The wicked ASX200

November was a strong month for the ASX, with further strength from this year’s unusually and exceedingly popular and altogether quite impossible to describe (as Glinda would describe them) IT (10.4%) and Financials (5.9%) sectors. They weren’t alone; almost all sectors had strong performance, other than Materials (the major miners) and Energy, which both declined, again reinforcing the patterns of 2024.

Three aspects of Australian equity market performance struck us through the month. Firstly, the announcement of the $4.3b Digital Infrastructure REIT raises several questions for investors. It is easy to muse as to how value can remain for subscribers to the IPO after fees, given most of the assets are being acquired (pre fees) for the purposes of the IPO in a market where data centre assets are already highly sought after. It would equally be churlish to diminish the ability of the promoters to identify and create value; between Chemist Warehouse and Sigma (ASX: SIG) and now this REIT, HMC are the Australian corporate manifestation of Elphaba; they are not causing a commotion, they are the commotion. Secondly, with the retirement of Shayne Elliott as CEO of ANZ (ASX: ANZ) after nine years, and the appointment of Nuno Matos to the role, three of the four major Australian banks have appointed new CEO’s this year, during which time the sector has been rerated to levels hitherto unseen. Can these new appointments unlock earnings growth after years of lacklustre if not declining underlying earnings growth for the sector; and if not, will the current high multiples be able to hold ? Finally, the rerating of sectors and some large stocks (notably CBA (ASX: CBA) and GMG (ASX: GMG)) has driven the ASX200 index performance during 2024. In more recent times, ever larger amounts of insider selling in some of the better performing stocks in 2024 have hit the market. What are the prospects for this rerating to recur, or reverse, in 2025?

At $4.3b, the Digital Infrastructure REIT is the largest IPO seen on the ASX for several years. The path has been laid; GMG has been the stellar performer in the REIT sector ever since two years ago it announced a strategic pivot into data centres.

As a multiple of work in progress, whereas many of its listed REIT peers struggle to be priced at book value, GMG has seen its multiple continue to move into the western sky. Partly this reflects investor confidence in operational execution and financial discipline; as can be seen, GMG has an exemplary record in allocating capital and deriving (cash backed) returns from development profits, through an extended period of time. In itself, this distinguishes itself from many of its REIT peers, which have struggled to grow cash backed net tangible assets per share through time.

Indeed, an extreme contrast is Lendlease, where for many years shareholders have been asked to fund investment in projects where returns to equity providers have been consistently less than those paid to the group’s debt providers. If an IPO tomorrow sought $5b to invest in a new REIT named Lendlease (ASX: LLC), with a history of mid single digit returns, a promise of slightly higher “above cost of capital” returns to come and with an intention to regear after the contraction of the group through the rationalization of offshore and redundant assets, could it be sold ? We doubt it, simply because there is little conviction in why Lendlease wishes to participate in the geographic and property sectors it is in, other than history, and little clarification as to why within those sectors it can provide better returns than any of its peers. Which is why it trades below book value (and is arguably more than priced for the strategic ambiguity). These views are hardly unique; even holders have let their frustration with Lendlease’s performance be known. Lendlease is the corporate manifestation of the Wizard’s boast, that “… the best way to bring folks together is to give them a real good enemy…”

In contrast, taking advantage of the GMG experience, where the global expectation of ongoing large levels of demand for data and the resultant enthusiasm for data centres / digital infrastructure has led to assets being priced well above book value and work in progress, Digital Infrastructure REIT has boldly packaged together assets for listing. Many of the assets are being purchased back to back with the IPO, that is they have not been owned, let alone operated, by the promoter prior to the issue. For HMC (ASX: HMC), the issue has clearly been a lucrative exercise, where boldness has been rewarded with a large, perpetual investment platform and notwithstanding a clever structure designed to attract passive funds flow sooner rather than later, HMC did need to attract a significant level of active investment to facilitate the initial asset acquisition, where those investors are by definition prepared to value the assets once listed, at more than book value.

For all of those REIT’s trading at or below book value, this should give pause for thought; would they be able to replicate this transaction and, if not, why not ? Is it that there are not exposed to “hot” sub sectors, such as digital infrastructure; or is it that investors’ are not convinced that the management team are likely to provide excess cash backed returns through time, even if they are operating in those sectors ? We have not subscribed to the Digital Infrastructure REIT and believe the management have significant work to do to grow into and maintain the valuation at ipo, given both the time needed to develop new productive data centres, and in turn the ability to maintain and grow rents as the leases (3 to 5 year terms) mature, especially at the second and subsequent renewals (which is obviously required given the high multiples of development cost the assets are trading hands at).

ANZ have announced that after nine years as CEO, Shayne Elliott will retire in coming months. Amidst an amazing year of market (if not operational performance), three of the four major banks have seen changes in senior leadership. The chart from ANZ’s 2024 result which in our mind sealed management’s fate is below. In an economic environment of full employment, driving asset growth and no bad debts, and a competitive environment where ANZ is widely considered to be the price setter in the Australian retail market, reflected in a material decline in margin, for ANZ’s Australian retail business to experience an underlying profit decline of almost 20% was a poor operational performance. Indeed, underlying profit for every one of ANZ’s businesses in Australia and New Zealand went backwards, weakening the case for internal succession.

