totally explained by net new capital raisings.
The increased profit of Australian companies that has translated from the growth in economic activity (GDP) has not resulted in increased valuations. The reason for this is explained by our modelling of Return on Equity (ROE), which shows that many of Australia’s largest companies have generated and continue to generate poor returns on equity.
Simply stated – Australia’s reported higher profits have not meant that our companies have reported higher earnings per share. The heavy capital raisings across the market (since 2007) have diluted earnings per share over the last nine years.

The underlying strength of the Australian economy

Australia’s population and employment growth
There should be no doubt that Australia remains a high-growth, transitioning economy. Sustained economic growth is one measure, but other positive trends are seen in both population and employment growth.
Since 2006, Australia’s population has lifted by 15%, or about 3 million people. This is impressive growth and it translates into growth in demand for services, infrastructure, housing, education and healthcare. The growth in population gives Australia an edge in forecasting that our growth will continue to be higher than that registered across Europe and Japan.
Total Australian Population
Figure 5. Total Australian Population (March 2006 – March 2015)
Source. ABS
The population growth results in growth in demand for goods and services which in turn results in employment growth.
Over the last nine years, Australia’s workforce has grown by 1.8 million people. These people have earned wages which have steadily grown over the period. From their employment has been created both production and consumption – the two essential ingredients of growth.
Total persons employed in Australia
Figure 6. Total persons employed in Australia
Source. ABS
Trade Account and the massive opportunity in tourism
Over the last fifteen years, the world has witnessed the sustained emergence and growth of the Chinese economy. In absolute terms, the industrial development and growth of China is unprecedented in human history. China’s development in 15 years matches that of the USA. The difference is that it has occurred in a third the time.
The benefit for Australia is seen in the growth of our trade volumes. The next chart, which tracks quarterly exports and imports, shows that Australia’s exports have lifted from about $200 billion per annum in 2006 to over $320 billion in 2015. More recently, there has been a decline in $A receipts (per quarter) as our major commodity prices have declined faster than the $A.
Quarterly trade figures
Figure 7. Quarterly trade figures (March 2006 – September 2015)
Source. ABS
The above chart highlights growth in both exports and in imports. The growth in imports reflects 3 key developments:

  1. The import replacement of Australia’s manufactured goods sector. Australia has closed major industries that previously competed with imports of textiles, electrical and automotive;
  2. Australia’s growth in population means we that we are consuming more imports; and
  3. The decline of the $A means we are paying more for imports.

The next chart shows the makeup of our physical exports, and it shows that prior to this year, the growth was driven by industrial commodities (iron ore and coal). The chart shows that Australia’s development of agricultural exports has been extremely disappointing and remains insignificant as a percentage of total exports – a major and ongoing lost opportunity.
Exports by industry
Figure 8. Exports by Industry
Source. ABS
The above trade account charts do not capture a significant move occurring in travel services. In 2014, the tourism deficit recorded by Australia was around $12 billion. That meant that Australians spent $12 billion more in overseas travel than foreign tourists spent in coming to Australia.
The extent of overseas travel, stimulated by a high $A, is shown by this observation: in 2014, some 1 million Australians (nearly 5% of our population) visited Paris. In 2015 about 1 million Chinese (less than 0.1% of their population) will visit Australia.
The opportunity that beckons from inbound tourism from China and the broader Asian region is enormous. Australia is already seeing growth in Chinese tourist numbers of 20% (2015 over 2014). At that rate, Chinese tourism will double in the next 4 years, but still represent just 0.2% of their population. Chinese travellers comprise 16% of inbound tourists and this percentage will swell in coming years.
Monthly Tourist Arrivals
Figure 9. Monthly Tourist Arrivals
Source. ABS
Increased inbound tourism will follow the weaker $A, and the increasing threat of terrorism in Europe. Australia is a unique tourist destination, with a large Asian population and distinctive attractions. The benefits of this trade shift will be felt across the Australian economy, and we expect retail expenditure to lift in 2016.

Some conclusions from the above

In this letter, we have focused more on the opportunity in Australia than on the major issues in Europe and Japan, or the interest rate machinations in the US. As for China, we believe they will continue to stimulate and maintain growth of at least 6% p.a.
Frankly, we believe that the developed world is on a “muddle-through” course. There is so much monetary support for economic growth, and yet, apart from the US, growth continues to be anaemic. The international risk of deflation appears absent in Australia.
We see the inbound tourism tailwind, confronted by resource price headwinds. As for inflation – this is checked for the present by lower energy prices. However, things could change quickly should oil prices rebound or the $A take another leg down due to further growth issues in China.
Our view of world equity markets is as stated up front. Market prices can be justified by low bond yields, but that hardly makes them compelling value. In Australia, the market presents as better value than most overseas markets following the correction from March 2015 to February 2016. Indeed, the fall in share Australia is tracking its own growth trajectory, with some fairly unique economic tail and headwinds. prices since April has lifted the forward yield and this is enhanced by franking.
We make the following forecasts and investment suggestions for 2016:

  1. The weakness in the $A will continue. The benefits of inbound tourism, from a currency perspective, are still significantly outweighed by commodity price weakness;
  2. Australia will not have a growth hit so long as the $A remains well below US$0.80 cents. The weak $A ensures growth in the domestic economy and this will be positive for the Australian equity market;
  3. Australian banks are oversold and represent good value on a 2-3 year view. The recapitalisation of bank balance sheets is 80% complete. They are strong banks, and well-managed and regulated, on an international comparative basis;
  4. Australian retailers are about to enter a period of solid revenue growth. The 2015 Christmas season was reasonable and smart retailers used this period to adjust their working capital. The retail sector is excessively shorted by hedge funds. However, the weakness in the $A suggests that capital employed by retailers will rise by mid-2016, and margin pressures could develop;
  5. The building sector is experiencing the highest levels of residential construction in a decade. In some respects, this is a catch-up. Arguably, the market has fully factored in this cycle and most builders present as fair value;
  6. The resources sector has been battered by very weak commodity and energy prices. This is a result of the substantial lift in production that flowed from high prices. The adjustment of commodity markets’ “supply/demand” mix will not be complete for at least a couple of years. Therefore, major resource companies must be considered as trades against sentiment, rather than fundamental investment opportunities;
  7. There are some unique growth opportunities in the Australian small-cap sector flowing from Chinese trade development. However, in the main, these companies do not present as value and the risk of disappointment is high;
  8. The Australian property market has been buoyed by international buying interest. This has flowed through to valuations and trading in listed property securities. History suggests that after a sustained re-rating, a cooling period follows. Listed property securities do not present as compelling value at present and we see better value in unlisted property trusts – however investors here need to be patient;
  9. The perverse effects of excessive shorting in the Australian equity market could result in a sizeable rally at some point. This will not be value-based, but a function of a market that is dominated by short term thinking and activity; and
  10. There will be an X-factor that we haven’t listed above – something unexpected. That is the nature of investing in uncertain markets. And yet, provided one invests sensibly and has an appropriate time horizon, the rewards will come. In due course.

Last updated May 2016.
Read the Q2 Letter to Investors – ‘Investing in Volatile Markets’ to see how our calls went.