Platform Availability
AMP North, APEX NZ, BT Asgard, BT Panorama, CFS Edge, Dash, Hub24, IOOF Expand, Centric, Hub24, Macquarie Wrap - IDPS & Super, Mason Stevens - IDPS & Super, Netwealth - IDPS & Super, Praemium - IDPS, Super, SMA & Powerwrap
Description
The Pengana Australian Equities Fund aims to enhance and preserve investor wealth over a 5- year period via a concentrated core portfolio of principally Australian listed securities. The Fund uses fundamental research to evaluate investments capable of generating the target return over the medium term. Essentially, we are in the business of seeking to preserve capital and make money – we are not in the business of trying to beat the market. We remain focused on acquiring and holding investments that offer predictable, sustainable and well-stewarded after-tax cash earnings yields in excess of 6% that will grow to double digit levels as a percentage of our original entry price in five years. We believe that building a well-diversified portfolio of these “gifts that keep on giving” represents a meaningful way to create and preserve financial independence for our co-investors.
COMMENTARY
Our analysis suggested that excess liquidity was driving share prices in a counter-intuitive fashion, particularly in the context of tougher trading conditions, a muted earnings outlook, and a materially higher cost of capital compared to the near-zero rates implemented by central banks in response to the COVID pandemic. In response, the Fund demonstrated its disciplined approach over the financial year by consistently building cash, choosing caution over momentum as equity markets rallied.
We were handsomely rewarded by the market’s reaction to the Trump Tariff plans, which created the opportunity to deploy our cash holdings (then exceeding 20%) into suddenly very attractive valuations. Importantly, we were able to acquire a range of new holdings that met our return requirements. These included Ramsay Healthcare, Ampol, Amcor, Bluescope Steel, Mirvac, Westpac, IAG and James Hardie.
We were able to significantly enhance the portfolio’s average after-tax cash earnings yield (ATCEY) through a series of disciplined decisions. This included the sale of our remaining CBA shares – an extremely high-quality company, but the valuation had reached a level we could no longer justify holding. We also acknowledged flaws in our investment theses on Kelsian and Ryman Healthcare and exited both positions. At the same time, we continue to build positions in existing holdings, such as Metcash and Stockland, alongside the addition of other high-quality, attractively priced companies noted above.
Commentary on significant contributors for the financial year
The largest individual contributor to the Fund was our holding in Evolution Mining. In prior updates, we have written extensively about both the challenges faced by this gold and copper mining company and the potential rewards of holding a low cost gold miner with unhedged gold production exposure. The management team rose to the challenge, turned around its underperforming Canadian mine – Red Lake, minimising weather related disruptions (including both water scarcity at Cowal, followed by floods, also at Cowal and additionally Ernest Henry), efficiently allocating capital expenditure across the portfolio and dealing with tight labour markets in certain regions.
We maintain the large position for several reasons, including the prudent balance sheet, the low cost nature of its gold production (admittedly assisted by its treatment of copper revenues), and its strategic decision to run an unhedged gold and copper exposure (which provides significant protection against very loose global monetary policies). In addition, we have been encouraged by improved operational outcomes and greater management bandwidth. However, we should not overlook the fact that a rampant US$ gold price created enormous value for shareholders. We are cognisant of the fact that it may reverse if the underlying pressures on gold’s desirability evaporate.
Our ongoing faith in Telstra was rewarded for a second consecutive year. Management continues to allocate capital wisely, particularly to the infrastructure assets. We remain optimistic around annuity streams generated by the existing NBN assets, the Mobile Phone Tower network, as well as the more recent capital city fibre optic capacity expansions.
As discussed in prior year commentary, Telstra’s ability to monetise its superior mobile phone network through core distribution competency and its enviable position as the lowest cost producer of mobile data at scale underpins our desired sustainable cash flows. At an industry level, stakeholders, including governments, large businesses, and consumers, are being educated on the increasing importance of resilient, robust, and protected data networks. We remain optimistic that the telco industry will be encouraged to invest in this infrastructure by being allowed to generate reasonable (read better) returns on capital. Note that both Telstra’s competitors currently earn sub-economic returns on their invested capital.
With respect to valuations, we note the following two important countervailing factors:
ResMed remains an extremely valuable position for the Fund. We have written at length about the factors driving the large trading range in its share price, which has ultimately added substantial value to our Fund. To summarise briefly:
The fundamental valuation for this strong and defensive cash producing business remains attractive – note customers buy flow generators and masks, with the latter being a recurring purchase 2-3 times a year. Flow generators are also replaced every 5 years. In addition, the business is globally diversified and participates in a non economically sensitive industry.
Outlook
Our view is that the Australian consumer has adjusted to a higher level of interest rates, due to a combination of: Cutting their expenses, benefitting from wage inflation and greater employment participation. While we are cautious around the issue of lacklustre productivity improvements at a macro level and its impact on GDP growth, we believe strong population growth will go some way to assisting overall growth. Furthermore, we anticipate at least another two interest rate cuts in the near term.
Importantly, the shift in the market environment in recent periods, from one driven by virtually free money and near zero discount rates, to a more normal level of interest rates, has, in our view, resulted in more rational valuations over the past 18 months. We believe the relative valuation appeal has shifted from business models that generate a significant portion of their profits/cash flows in the future back towards those that are generating profits/cash flows today. Such a dynamic is better aligned with our strategy and positioning, and we look forward to the underlying cash flows of our investments asserting themselves on valuations in the near term.
We remain as focused as ever on our primary objectives of capital preservation and generating a reasonable real return for our investors. We continue to believe this is best served by a disciplined approach and consistent investment methodology. A variety of good businesses run by honest and competent management teams at the right price will create a well-diversified portfolio of ever-growing cash earnings streams.