Quarterly Investor Letter - September 2018
Over the September Quarter developed equity markets remained in a sanguine mood, despite the escalation of a myriad of geo-political challenges. Buoyed by a robust US economy and a company reporting season that delivered earnings growth broadly in line with market expectations, the Australian share market recorded another quarter of positive returns.
A heightened consciousness of regulatory risk is playing a greater role in re-shaping our investment portfolios. A maelstrom of regulatory risk is encroaching on the banking, energy and health care sectors. Our portfolios remain underweight in financial services, regulated energy markets, and to the providers of healthcare services in the aged care and private health sectors.
This mercurial political landscape has largely contributed to a dysfunctional national energy market, whereby neither climate change nor investment
considerations are being adequately addressed.
The Blended Australian Equity Portfolio finished the September Quarter up 5.55% (including franking credits) compared to the ASX 200 Accumulation Index up 1.53%. The major positive contributors to the investment performance were Brambles (BXB), Washington H. Soul Pattinson (SOL), Nearmap (NEA) and Cleanaway Waste Management (CWY). The main detractors to performance were News Corporation (NWS), Adelaide
Brighton (ABC), and Origin Energy (ORG), which was divested during the quarter. The investment performance was also constrained by a cash weighting of c18%, as valuations remain broadly elevated and finding value in an absolute sense remains challenging.
The Blended Australian Equities Portfolio commenced investing in February 2014. Since its inception, the portfolio has achieved a compound annual return of 12.48% (including franking credits) compared to the ASX 200 Accumulation Index of 7.79%.
Over the September Quarter we actively changed our exposure to the energy sector. We exited Origin Energy, having already reduced the position during July. The FY18 result was in line with guidance but the outlook for FY19 disappointed because Origin will absorb the impact of rising NSW wholesale electricity prices rather than pass these on to consumers at a cost of $80m. This is a decision based on the increasingly hostile political and regulatory environment, with both sides of parliament competing to reduce costs to consumers and in the process damage retailer returns.
Our energy exposure has decisively tilted toward companies unconstrained by regulatory intervention. As such, we purchased Cooper Energy and Senex that are well placed to supply uncontracted gas to the east coast gas markets.
Cooper Energy is expected to grow its revenues from $67.5m in FY18 to more than $300m in FY20, with production from the Sole field in the Gippsland Basin, followed by its Mantra development. Senex is developing the Atlas project in Queensland which is in a well-defined area surrounded by LNG export projects. Senex’s revenues are expected to grow from FY18 $73.1m to more than $200m in FY20. Our decision to own both companies is to diversify the risk of project timing and completion and to aggregate a position in the major sources of new domestic gas supply for the east coast in the near term and out to the mid-2020’s. Importantly, these companies are not integrated electricity retailers nor LNG exporters, so they are not the focus of political regulatory scrutiny while they are adding to the domestic gas supply.
The Australian Income Portfolio finished the September Quarter up 4.43% (including franking credits) compared to the ASX 200 Accumulation Index up 1.53%. The major positive contributors to the investment performance were Washington H. Soul Pattinson (SOL), Brambles (BXB), Qube Holdings (QUB), and Coca-Cola Amatil (CCL). The main detractors to performance were Adelaide Brighton (ABC), IAG, and Caltex (CTX). The
investment performance was also constrained by a cash weighting of c.14%, as valuations remain broadly elevated and finding value in an absolute sense remains challenging.
The Australian Income Portfolio commenced investing in May 2014. Since its inception, the portfolio has a compound annual return of 10.93% (including franking credits) compared to the ASX 200 Accumulation Index of 7.65%.
During the Quarter the Australian Income Portfolio added to its positions in Caltex and Woolworths. Both stocks were “sold off” after they announced their FY18 results, which provided an opportunity to build our positions in companies which we believe offer long term attractive investment metrics.
Woolworths recent share price weakness can be attributed to a mildly softer than expected FY18 result (Big W) and slower 1H19 sales growth in its Australian Food division (c.70% of Group EBIT).
Interestingly, the transition of phasing out single use plastic bags has been problematic for the major supermarkets, as consumers purchased fewer items per basket. Nevertheless, based on similar programs executed by supermarkets internationally, we expect this to be a temporary adjustment.
Holistically, our investment thesis in Woolworths is supported by the likelihood of further capital management. WOW recently announced a 10-cent special dividend and a successful divestment of both its pubs investment in ALH Group and its petrol sites business should underpin further capital management initiatives.
The Caltex 1H18 profit of $296m was a record result but at the lower end of guidance due to a weaker than expected refiner margin in June. However, the decline in the share price was driven by disappointment in the lack of restructuring to enable the return of the company’s significant franking credit balance to shareholders.
The strategic review resulted in plans to “explore” forming a partnership with a property
company and the ultimate sale of 15-25% of the site portfolio which is valued at c.$2bn. Whilst acknowledging this as a positive first step, its quantum was underwhelming. It may, however require greater investor activism to realise this value. Unambiguously, we see potential strategic value in the company’s assets and took advantage of the share price reaction.
As the Australian equity market is close to decade highs finding value in an absolute sense is proving to be challenging. Hence, at this point in the equity market cycle we are increasingly looking for stock ideas with a value bias. Our portfolios are weighted toward companies that provide a “margin of safety” either through holding companies that have already rebased their returns to more sustainable levels (Brambles, Coca-Cola Amatil, QBE & Woolworths) and/or companies focused on capital discipline and healthy balance sheets (ASX, BHP, & Wesfarmers).
Our investment process of an active company and industry visitation program continues to underscore the value of identifying catalysts and inchoate themes in the Australian share market.