Lead us not into temptation

“I view what’s going on right now as part of market structure being fundamentally broken.”

“People who are investing money mostly care about price, not value.”

We find it difficult not to share at least some of the sentiment of Greenlight Capital’s David Einhorn. Emerging from a results season marked by disconcertingly large moves on pieces of information which are generally small pieces in the puzzle of determining long-term business value, only an unbridled optimist could suggest market efficiency is heading in the right direction. It is easy to level the blame at passive investing and the vast assortment of trading strategies which rely on share price movements and history as their raw material. While undoubtedly shouldering some of the blame, the propensity of fundamental investors to gradually shed belief in valuation anchors and capitulate to the temptation of mimicking price focused strategies is possibly more important. Following the crowd is almost always the easy path. Confusing earnings and share price momentum with business value is creating great opportunity for those able to maintain a long-term focus. When Warren Buffett quipped some years ago that “Nobody buys a farm based on whether they think it’s going to rain next year” it seemed tough to argue. Wind the clock forward to 2025 and plenty of investors seem to be doing exactly that..

Amongst the myriad of interesting stock specific facts to emerge from results season, there were a number of broader themes which we felt permeated management commentary and outlook. In no particular order;

• New Zealand and Victoria were the epicentres of weakness for many businesses. New Zealand has undoubtedly been pressured by more aggressive action on interest rates than Australia. The issues in Victoria are more structural and seem likely to have more durable impact on business investment.
• Operating margins, rather than revenue growth, were the salvation for most results. Revenue surprise was rare.
• Divergent trends based on demographics and wealth inequality remain pervasive as highlighted in the always useful CBA (ASX: CBA) spending graphic. Despite tentative signs of stabilisation, discretionary spending and saving continue to strongly favour older demographics. Shrinking workforces relative to total population bode well for ongoing low unemployment, however, the inequality impact of interest rates as a tool to address inflation remain powerful and poorly understood.

• Technology investment and enthusiasm for AI remain strong. Evidence of improved revenue prospects and significant productivity gain are more elusive. Large data sets are powering data centre and technology spend; a multitude of companies believe their customer experience is improving, not many have smaller workforces.
• Acquisition based growth strategies remain broadly disastrous. Evidence of better performance from companies focused on organic growth, simplification and growing economic value remains persuasive. Using the all-important banking sector as an example, whilst we still struggle to comprehend quantum of the valuation gulf between CBA and other banks, the long-term difference in economic value creation is unarguable. When it comes to productive uses of AI, the diversion of all investment banker emails to junk and calls to voicemail would be a good start.

• Founder led companies do not seem to be the same foolproof method for making money as they were a few months ago!

The above graphic summarises the share price moves over results season. As always, there are some with which we agree (in fund manager parlance these companies moved closer to our assessment of fundamental value), and others where we believe price setting is in the hands of lunatics, computer models or both (we don’t agree with these)! While there was generally some element of reversion (higher multiple stocks derating and cheaper stocks moving higher), these moves were fairly stock specific and valuations for market darlings remain wildly optimistic. In a world of heightened geopolitical tensions, increasing protectionism and government distortion we struggle to rationalise the tolerance of vast market value based on earnings in the distant future.

Distinguishing durable value creation from the transitory and determining where fundamental business value is changing will always be part art and part science. As noted above, we believe it often has little to do with the outlook for the coming year. We’ve touched on our interpretation of some of the results and management commentary we found interesting below.

As one of the exceptions to the rules around M&A value destruction, Computershare (ASX: CPU) has a long (and generally more positive than negative) history of growing by acquisition. Though the associated history of below the line integration costs can’t be ignored, management have a solid record of integration and cost reduction. The acquisition of the Wells Fargo corporate trust business in late 2021 will go down as one of most value accretive. Completed at basically the trough of ludicrously low interest rates and central bank experimentation, the rapid rise in US interest rates has seen explosive margin growth. The complicating factor in valuing the Computershare business is the assumption one chooses on sustainable interest rates. The impact of rising interest rates on profitability is abundantly clear in the margin and revenue charts below. The US economy remains a convoluted one when it comes to interest rate transmission. With homeowners insulated by mortgage rates attached to long bonds rather than short rates, higher interest rates can sometimes (simplistically) look like a transfer from the US government (paying the higher interest rates) to the companies and individuals receiving them. Computershare is on the receiving end. Margin income is some 70% of the earnings base and sustainable earnings depend hugely on your views of sustainable interest rates. Hedging might smooth and sustain short-term earnings, however, it does little to impact long-term value. As always, those focused on short-term earnings momentum took great solace in the ‘guidance upgrade’. Our view of value remains anchored in an expectation that interest rates are generally above sustainable levels, particularly in the US, with revenue and earnings likely to revert accordingly. Guidance and earnings upgrade doesn’t always equal value upgrade. With the equity valuation some 60%, or $9bn higher than 12 months ago, our views of value have shifted less quickly than the share price.

