During December the Ethical Partners Australian Share Fund returned -2.47% versus the S&P/ASX 300 Accumulation Index of -0.23%, an underperformance of -2.24% (after fees). Since inception on 9 August 2018 the Fund has returned -8.78% versus the S&P/ASX 300 Accumulation Index of -8.04%, an underperformance of -0.74% (after fees). During the month the Fund benefitted from overweight positions in Graincorp, GWA Group, Downer, Medibank and NIB Holdings. Key detractors for the month included oOh Media, Bega Cheese, TPG Telecom and having no position in BHP Billiton and CSL detracted from the Fund’s relative performance.
The Fund added no new companies to the portfolio during the month and sold out of one position.
Amidst the market volatility (during December 2018 the market traded in a 6.8% range and closed only slightly down) and significant share price declines across the market since mid-year we have had a look at which categories of stocks within the Fund have added value and which have detracted value. Below we divide the portfolio into a number of different categories - similar to those found in Peter Lynch’s book “One up On Wall Street”, from 1989. We define our own four categories below and take into account the company earnings profile as well as how the stock itself tends to trade when making these classifications.
We divide the portfolio into the four following groups:
Yield: those companies that are held due to their ability to pay a reasonable dividend, backed by strong cash flow. They are not growing earnings quickly and usually have stable oligopoly market positions.
Defensives: those companies that are held that have a relatively stable earnings profile that tend to be sought after as a safe haven during times of market volatility.
Growers: companies that we have identified that we can buy at a cheap price that have demonstrated an ability to grow earnings ahead of competitors and industry group. At the time of our purchase there will usually have been an event where the market perceives the growth opportunity no longer exists, ensuring that we can make a purchase at a reasonable valuation.
Cyclicals: companies that are held whose earnings are cyclical or are perceived by the market to have a cyclical earnings profile.
We show the returns that are attributable to stocks held in each of the four categories since inception of the fund in August 2018:
Category Average Weight
% Fund Attribution to Excess Returns (including dividends)
Yield 36.9% 0.06%
Defensive 17.4% 1.39%
Growers 10.3% -0.41%
Cyclicals 32.0% -2.41%
Cash 3.8% 0.60%
Not held but in benchmark 0% 0.53%
Note: performance attribution totals will not add exactly to fund excess returns due to the timing and effect of cash flows.
There are some important points to note from the table above. Firstly more than half the Fund has been invested in stable, albeit low growth companies in the Yield and Defensive categories that are producing strong cash flows and paying good income to our clients. These twelve larger positions have done their job in a weak stock market over the course of the last few months and added value over and above the benchmark.
Secondly, not to be confused with buying the latest most popular stock on the ASX at any price, our four Growers are in various stages of gearing up for what we believe is the next phase of earnings expansion. The market has “given up” on a few of them and these have detracted value in the short term but it also allows us to purchase more stock at what are excellent prices, in our view. Two of these companies have just added to their suite of businesses through takeovers that we believe make a good fit with existing operations. One company is in the midst of a merger that should yield significant benefits to shareholders and one company has de-rated with the recent market weakness but we believe its medium term growth prospects are still good. We believe these companies have the potential to produce some excellent returns for clients going forward.
Lastly our Cyclicals positions have detracted the most from returns thus far and it is worth some explanation. We hold these thirteen positions because our team believes that, despite the market taking what we believe is a short term view and putting significant selling pressure on their share prices, these companies have excellent potential to add value on a medium term basis. Timing the entry to these stocks is difficult and we unfortunately tend to buy too early (and sell too early upon recovery). Nevertheless, with the market generally afraid of buying businesses with likely declining earnings profiles this creates the opportunity for the Fund to get set in some excellent medium term opportunities. We have taken a longer term view and looked hard at balance sheet, asset values how the companies are being managed at this stage of the cycle. Our conclusion is that this area of the portfolio has the largest latent upside or realizable value from here with respect to medium term earnings potential and/or the realisation of asset values versus current share prices. In some cases it will be a private buyer who recognizes this value rather than equity market participants. A case in point is Graincorp, with the company announcing during December that a private market buyer had approached the Board with the intention of buying out the equity at a price significantly above where the shares were trading.
Also of note is that cash has averaged around 4% of the Fund as we continue to find opportunities to invest at reasonable prices. With respect to those opportunities, over the past five months some sectors of the Australian market have become better value than others and the Ethical Partners team has found opportunities to progressively invest in the small caps space in particular. In recent times, peak (30 August) to trough (24 December) the S&P/ASX 300 price index has fallen -15.2% and the S&P/ASX Small Ords has, peak (24 August) to trough (24 December), fallen by -19.1%. At this juncture we remind ourselves of the maxim in the Davis Dynasty by John Rothchild that “eager buyers in the extravagant phase avoid(ed) buying in the bargain phase”. As such the Fund has progressively made further investments in small caps over the last five months, steadily increasing our weighting to select companies.
We continue to progressively invest in stocks where the future expected returns are greater and reduce our exposure to positions with lower expected future returns. The stocks with the higher future expected returns are those, in this market, where the stock price has declined more than the potential change in the underlying business value. As other market participants exit these stocks we tend to become more interested as prices decline to more favourable levels.
Our outlook for the Australian market takes into account that earnings growth for the S&P/ASX 200 peaked in early 2018 and has been steadily declining, as well as expectations that are now being factored in. Because the equity market is forward looking, actual earnings growth normally follows equity market changes over the ensuing 12 months, as in the chart below. According to Citigroup, historical earnings growth has now fallen to -1.5% yoy while the current level of the equity market is implying that they may fall to around -7% yoy. Forecast earnings growth expectations are also coming down but the question from here is, can the local market rally into declining earnings growth expectations like it did in 2013, 2014 and 2016?
The answer is likely to be found in the intersection of both current valuations and forward expectations.
“Stocks don’t read the papers or swoon in response to scary headlines. When they’re priced for desperation, they can rally in the face of desperation, escaping the dumps while the companies to which they’re attached are still wallowing in the dumps” The Davis Dynasty, John Rothchild, 2001
There are a number of stocks in the Fund, especially our cyclicals exposure where the stocks appear to be priced for desperation and this gives us cause to think they have limited downside while retaining the ability for reasonable future returns; having done our homework on management, balance sheet and cash flows.
Nathan Parkin Matt Nacard
Investment Director Chief Executive Officer