ANZ has three major organisational imperatives. Firstly, it needs to address its poor operational performance. To be fair, none of the major banks is currently forecast to see growth in underlying profit through 2025 (just as it wasn’t experienced in 2024 across the sector), giving lie to the market performance. More idiosyncratically, it needs to douse the flames of concern from APRA and ASIC with respect to ANZ’s culture, conduct and accountability. Whilst the change in CEO works to cauterise the near term attention on these issues, which will be inflamed by this month’s AGM, it does nothing to address the structural operational issues which remain. Finally, all of this would be assisted should ANZ add an executive with operational, commercial banking experience (obtained outside of ANZ itself) to its Board.

For both digital infrastructure REITS and banks, much of the outperformance through the past year has been driven by rerating of multiples, not by earnings growth. Indeed, this has been the case for much of the market this year, across every sector. Whilst IT has been the standout sector in terms of percentage gains, the sheer size of the banking sector means that its outperformance has dwarfed IT and much else in driving the Australian equity market higher in value in 2024. For the increase in market capitalization of almost $60b this year, whilst seeing its earnings go backwards (as indeed they are forecast to do in 2025), investors in CBA could otherwise have acquired the entire supermarket sector, which would bring more than $5b of annual EBIT with them. Unless underlying earnings are to increase materially, which they haven’t done now for five years for the banking sector, the rerating which has been enjoyed through 2024 may well revert.

There is of course precedent for multiple reversion when expected earnings don’t eventuate, or at least to the anticipated extent. Locally, in late 2020, the WAAAAX stocks (Wisetech (ASX: WTC), Afterpay (ASX: APT), Appen (ASX: APX), A2 Milk (ASX: A2M), Altium (ASX: ALU) and Xero (ASX: XRO)) in Australia were all the rage. They have had varied market performance since that time; Appen is 95% below its peak, A2 is 75% below its peak, whereas Xero has recovered to now be 10% above its 2020 peak, and Wisetech has quadrupled since its 2020 high. Whilst we shall never know what fate awaited Afterpay given its untimely acquisition by Block (ASX: SQ2) in 2021, it’s fair to say that earnings for Buy Now Pay Later operators have failed to match the high expectations of that time, and yet equally the market performance of Zip has been very strong as it continues to grow its market share, especially in the US market. Altium was also taken over. From the 2020 peak, some high multiple stocks have done extremely well; just as some have done extremely poorly. What appears unlikely is that an investor receives “market” performance when investing in any company when sentiment is strong and multiples are high.

Global examples abound as well. Less than a year ago, Uber traded at its highest ever multiple. With the emergence of Google’s Waymo through the course of this year, Uber has been derated materially to 30 times, even as earnings have grown materially. The perception of future earnings growth is by far the biggest driver to share prices for companies in the high growth phase, such as Pro Medicus, Appen, and even Uber, and changes in these perceptions presages wild swings in share prices. Risk tolerance through 2024 has grown, and grown, and grown, even as the cost of money (as represented by the risk free rate) has stayed higher than almost all would have anticipated. We will be immensely surprised should this recur through 2025, and from current starting points the derating may be immense.

That presumably is behind the recent and ever increasing amounts of insider selling which has arisen with some of the better performing stocks during 2024. The founders of Pro Medicus sold $500m worth of their holdings; a co-founder of Wisetech sold her holding to the other co-founder for (well) more than $1b, albeit with $300m upfront and the residual paid quarterly based on the weighted shareprice of Wisetech through the next seven years; and then CIC, one of the largest shareholders, sold almost $2b in GMG shares. These are all large trades, in companies which have enjoyed an aggressive rerating through 2024, with knowledgeable sellers. In almost all large transactions, whether that be via mergers and acquisitions, or just secondary market sales, over several years almost all transactions ultimately throw up a mismatch of value; that is, one party to the transaction clearly emerges as an outsized winner.

Market outlook

At a risk free rate of 4% or more, most assets are currently expensive, unless they can produce sufficient real growth to grow into stretched multiples, which has always proven hard to sustainably achieve and hence is a scarce asset which should be prized. All the more so after a year of rerating, the market clearly does this; the question is whether it is being appropriately priced, in the absence of corporate magic. For businesses with large investment requirements and/or labour forces, the emergence of inflation has only made the attainment of real growth even harder, and few have proven up to the challenge. In this context, for the Australian equity market, with no net earnings growth, to have performed as well as it has through 2024 has surprised us, to say the least. Consequently, our portfolio is more focused on capital preservation than capital appreciation as we enter 2025. The best prospects for capital preservation are unlikely to be the stocks and sectors which have benefited most from 2024’s rerating, especially if earnings growth continues to be deferred, at best, as in the case of the financials sector. Increasingly, founders/insiders/large shareholders appear to agree with us, as large stakes are sold in some of the best market performers of 2024. It would appear they agree with Dr Dillamond; a company which possesses true magic has become all too rare.

Learn more about investing in Schroders' Australian Equities.