Quarter in review: December 2018

31 December 2018

The last quarter of 2018 was a tough one across global markets. The Australian market (ASX 300 Accumulation Index) was not immune falling 8.4% as investors became increasingly concerned about the negative impact on earnings from a continuation of the US-China trade war and the US Federal Reserve’s (Fed’s) hawkish tone despite weak economic data globally. Investors were also likely positioned for a pre-Christmas ‘Santa’ rally that didn’t eventuate and the resultant unwinding of positions in a very illiquid market just before Christmas added to the sharp drawdown in December.

The best performing sectors in the ASX 300 for the quarter were Utilities (-3.1%), Materials (-5.0%) and Real Estate (-5.3%). The underperforming sectors were Information Technology (-14.2%), Communication Services (-14.9%) & Energy (-21.6%).

There was plenty of uncertainty going into the quarter – issues that have occupied our minds and those of other investors for a while now and which have been well documented in our previous quarterly reviews e.g. Fed hawkishness on US interest rates, the US-China tariff war, Chinese economic slowdown and the US dollar strength that was hurting emerging market economies. Domestically, the economic impact of the housing slowdown, the Royal Commission on the financial services sector, regulatory risks especially in the electricity and health insurance sectors and general political uncertainty have weighed on the minds of investors.

To add fuel to the growing uncertainty, the oil price fell 35% during the quarter. The US chose not to enforce the ban on oil imports from Iran by countries such as China and India in November. The commodity markets were wrong-footed, and the expected additional supply led to a sharp fall in the oil price and therefore, oil and gas stocks.

In retrospect, what likely triggered the market drawdown was the hawkishness of Fed Chairman Jeremy Powell in his press conference post the December rate increase. It also didn’t help that despite the conciliatory tone at the Xi Jinping-Trump meeting at the G20 summit in Argentina in early December, Canada arrested the CFO (and daughter of the founder) of Chinese telecom company Huawei Technologies in Vancouver at the behest of the US authorities.

Investors interpreted this as a sign that a lot of the issues in the US-China trade dispute were intractable and linked to technology and intellectual property, implying very little chance of an early resolution.

We have, in most of our conversations with investors over the last 12-18 months, cited the concerns that we have had on stock valuations and our inability to find quality companies trading at a reasonable price. Whilst our performance in the quarter roughly mirrored the falls in markets, we believe that our investment process designed to focus on “Quality at a Reasonable Price” helped us to take advantage of the more attractive valuations on offer, increasing our holdings and selectively adding new names to the portfolio.

We always find it useful to do a post-mortem of drawdowns and learn from it. Some of our key findings from the recent episode (the ASX 300 fell ~10% from the end of August) are detailed below:

  1. The ASX300’s worst performers (and reasons) were:
    • Royal Commission into Financial services – IFL & AMP
    • Brexit – CYB, URW & JHG
    • Housing construction peaking in Australia and slowdown in the US – CSR, ABC, JHX, BLD
    • High PE – Technology, Healthcare, XRO, CAR, TWE, Small caps
    • Oil and single commodity exposures – OSH, WPL, AWC, ILU
  2. The best performing stocks in the period were in sectors fund managers traditionally have low exposure to:
    • Gold up 8% and,
    • Utilities & Property Trusts only down 6% and 4% respectively
  3. M&A (predominantly private equity) takeovers have involved out of favour stocks with challenging operating dynamics– TME, GXL, TRS, NUF & NVT. In addition, Brookfield confirmed its interest in Healthscope post due diligence.
  4. Large acquisitions funded by substantial equity raisings have typically struggled with stock indigestion and under performance – WOR, RWC, TCL & BIN.
  5. The divergence in multiples between value and growth stocks reduced. Despite that, some low PE names such as IFL, VEA, CYB and CSR have substantially underperformed.
  6. Quant funds selling on momentum, earnings per share (eps) and broker upgrades and downgrades, not on valuation. This was certainly exacerbated by the lack of buyers/liquidity.
  7. We also note an acute dislocation and elevated mandate transition in small caps in recent months. We note more insourcing of small caps by the large industry funds, fund closures and mandate losses. There was market chatter and “intelligence” suggesting the closure of hedge funds and winding back of risk from several international and Pan Asian investors, who are typically active in Australian Equities.
  8. While Intra-sector correlation (industry headwinds and tailwinds) was clearly evident across some sectors (property trusts, gold, energy) – there were some high profile divergences worth noting:
    • Healthcare – RMD was up ~3% while CSL and COH were down ~20%
    • Resources – BHP / RIO protected by large capital management programmes and exposure to iron ore which has been steady vs AWC and ILU
    • General Insurance – IAG outperformed whilst SUN underperformed
    • WOW +4% had strongly outperformed WES/COL

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