The reverse situation applies in a business such as Bluescope Steel (ASX: BSL). Without diminishing the many years of hard work in growing Colorbond, improving the profitability of Port Kembla and growing the US business around North Star, steel spreads remain a material driver of profitability. In the currently perplexing world in which the quantum of Chinese steel exports eclipses the annual production of all countries other than India, divining the future is tough. The 1bn tonnes of Chinese production (more than half of global output) seems unsustainably high and commonsense suggests rationalisation is required. Still strong iron ore prices, compressed steel spreads and impending tariffs do not imply a comfortable equilibrium for most parts of the value chain. Those with a proclivity for earnings momentum as a North star (pun intended) will remain focused on the short-term direction of spreads as the determinant of share price direction. Yet despite tough operation conditions and depressed Australian construction activity, the business was still able to earn more than $300m EBIT for the half. When accompanied by a balance sheet with no debt and a management team focused on delivery of growth and efficiency targets which are incredibly material to a business commanding a total valuation of $10bn, we continue to see Bluescope as an attractively priced investment regardless of the short-term earnings direction. When efficiency can support a reasonable level of earnings in challenging conditions and sensible financial leverage doesn’t jeopardise the business future in tough times, the optionality for vastly better performance in more benign conditions is valuable.

The spectrum of retailers across both staple and discretionary categories provided some of the most stark performance contrasts of reporting season. It is invariably a sector on which we have vigorous debate as to the extent to which current year earnings reflect durable value. This year was no different. The lure of earnings inflection points was apparent in both directions. Eagers Automotive called the bottom on a period of volume and margin pressure for the car industry, seeing the share price recover strongly. As the Chinese increasingly dominate auto manufacture and the transition to electric vehicles continues, the ramifications are profound. Eagers have continued to consolidate dealerships, reduce headcount, costs and reliance on individual brands, potentially positioning themselves as a powerful market leader. At the other end of the spectrum, Ampol (ASX: ALD) and Viva Energy (ASX: VEA) face a more challenging future. While government intervention has mitigated potential losses in refinery operations, the search for growth has seen them embark on refurbishment programs, acquisitions and expansion of convenience retail. While there will always be exceptions, businesses do not often make their best decisions under pressure. Whether it be mines nearing the end of life or businesses looking to diversify away from unpopular and low growth earnings streams, financial discipline often ebbs (it isn’t always that great when things are going well either!). The OTR acquisition for Viva Energy is unfortunately shaping up as another victory for the vendor in this regard. Illicit tobacco and cost of living pressures on the revenue side and wage increases on the cost side are undoubted headwinds, however, the path to making much higher profits from $5 bottles of water and the impending shortage of barista coffee within 100m from home isn’t totally obvious from our standpoint. Earnings rebound doesn’t always follow earnings pressure.

Fast food retail was even more devoid of winners. The offshore expansion which so excited Domino’s Pizza (ASX: DMP) investors in years past has not proven a bed of roses. Announcing the closure of 205 loss-making stores (172 in Japan) and still facing anaemic sales growth, particularly outside Australia, investors were reminded of the perils of extrapolating Australian experience elsewhere. The nearly 4000 stores across the globe and are currently supporting a market capitalisation of around $2.6bn. The 239 stores in the GYG (ASX: GYG) global network (210 in Australia) are supporting a market capitalisation of $3.5bn for GYG, even after a torrid month. While store rollouts create the excitement and earnings momentum, sustained per store profitability over an ever larger store base and extrapolating domestic profitability into differing geographies has not proven a reliable forecasting methodology. As Domino’s incrementally address the issue of restoring franchisee profitability, it should serve as a reminder that splitting ownership cannot dissociate owners from the importance of overall store profitability. Owning the ‘capital light’ piece is attractive when things are going well for the ‘capital heavy’ piece. Blood sucking hosts don’t tend to thrive when the patient runs out of blood.

