Chasing the sun

As investors have shed the mundane and bought perceived growth and excitement everywhere, it is perhaps unsurprising that US exceptionalism has remained the order of the day. Good news remains elusive in Europe and China, while US economic resilience has defied the sceptics. ‘Chasing the sun’ has remained the most lucrative investment strategy. 

Equities have continued to trounce bonds in the battle for investor flows, yet US dollar strength and equity market valuation suggest the net appetite for US dollar assets remains firmly positive despite treasury market headwinds. The world has an alarmingly large wager on ongoing US exceptionalism. Observing moves in the domestic market over the quarter (and longer periods), the wager is often replicated further as US themes and exposures permeate non-US markets. 

While enthusiasm for technology exposure is obvious, the cumulative shedding of exposures perceived to be ‘China linked’ (materials and energy) in favour of US Dollar earners has been marked. Alongside the assortment of predominantly US based technology winners such as Life360 and Pro Medicus, US exposure across gaming (Aristocrat, Light & Wonder), payments (Zip, Block), healthcare (ResMed, Fisher and Paykel), media (News Corp), insurance (QBE), services (Computershare) and broader industrials (Brambles, Reliance Worldwide) evidence the breadth of the love affair.

These trends provide plenty of food for thought. The US has doubtless created the environment and economies of scale to nurture and build many of the world’s great companies. It remains the epicentre of capitalism in a world in which populism has featured prominently as politicians sought to buy popularity in a period in which trust in government has continued to ebb. The challenge for investors is pricing the outlook for this ‘exceptionalism’. 

Current pricing and positioning suggests it is very bright. Indicative global benchmarks such as MSCI World are more than 70% US exposed, while the top 10 stocks are all US-domiciled and nearly 25% of the index.

Interestingly, despite this perceived exceptionalism, it is more difficult to differentiate the US when it comes to sustainability and the implicit trust in the ability of governments to perpetually prop up asset prices and economies with ever greater money supply and deficit spending. Across much of the world deficit spending is beginning to displace bank lending as the primary source of monetary growth. This includes the US. 

Given bank lending tends to disproportionately support asset prices (particularly housing) while deficit spending is a touch more scattergun, the concern of investors in attempting to protect against the ravages of inflation seems very logical. It is perhaps unsurprising as this transition takes place that house prices rises are slowing or stopping while cost of living rises aren’t. 

This quest for inflation protection perhaps best explains the growing preference for higher equity allocations and the resultant evaporation of the equity risk premium. 

Whilst we remain cautious on the extreme pricing of US exceptionalism, we wholly understand the scepticism many investors hold on declaring the inflation dragon slain.

Domestically, when forecasts for every major category of government spending are 5%+, drawing a line of best fit at the 2-3% level and telling everyone inflation is under control could perhaps be described as optimistic. The good news is that forecasts see a gradual improvement in the structural budget balance and by 2035 things should be looking hunky dory again. Convenient, as 2035 was also the year I plan to qualify for the Olympic 100m final. Best endeavours basis of course!

Investment approaches to mitigate the above mentioned inflation challenges will vary wildly. Gold and bitcoin (gold for younger people) have both delivered strong returns in 2024 through the simple scarcity concept. While neither have much value in use, the principle of restricted supply relative to an expanding money supply is the source of appeal. 

Having done vastly better over 2024 than the increase in money supply, the more realistic reason behind the price rises in these assets is that more money chased them. When you’re an existing owner, the most reliable way of ensuring the price rises is to convince others to buy. While the scarcity concept has obvious appeal (it is more difficult to produce more gold than to print more money), we have always preferred to match the principle of restricted supply with ‘value in use’. Adding production capacity in iron ore, alumina or copper presents largely the same challenges as gold; it requires finding new deposits and large amounts of investment to develop. While the incremental gold produced adds to the existing stock of jewellery or gold bars, the iron ore, alumina and copper is utilised productively in the world’s capital stock. While supply/demand imbalances will always drive prices up and down, in the longer run, if the world struggles to add more than 1 or 2% per annum to supply (an increasing challenge given difficulties in finding new deposits, ever more onerous regulation and higher development costs), and money supply grows at a much faster rate, commodity prices should rise to compensate. 

History has shown that rising living standards are inextricably linked with greater energy and commodity use. The linkage with money supply is a little more tenuous. In a world in which reducing carbon emissions is vital, the additional protection in producing something that is vital to living standards rather than using vast amounts of power to mine bitcoins or vast amounts of diesel to produce gold to store in a vault seems worthwhile from our perspective. 

As always, the starting point on price relative to the supply/demand outlook will matter (regardless of the commodity). The good news is that bearishness on everything China related means most commodity stocks are priced for an outlook which is approximately the opposite of that assumed for the US.

