by Andrew Fleming – Deputy Head of Australian Equities
Changes to the banking status quo
The big four may need to be renamed. For so long, the titans of finance in Australia, Macquarie has now overtaken both ANZ and Westpac in market cap. CBA is now larger than the market value of ANZ and Westpac combined despite having the lowest forecast growth in underlying earnings through the next several years and only a marginally higher return on equity profile. The sector has been under earnings pressure for some years, with revenues peaking five years ago and costs proving resistant to persistent attempts at moderation. Interestingly, revenues have plateaued despite mortgage loan to income ratios continuing to rise 30% through that time to 6.5 times currently, well above the levels of any comparable country. This will place a brake upon volumes, and in turn, that change in supply and demand is likely to continue to pressure net interest margins. Sticky costs are spawned more through ineptitude than under investment – in the past decade the sector has capitalised almost $30b in software and implementation expenditure, and in return, shareholders have received systems which struggle to determine which loans are interest only. Through the past year, however, despite earnings and commercial challenges, the sector outperformed the market materially, as reported profits grew, reflecting an unwind of ultimately unneeded bad debt provisions built up two years ago with the emergence of Covid. This outperformance was disproportionately led by CBA and our positioning – most underweight CBA – has hence proven a drag on our relative performance. Through the past month, however, as the ephemeral benefit from the Covid provision unwind fades, and ongoing margin pressures have again been reported and redirected the market’s attention to the attendant revenue pressures, CBA and the sector’s performance has again come under pressure.
If success has a thousand Fathers (and Mothers), failure remains an orphan. Polynovo had been a stellar market performer through recent years, seeing the market cap peaking at circa $3b a year ago, just after revenues were reported at $20m with the prospect of great growth ahead. It eventuated; revenues grew 50% last year and are forecast to grow a further 50% this year, and then again next year, notwithstanding delays in adoption of Polynovo’s skin regeneration medicines in the US (attributed to Covid). Alas, market expectations were even greater still, and in turn, the share price has declined circa 70% from the highs of a year ago and went further lower through the past month following the resignation of the Managing Director Paul Brennan, which the company attributed to “… increasing differences with the Board in relation to Paul’s interaction with the company’s senior management team and his management style …”. Which is not a lot different to the announcement by Bapcor that “… a marked deterioration in the relationship between the Board and the CEO …” saw the immediate exit of their CEO. It is noticeable that as market prices for more speculative stocks on the ASX has started to unwind through the past year, those making an organically driven profit but which had been bid to aggressively high multiples requiring implausible growth in cashflows, have been subject to the most selling pressure as those lofty expectations have met (the disappointing) reality. The mooted acquisition by CSL of Vifor is interesting in this context, given the high multiple CSL continues to trade at despite some retraction of relative performance through the past year.
Product and service price changes across the market are material, accelerating and often critical just to hold margin. A waste company has recently increased prices circa 10% and yet doesn’t expect margins to expand (and received very little customer push back, let alone market share loss, as a consequence). Cleanaway is in the throes of acquiring assets from Suez in Australia, and Suez and Veolia globally are merging, meaning that the concentrated waste industry in Australia will soon see the three largest players reduce to two. Pricing power will be augmented once those transactions are completed, reinforcing the attractive characteristics of economically defensive revenues with pricing power attributable to the sector. Brambles have also spoken to increasing prices materially, up to 10%, but again without seeing material margin benefit, reflecting input cost pressures. James Hardie is likewise increasing prices materially without markedly increasing their very high margins. Banks have increased fixed rate prices four times through the past month; and insurance premiums are increasing as well. A more recent sleeper in terms of price changes is the Chemicals sector, where a new CEO is leading a new philosophy on pricing at Orica, after his predecessor had brought the “volume over value” mantra that might be expected of someone with a mining background to the role. Management at both Orica and IPL are now talking to the need for pricing to be restored to reflect a premium to be paid for domestic production, and their willingness to walk from volume if required prices are not able to be achieved. Healthcare as a sector has performed relatively best through recent years when product prices were increasing at a faster rate than prices for other goods and services; it is little surprise that as price changes have broadened across sectors through the past year, the spread between the relative performance of sectors across the market has become less extreme.
Energy has been the sector through the past quarter where price changes have been arguably most pronounced and impactful upon the market. At a direct level, the energy stocks have benefited from rising oil and gas prices. Further, given its fertiliser business effectively manufactures and distributes solid gas, Incitec has seen its share price also recover through recent months. At a broader level, the tight correlation between the Chinese producer price index and the US consumer price index has held as energy costs have risen, driving the Chinese PPI higher and in turn, taking consumer inflation in the US and elsewhere with it. As the world migrates to a lower carbon world, it is difficult to see the inflationary impact of the energy transition not continuing to place upward pressure on producer and hence consumer prices.
We continue to be most overweight the Mining sector and its long life, low cost, lowly geared constituents, albeit at levels well below where we were a year ago, and the Chemicals and Industrials sectors, and we are still most underweight consumer banks, consumer discretionary and Health care stocks. Performance in the past year has come from most of these positions, but offset by some poorly performing Industrial stocks such as Lendlease, Brambles, and Worley, all of which are retained in the portfolios as operating performance is improving and multiples remain undemanding. The transition in energy is co-inciding with the transition from a deflationary to an inflationary environment; there is no doubt the energy transition driven by decarbonisation will be ongoing, and we suspect the attendant price pressures this causes will be ongoing as well.
The Schroder Australian Equity Fund invests in a broad range of companies from Australia and New Zealand, and aims to outperform the S&P/ASX 200 Accumulation Index after fees over the medium to long term.