Amongst many more examples of divergent performance in the retail sector, the Coles (ASX: COL) versus Woolworths (ASX: WOW) battle always offers a few insights. While the supermarket giants have invested heavily in logistics assets offering a veritable acronym feast (CDC’s, ADC’s, CFC’s), the engine of valuation for these businesses are the 1,100 Woolworths supermarkets in Australian Food (making about $2.7-$2.8m each on average) and the 850 Coles supermarkets (making about $2.3-$2.4m each) which these logistics businesses serve. While Woolworths has spent recent years acquiring and extinguishing the profitability of ancillary and immaterial businesses in the name of building a ‘marketplace’, Coles has pursued a simplification strategy. The scoreboard is comfortably in Coles’ favour as the game stands while Woolworths have announced a $400m support office cost reduction strategy in an attempt to get things back on track. Though we continue to believe the profits of these businesses are more durable and valuable than most other retailers, adding the cost and complexity which allows categories to be picked off by the likes of Bunnings and Chemist Warehouse only jeopardies this value. Focusing on getting better seems the vastly preferable strategy for shareholders.

In one of the more entertaining (at least from our perspective) post result meetings, my learned colleague Mr Fleming, came equipped with a carefully prepared template for completion by Fletcher Building (ASX: FBU) management. The task was simple; add details of the business acquisition and disposal activity which had contributed positively to shareholder value over the past decade. The perceptive amongst you will have predicted that no writing implements were required in the completion of this template. To the credit of the new management team, they have progressed through most of the 5 stages of death and dying and seem in the acceptance stage. The grossly excessive corporate costs, ERP systems and accounting window dressing to disguise abysmal business performance are hopefully in the process of being addressed. The vastly superior performance currently being achieved by extremely capably run businesses such as Seven Group in similar areas serves to highlight the size of the prize should the cavernous gap be successfully bridged.

The message from our perspective is straightforward. Earnings momentum is a lazy and simplified measure which often provides little assistance in the assessment of business value which we believe is the essence of our value proposition to clients. As the lazy and simple has worked ever more effectively, the temptation to shed the more complicated task of separating a business into its component parts and understanding the factors which can drive the sustainable levels of earnings higher or lower has been significant. There is good news for the patient investor. Seemingly crazy valuation divergence remains plentiful. The Kraken technology business which is part of the Octopus Energy business in which Origin (ASX: ORG) is a 23% shareholder is expected to have around 100million accounts and $1bn in annualised revenue by 2027. Origin’s share of this revenue is in the same ballpark as the revenue of Pro Medicus (ASX: PME). Ignoring for a minute the value of the 15million customers in the Octopus Energy retailing business, the 27.5% share in APLNG , the 4million customers and 16GWh of energy which the business generates and sells in Australia which delivered a profit after tax of a little under $1bn for the half year, investors have decided that the equity value for the entirety of Origin is about $9bn less than that of Pro Medicus. While the earnings momentum of a large business subject to the vicissitudes of electricity and LNG prices may not appeal to everyone, this seems like a pretty high price for earnings momentum. Earnings growth rates remain a powerful aphrodisiac, creating great opportunity for the less excitable.

Market Outlook

Questioning the ever greater application of technology in determining the market valuation of investments runs the obvious risk of being labelled luddites. We do not question the vast array of benefits technology delivers. Nevertheless, we would argue the nuance and complexity which underlies the operations of almost every company is tough to distill in algorithms which rely heavily on pattern recognition in vast data sets such as earnings per share and share price movements.

The comparative calm which has accompanied decades of globalisation, financialisation and buoyant asset pricing may not be the playbook for coming years. The temptation to fall into line with the earnings momentum chasing investment strategies which have fared so well has been strong. We continue to find greater opportunity in businesses which do not comfortably fit the model of simple, high margin, high return on capital businesses with strong earnings momentum which have won the day in recent years. We are certain the price paid for an investment will remain an important determinant of future returns. These conditions leave us optimistic on the returns available to those able to resist the temptation of following the crowd. The ‘deliver us from evil’ of my Catholic upbringing might be an overstatement, but you get the gist.

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