SUMMARY
- The Fund generated a robust +5.1% return during July 2024.
- By way of comparison, the Australian stock market rose by +3.8%, whilst our RBA cash rate plus 6% target equated to approximately +0.9% for the month.
- Calendar year to date, the Fund has achieved a solid return of +9.4%, comfortably ahead of both the market (+8.2%) and our RBA cash plus 6% benchmark (+6.0%) over the same period.
It is important to highlight that these strong returns were generated while simultaneously balancing performance with our focus on capital preservation. For some time now we have been commenting on exuberant investor expectations creating a disconnect between share price implied valuations and a materially higher cost of money environment. Consequently, the portfolio has retained its disciplined approach of focusing on appropriately priced, defensive business models under pinned by healthy cashflows. The Fund also has over c10% in cash, highlighting our discipline, with the anticipation that liquidity to take advantage of opportunities will be very beneficial for our unit holders.
Investors have become extremely twitchy over several forward-looking measures including inflation, employment statistics and their impact on interest rates. Market sentiment around the implications of each reported number has also become somewhat complicated. A slowing economy means lower interest rates which means higher asset prices; full employment implies an overheating economy which requires higher interest rates – lower asset prices. So bad is good and good is bad… Our view is probably along similar lines except that we focus on the US’ deficits and its ability to service them by growing the economy. Given the enormous increase in interest costs (both absolute value of deficit and interest rates have increased) we worry about the implications of a hard landing and the probability of stagflation. Domestically the level of the A$ continues to puzzle us. Our negative view on sticky inflation implying we are out of step with the US economy should have seen a larger rally in the A$. Are we underestimating the risks around a faltering Chinese economy and its effect on our exports?
We note that much of the domestic share market’s performance during July was driven by a multiple re-rating, as opposed to an improved earnings outlook. That is to say stocks simply became more expensive during the month. The ASX 200 finished the month on 17x aggregated forward earnings, up from 16.4x at the end of June. We have previously expressed our view that the negative impacts from central bank experiments with quantitative easing, deeply negative real interest rates and ever-expanding fiscal deficits are still to play out, and whilst data points in July were taken positively, more recent data, particularly in the US has seen sentiment swing firmly back into negative territory. Amidst this period of increasing volatility, we believe that a focus on strong business models, backed by healthy cash generation and stewarded by competent management comes to the fore. With a defensive bias and a lower equity exposure, the fund has held up well relative to the market amidst the difficult trading conditions so far in August. Essentially, we insist on getting paid for owning companies by their earnings yields rather than by expanding multiples of these earnings.
COMMENTARY
The Fund was rewarded during July for its conviction across a number of core holdings that were among the primary detractors to performance in the prior quarter – with leading contributions from ResMed, Telstra, Evolution Mining (Gold +8.4% for the month), Ryman Healthcare, Credit Corp and Super Retail Group.
Telstra continues to be a mainstay for the Fund although it was a detractor from performance over the previous financial year. Telstra’s earnings momentum remains solid, in particular, the core mobile division and the inflation linked recurring NBN income stream (combined >85% of total valuation). We wrote previously of the factors impacting Telstra’s share price performance in FY24, in particular around pricing announcements late in the period, and our rationale for looking through the near term noise. Subsequent events have validated our initial analysis, and with clarity now restored on the outlook for pricing, Telstra shares are trading >15% above lows following the May announcement, with most of that gain playing out in July.
Ryman Healthcare was another key detractor for the Fund in FY24, as it continued to navigate its way through a substantial development pipeline amidst rising interest rates and a challenging property market environment. The challenge for our holding is that whilst we believe the shares to be undervalued at current levels, its asset portfolio is characterised by long dated returns, meaning even substantial improvements applied now can take a period of time to work their way into cash returns. We note the recent third party bid for Ryman’s peer Arvida at a substantial premium to trading value as evidence of a sector that has been oversold. We have further been encouraged by the renewal at both management and board level, and that our strong feedback around focusing on cash generation and a more pragmatic perspective of returns on invested capital have been adopted by the board, and incorporated into managements KPI’s. The shares responded well in July, up by more than 30% over the month. We nonetheless continue to monitor our holding closely.
Detractors during July were few, and focused around SG Fleet (consolidating after a strong FY24) and Contact Energy. Purchases were limited as is typical in a strong equity market, whilst the Fund was an active profit taker into strength across a number of names including Telstra, JB Hi Fi, CSL and the banks. The CSR transaction closed in July, with the fund crystalising the previously realised gains made as a result of the Saint-Goban acquisition of the company.
We continue to believe that the Fund is well positioned to navigate the existing volatility and deliver on our objectives of cash plus 6% in the medium term, given its defensive positioning, with solid balance sheets, and focus on businesses generating cash now. At month end the portfolio was generating an after tax cash earnings yield of 6.1% for FY25 – underpinning our focus on fundamental value. Our expectation of these earnings, combined with further earnings growth, capital returns and potential for valuation multiple uplifts provide comfort in achieving our return objectives.
Our longer held view that inflation will continue to percolate through the global economy has now been adopted by consensus, following fluctuating expectations year to date. From a valuation perspective, this environment typically favours portfolios whose valuation is predominately focused on current earnings and cash flows (such as this Fund), as opposed to those whose valuations are more dependent on future earnings and cash flows. Our cash balance remains healthy and ready to deploy should future opportunities present.
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.