Our 2025 Investment Outlook – big themes for the year ahead

The Big Themes for 2025

• Cyclical value stocks stop falling as China eases
• Banks underperform the market in 2025 but don’t collapse
• Industrials cut innovation to save costs
• Real asset M&A ramps up
• Indexing gets crazier

Cyclical value stocks stop falling as China eases

Long term, structural concerns on China are real. Falling birth rates and excess property are two of the major headwinds that have been well documented. The Chinese Government knows the challenges and we believe they are concerned too.

China is now at a turning point where they will do ‘whatever it takes’ to stimulate an acceptable level of growth. It’s not likely to be aggressive stimulus, but we believe China has pivoted to be more pro-growth and market expectations are low.

Figure 1: The evolution of key quotes from high ranked officials in China over the past 3 years

Resources and Energy stocks have traded poorly on the back of pessimism on China throughout 2024. Resources prices have been pretty good. Iron ore has averaged over $100/t. Oil traded around $75/bbl for most of the year. Current prices are terrific for producers, particularly with a 20-year low AUD/USD (ex GFC, ex COVID). In our view, any view of China stabilising growth would be supportive of many companies in the resource sector. Today, most resource and energy companies price in commodities well below spot (excluding copper).

Figure 2: Resources and Energy underperformed the ASX200 by 30% in the past year

You can cut it many ways, but Santos (ASX: STO) continues to look undervalued to us. The chart below illustrates the large gap that has opened between the cashflow driver (AUD Oil) and the share price since 2021.

Figure 3: Santos has a material gap to oil in AUD term

Banks to underperform the market in 2025, but won’t collapse

Any stock can underperform the market in two ways:

1) Earnings fall

2) Valuation multiple falls

On earnings, we see long term competitive threats in major business lines. For example, Macquarie (ASX: MQG )  has emerged as the price setter in residential mortgages driven by a cost and technology advantage. But in the year ahead, there is little to derail earnings. Revenues will be supported by an ok economy and rates that seem to be settling a bit higher, aiding interest income. On costs, there is upward pressure from both labour and technology costs requiring management to work hard to control them. Bad debts are likely a source of earnings upside given reasonable conditions and strong provisioning across all the banks.

We don’t see downward revisions to earnings from where we sit today.

On valuation, we expect a change. Any absolute or relative valuation analysis suggests Australian banks are overvalued. “Valuation doesn’t matter”…until it does.

We continue to believe underweight the banks will be a source of alpha in the year ahead.

Our preferred metric is price-to-book versus return on equity (ROE). The higher the ROE, the more the market is willing to pay for an asset. If CBA trades back to something more ‘normal’, given its fairly muted ROE outlook, you should expect a 30%+ retracement in the valuation at some point!

Figure 4: CBA ROE is not growing

Figure 5: CBA price-to-book ratio looks at least 30% too high if history is any guide

Industrials cut innovation to save costs

Industrial companies are set to cut costs and innovation. Why?

1) Industrial companies are fighting to sustain current earnings in the face of rising costs and tepid toplines

2) A higher cost of capital leading to lower projected returns

Recent examples include:

• Ampol (ASX: ALD) – after a few years of record profits >$1bn, Ampol is having a tougher year in 2024. As a result, Ampol have announced a cost out program. We believe the cuts will focus on areas outside the core such as hydrogen where profitability remains elusive.
• CSL (ASX: CSL)  – CSL is expected to grow at double digits, but likely at a lower rate than history. After a few large-scale failed trials, CSL is moving back to lower risk, smaller scale trials.
• Resources/Energy Sector – The view from most mining companies is “how can we do the same production with less costs?” Exploration isn’t on the agenda for many resource companies. BHP and RIO are voting with their scrip / cash as they choose to buy assets (copper and lithium) versus a build strategy.

Who are the winners out of less corporate innovation?

The companies that “innovate for others”.

Consider logistics software provider WiseTech (ASX: WTC). When a freight forwarder implements WiseTech software, they reduce costs materially, in some cases >30%. That kind of value proposition doesn’t go away when cost becomes a focus. It often becomes MORE valuable in the eyes of the buyer.

Companies that have market leading software like Origin’s Kraken (ASX: ORG) or Block’s Square platform (ASX: SQ2) also stand to benefit from an increasing focus on reducing costs.

Real asset M&A ramps

Building stuff has always been hard. But it’s getting harder. Community expectations are rising. Governments want to be more involved. Environmental requirements are higher. Most of these trends are structural, driven by society, government and the investment community. Our view is that expectations are unlikely to be walked back any time soon.

Major miners have done the work and are showing their hand. BHP bought copper company OZ Minerals two years back, in what has turned out to be a shocking acquisition, writing off a nickel project while facing issues in the core operations. Earlier this year BHP then tried to buy diversified miner Anglo American for their copper business. Rio Tinto bought Arcadium at a 90%(!) premium to grow its presence in Argentina lithium. The trend is clear – big miners are buying not building.

But it’s not just miners. Energy companies are eating each other. Chevron (NYSE: CVX ) and Exxon (NASDAQ: XOM) both made major acquisitions in 2024. Building companies are being snapped up. Boral and Adelaide Brighton both were bought by family businesses while CSR is now owned by the French giant Saint Gobain.

If you tried to replicate some of the assets that Australian companies own today, you can forget about it. IF you were approved to do so, the cost to do so would be uneconomic. Origin’s gas fired power stations across the east coast and Ampol’s refinery in Brisbane spring to mind as strategic assets that are impossible to replicate.

What could be the fly in the M&A ointment? Protectionism is alive and well (often mixed in with security concerns). The Australian Government broadly doesn’t want to see foreign ownership of strategic Australian assets, with some small exceptions. The Canadian Government will only approve foreign takeovers of large Canadian mining companies involved in critical minerals production “in the most exceptional of circumstances”. And at time of writing, the US has just blocked Japan’s acquisition of US steel. Protectionism is here.

It may prove very hard for anyone to acquire Australian assets.

Indexing gets crazier

Index inclusion is wreaking havoc on markets, especially at the smaller end of town. But with havoc comes opportunity, so we aren’t complaining! Expect it to get crazier.

Here are a few index ‘clangers’ from 2024:

• Sigma (ASX: SIG), the owner of Chemist Warehouse, jumped from a 35x PE to >50x PE after the market speculated it would be included in the ASX small ordinaries index.
• Life360 (ASX: 360)  was upweighted in the Russell 2000/3000 forcing the buying of $250m USD on market. The stock rallied 25% over 10 trading days. Russell, the index maker, then announced the index had been miscalculated, causing a 15% sell off in Life 360.
• Ampol traded $900m on Monday the 25^th of November. 15% of the companies shares on issue! Big announcement or news to change people’s mind on the stock? No. MSCI announced the deletion from an index.
• One of the top 5 positions in the Avantis “US Large Cap Value” ETF is Costco (NASDAQ: COST) , trading on a pedestrian 60x PE!

Figure 6: Ampol traded $900m on Monday the 25th of November. 15% of the companies shares on issue!

If you got this far – thanks for reading. Here is a funny chart. Well, it made us laugh anyway! Good luck for 2025!

Figure 7: Datasaurus