During February 2019 the Ethical Partners Australian Share Fund returned 7.30% versus the S&P/ASX 300 Accumulation Index of 6.01%, an outperformance of 1.29% (after fees). Since inception on 9 August 2018 the Fund has returned -0.69% versus the S&P/ASX 300 Accumulation Index of 1.26%, an underperformance of -1.95% (after fees). During February the Fund benefitted from overweight positions in Nick Scali, Monadelphous, CSR Limited and GWA Limited and holding no position in CSL benefitted the relative performance of the Fund. Key detractors for the month included Bega Cheese, TPG Telecom and oOh Media.
Approximately half the total market return in February came from less than ten companies with almost one third of the total market return being contributed by the four major banks (in the first week of February following the release of the final report from the Royal Commission) and another one sixth of the return coming from five major resource companies (not held by the Fund).
With most of the companies held in the Fund reporting their financial results for the period ended 31 December, reporting season is always an important fundamental mark to market period; a report card on the stocks we hold and our overall positioning. Of the thirty stocks held in the Fund twenty companies reported their financial results (with the other ten having a different financial year end). Pleasingly nineteen of the companies that reported during February posted results that were in line or better than expectations while one of our holdings missed.
For us, one of the best indicators of confidence for the future is the Board deciding to increase the dividend. The solid results helped underpin fourteen of our companies increasing their dividend per share on the prior corresponding period, while three companies held the dividend flat and three were down year on year. Two companies paid special dividends following asset sales or better business performance and one company materially increased its dividend payout policy.
Taking all this into account the weighted average dividend growth across the portfolio was around three percent on prior corresponding period. Importantly with many of the companies in the portfolio reporting growing revenues or balance sheets being in excellent shape, Boards have had the confidence to increase dividend per share for many of our holdings. Our general observation is that companies that report well and show this confidence usually continue to get support from the share market over the ensuing months as investors move towards them as the better placed opportunities.
One of the key themes coming out of reporting season was that Australian corporates are still returning significant amounts of capital to shareholders, in part because they are still reticent to engage large capital expenditure programs and also to distribute excess franking credits ahead of potential change in government policy; and that investors are still seeking out and supporting such companies.
The Fund generally benefitted from individual stock selection in domestic cyclical names as well as a position in the banks. We hold a position in the banks on account of reasonable valuations and the Royal Commission process being a catalyst and a critical path to the change that needs to occur in attitude towards customers, remuneration frameworks and culture within Australia’s major financial institutions. In time we believe this will be looked at as a turning point. And the change needs to come from the top. It will not have been lost on other executives in the sector the swift reprisals at National Australia Bank where leadership had fallen short of expectations.
From here, with the amount of focus and higher expected standards on customer service, more visible management and Board accountability and increased powers for regulators it will be hard in our view, for the banks to lapse back into their former practices. That said, however it is not the first time that National Australia Bank has lost its Chairman and CEO on account of falling short of expectations. In early 2004 Charles Allen and Frank Cicutto, NAB’s former Chairman and CEO respectively resigned amidst a currency trading scandal said to have had its origins in a culture where compliance was lax and routine breaches of risk limits were common place. We remain conscious of the past wrongs and the required changes to which the leadership has committed. Our team has already engaged with the major banks around these issues and our focus from here is being another voice to help hold banks accountable to making these critical transformations.
Looking at some key results, Commonwealth Bank reported profits just below analyst expectations and saw continuing pressure around Net Interest Margin from competition, slight revenue increases and lower costs. Profit was marginally ahead of last year and capital remains high and will be further boosted by announced asset sales. We believe the market will be supportive of capital management. During the month the stock carried its dividend for the first time in a while indicating that the attractive yield and all time high spread versus term deposits is luring investors back. ANZ reported sluggish volume growth in its first quarter update and due to its share price outperforming the sector the Fund has reduced part of the holding as the bank comes towards the end of a $3bn buyback. Wesfarmers, IAG and Nick Scali were all supported by investors as they returned further capital through special dividends or a higher payout ratio on the back of asset sales, solid balance sheets and better than expected results.
Another major sector that contributed to overall market returns during the month was resources. This was a significant headwind due to the Fund’s underweight position as investors chased strong commodity prices, boosted by supply side constraints around tailings dam collapses in Brazil, and record profits and dividends for the sector. Interestingly the ordinary dividends (excluding specials) of BHP Billiton and Rio Tinto are now above what they would have been if those companies had not dumped their (fourteen year old - in BHP’s case) progressive dividend policies three years ago; indicating the fallibility of the Board, let alone investors, trying to predict dividends from resource companies.
Outlook
Turning to the outlook it was a more accommodative US Federal Reserve, stimulus from the People’s Bank of China, the European Central Bank stepping back from Quantitative Tightening and the Reserve Bank of Australia moving to a more neutral footing after retreating from their stance that the next move in interest rates would likely be up, that saw markets rally from the December 2018 lows. With markets stabilizing amidst global policy support, many of our portfolio companies have exhibited strong recoveries in their share prices but with central banks likely to resume their gradual withdrawal of liquidity at some stage we are questioning what exactly will drive further gains from here. Despite markets appearing relaxed at present our view is that solid balance sheets, robust cash flows as well as valuations based on realistic expectations are likely to be a good measure of protection for shareholders. We remain wary of companies that are wholly dependent on exuberant equity markets for their expansion and ongoing funding.
Nathan Parkin Matt Nacard
Investment Director Chief Executive Officer