When it comes to maintaining value and growing earnings faster than inflation, it is clear that many technology stocks have accomplished this feat admirably. Share prices are assuming they will continue to accomplish this vastly better than other businesses. While the theory of technology as a productivity enabler remains persuasive, it is clear that many technology companies have become adept at extracting the vast majority of any delivered productivity gains (and often more), in the form of higher prices. 

REA Group (ASX: REA) and CAR Group (ASX: CAR) have been the poster children in this regard, raising prices consistently despite minimal volume growth in either housing or vehicle sales through time. Combined with higher margins and less exposure to wage costs than many peers, the allure of ‘operating leverage’ has been powerful. 

While the market positions of these and a number of other technology businesses are strong, as capital continues to flood into the technology industry the expectation that many of these companies can extract all of the benefit looks optimistic. Increasingly, we’d expect customers to improve efforts to mitigate technology dependence and to avoid having all productivity gains subsumed by technology providers. While this may take time, the enormous quantum of earnings growth and duration assumed in most valuations prices no such risk.

As another quarter of bank share price outperformance passes, with Commonwealth Bank (ASX: CBA) again leading the charge, we continue to search for what we’re missing in the love affair across banks and financial exposures (particularly payments). One possible explanation lies in most of these businesses being ‘ticket clippers’ on ever increasing money supply. As belief in the ability of ever increasing money supply to avoid downturns rises and adherence to more traditional attachment to cycles and mean reversion collapses, it is perhaps logical to prefer exposures to the monetary over the real. Given the shift away from bank credit growth and towards government spending as the source of new money (as has been the case in markets like Japan for many years), we remain a little perplexed as to why banks should provide such insulation. In highly indebted economies, private credit growth eventually hits a wall. Despite still strong credit growth domestically, banks have not managed to deliver the earnings growth required to immunise investors from inflation. 

While Australian GDP continues to be propelled by increased population rather than improved living standards and GDP per capita, this perhaps provides some insulation for banks, however, even assuming a continuation of this lazy and ineffective approach to economic growth, it requires banks to begin turning this volume growth into earnings growth. Nothing in the cost plans of banks makes us optimistic on this prospect. 

Similarly, in payments, hope rests on payments providers being allowed to retain the benefits of volume growth rather than passing them to consumers. While Mastercard and Visa have proven adept at this historically, evidence points to increasing rather than declining competition. In addition to the dangerous sensitivity to bad debts which broad based credit provision necessarily involves, we find ourselves again relying on a rear vision mirror view of the world in trying to support valuations. Market share gains, volume growth and an absence of bad debts remain the order of the day in dissecting valuation assumptions.

Single stock deep dive: Ramsay Healthcare

In the myriad of sectors providing more attractively priced exposure to earnings than financials and technology, and which should be relatively immune to the prevailing monetary environment, Ramsay Healthcare (ASX: RHC) is undoubtedly one of the more interesting at present. It has been one of the most painful portfolio positions in the past year, immune only to a rising share price. The equity value of the business is now less than $8 billion. This $8 billion buys 100% ownership of the Australian and UK hospital operations and 52.8% of the Ramsay Sante European operations. 

Without a shred of US exposure, it's little wonder it’s unloved. Much of the debt in Ramsay’s business (about $6 billion of $10.3 billion given consolidation of Ramsay Sante) sits in the European operations. While the Ramsay Sante business is listed in Paris and still evidences a market capitalisation of €1.4 billion (effectively valuing the Ramsay stake at about $1.2 billion), this is an artifice, given almost no free float (Credit Agricole and the Attia family own nearly all the rest). 

Importantly, as Ramsay emphasise, this debt has no recourse to the rest of the Group. The €5.1 billion of revenue produces some EBITDA but no earnings given €3.6 billion of net debt. While management are keen to persuade investors they have not set fire to large amounts of shareholder’s money and are not operating a charitable operation for a bankrupt French government, current evidence is not hugely supportive. 

As is the case with hospitals everywhere, labour and capital intensive operations without great scope for productivity gain are providing funding headaches for governments not keen to raise taxes and ageing populations desiring quality healthcare but keen for someone else to pay for it. Whilst highly leveraged operations always retain option value should funding and operating conditions improve, our key concern is to avoid tipping in more equity. 

The threat of bankruptcy and leaving operation to the French government remains the key point of leverage for Ramsay. Assuming no more equity is contributed it cannot be worth less than zero and problems reside with debt holders. Assuming anything like the $1.2 billion in value would be a meaningful windfall gain.

Assuming we attribute no value for Ramsay Sante, we need to find about $12 billion in value ($8 billion equity + about $4 billion in debt) for the 100% owned Australian and UK operations. 

Given margins below 10% and ROIC in the single digits on invested capital levels far below replacement cost, it is unsurprising private hospitals do not have a long queue of new investors lining up. The government managed to spend almost $4 billion on Royal Adelaide hospital building around 800 beds. 

Ramsay operates around 70 facilities in Australia and owns a significant proportion of the underlying land and buildings. Earnings remain squeezed by admissions which still haven’t fully recovered from COVID interruptions and nursing wage increases which haven’t been compensated in health fund reimbursement. Even assuming the $700 million EBIT did not grow, the $12 billion EV would imply about 17x EBIT or about 6% un-geared returns in a business largely backed by underlying property value and trading vastly below replacement cost. 

We’d assume they need to improve materially to get anywhere near the level likely to encourage new investment in the sector. For investors with patience, we believe the odds are firmly in favour of things improving significantly.

Contributors

BHP Group (Underweight) (-14.0%)

As the still dominant value driver of BHP, pessimism on the iron ore outlook is without doubt a major factor in driving share price performance. As the additional supply from Rio Tinto’s Simandou project sits on the horizon in a steel market which is already struggling to digest surplus Chinese production, it is easy to understand iron ore price pessimism. To date this pessimism hasn’t materialised and BHP earnings have remained extremely solid. Despite our expectation for significantly lower iron ore pricing and concerns over an acquisition appetite which seem more focused on size than value, share price declines are improving the appeal of a business which still believe has solid long-term prospects.

News Corporation (Overweight) (+22.7%)

While the 61.4% shareholding in REA remains an important driver of valuation, management have worked hard to grow and realise the value in the Dow Jones franchise. Given the importance of information services in the current era, we remain optimistic on the ability to grow earnings in this business. Having used too many words to highlight our concerns on US exceptionalism, it would be hypocritical not to point out that News Corp’s domicile has probably not hindered share price performance!

QBE Insurance (Overweight) (+16.0%)

Whilst potentially harsh, industry conditions which have seen strong price rises across almost every geography, rather than anything exceptional about company performance, have been the dominant drivers of share price performance. Domestically, few sectors of the economy have experienced the price gains which insurance has enjoyed of recent years. Whilst similarly strong claims inflation has suppressed margin gain to date, the lag between premium increases and claims position QBE to enjoy margin benefit in near term. We remain a little concerned over the reliance on price rather than efficiency improvement in driving profitability.

Detractors

Commonwealth Bank (Underweight) (+13.2%)

Matt Comyn, the extremely sensible and impressive CEO of Commonwealth Bank, is presiding over a bank with decidedly uncommon valuation parameters. As the best and largest domestic bank, albeit with cost structures to match, it is the $250 billion+ valuation and inexorable share price rise without accompanying earnings growth which drive portfolio positioning.

Ramsay Healthcare (Overweight) (-17.0%)

As explained earlier, the structure and apparently high gearing of a business with strong underlying assets disguises significant opportunity. As is often the case, when management and the Board have presided over unsuccessful offshore expansion and value destruction, contrition is not the initial reaction. Nevertheless, as a new CEO takes over and technology investment, improved compensation from health funds and slowly improving utilisation arrest the challenging conditions of recent years, the potential for earnings and share price improvement is material.

Bluescope Steel (-15.8%)

Surging Chinese steel exports and resultant steel price and spread pressures are being quickly reflected in the share prices of Bluescope and steel producers across the globe. Whilst constraining production to support prices and profitability remains anathema to Chinese steel producers, history and logic suggest depressed prices and margins eventually give way in an industry accustomed to sharp cycles. Cost and efficiency focus, a strong consumer brand in Colorbond alongside a strong balance sheet, leave Bluescope well positioned to weather the tougher times and flourish in the more benign conditions which invariably follow.

Market Outlook

Our concerns over elevated equity valuation levels sit alongside an understanding of why investors are reluctant to embrace increased allocations to government debt, despite apparently attractive valuation levels. While governments may surprise everyone and adopt a push towards smaller government, lower regulation and more productive spending, my 2035 Olympic victory looks to have the probability edge at present. 

Without vast shocks to the financial system which restrict the ability of governments to fund spending through increasing money supply, attempting to preserve wealth against this eventuality would seem to remain the order of the day. To date, US denominated assets, and equity markets in particular, have been the successful method of wealth preservation and growth. Much of this has been driven by ongoing erosion in the equity risk premium.

Attempting to use the non-artificial type of intelligence in standing against the pattern recognition and replication of powerful US themes across other global equity markets has been an exercise in futility. As capital crowds ever more into US assets, it is hard to find a time in history where the wager on US exceptionalism has been larger. Unsurprisingly, this has left those with an appetite to seek diversification elsewhere with a fairly broad array of far more sensibly priced opportunities. 

While seeking opportunities in the shade has been ever more painful than chasing the sun, we struggle to understand why sun block seems so unpopular when sunburn seems inevitable.