Holly Old
Hello, and welcome to the latest in our podcast series with Touchstone Asset Management. My name's Holly Old and I'm one of the account directors with Bennelong Funds Management. Joining me today is Ron Sargeant, investment specialist with Touchstone Asset Management. Welcome, Ron.
Ron Sargeant
Hey, Holly.
Holly
Ron, you've recently spent some time with investors in Melbourne and in your hometown of Sydney, and I'm keen to get your observations on those discussions. But before we do that, and probably for our first-time listeners, can you provide a quick snapshot of the Touchstone philosophy and a couple of bullet points on the team's process please?
Ron
Yeah, we could probably do a whole podcast on that, but I guess the highlights are really, number one, we think the index in Australia is very high risk. It's obviously concentrated between the banks and the resource stocks. That's about half the index in a small number of stocks. So that means we're index unaware. And then secondly, our philosophy really is that quality stocks outperform through the cycle and that's due to the fact that one, they're lower risk. But then secondly, quality stocks have the ability to reinvest capital at high rates of return and therefore grow earnings. So they generate higher returns through the cycle. The real key though, is not to overpay. So what we're seeking to do is buy quality companies at a reasonable price, or as we shorten it, QARP. I won't explain the whole process, but I guess the areas where we're different is, number one, we've got eight investment professionals with an average of 25 years’ experience. So, we're far, far more experienced than most investment teams. And then secondly, I think where our process really shines, is we do as much work around quality and assessing quality in an objective, repeatable, consistent framework, than most other buy-side firms.
Holly
Yeah, amazing. Thank you. That was really quick and thorough. Thank you.
And as I mentioned, you recently spent some time seeing investors in Melbourne. What were some of the observations that you came away from that trip and anything that might've changed your thoughts prior to those meetings?
Ron
Yeah, I've seen before doing the meetings that spending by consumers on cafes was at something like 40-year highs. And I tell you what, that was well and truly on display in Melbourne. Everywhere we went was obviously packed, and it seemed somewhat inconsistent with the higher interest rates we've seen from the RBA.
The other thing that stood out to me, which is, I've sort of been thinking about since, is how many clients we saw who had as a really large core part of their portfolios, index ETFs. And that's obviously been a great strategy, you know, for the last 10 years or so, since the GFC. I just have two concerns. One is indexes globally have become far more concentrated. So in the US you know, the S&P Index, about seven stocks are about 30% of that index. And more importantly, they're really only one sector, i.e. sort of tech or high growth. That's similar to Australia, as I said, we've basically got banks and resources at half our index, so four banks and a couple of resource stocks. The second issue is that passive or ETFs to a large extent can be a momentum strategy, and that's been a big beneficiary of QE-era low volatility, with the end of secular stagnation and a more normal economy. I just think that active management will offer superior risks and possibly with quite a bit lower risk because we don't have the concentration.
Holly
So interestingly, that term ‘secular stagnation’ came up once or twice. What's it referring to and why does it actually matter?
Ron
Yeah, it's starting to get a little more airplay and what it was describing was the situation, where basically investment in the economy is insufficient to absorb excess savings. So you get a period of very low interest rates, very low growth and inflation. So that's post-GFC decade. Now that was supportive of momentum strategies, as I said earlier, and long duration assets. What COVID, though, led to was companies needing to de-risk their supply chains, so bring more production capacity back closer to home, and similarly governments for all sorts of different reasons are now spending more on making sure they've got access to critical materials, spending more on infrastructure, spending more on defence, and also they've enjoyed the benefits of just generally higher fiscal policy, greater spending on voters. And so that seems to be more of a trend going forward.
And then at the same time, central banks I think have learned the dangers in trying to be reactive to inflation, so they'll be more proactive going forward. When you put all this in the mix, more investment, more reactive central banks, it just means you get more normal levels of interest rates. I don't think you go back to that ultra-low era of near zero interest rates. And so that means a bit more volatility, more normal economy, and I think more opportunities for stock-picking rather than that just passive approach and chasing momentum.
Holly
Hmm, interesting. The other area that was discussed quite a bit was the Australian consumer spending, and it seems to me that the consumers are still pre spending pretty well, and, and based on your comment earlier about the restaurants and pubs of Melbourne, and I think you might've said it was 50% of GDP, but you feel like that's going down. Why is that?
Ron
Yeah, so in Australia at least, consumer spending historically has been about 50% of GDP. This year it's been even closer to 80 at times, 80% of GDP growth. The real reason that we think consumer spending is slowing is there seems to be a view that, well, the RBA’s got the cash rate to 4.1%. It seems like they might increase rates once, possibly twice more. So, you know, the market expects a rate of about 4.5, but the RBA’s more or less done what it's gonna do. I think what the market's missing, though, is there's a huge lag from when the RBA increases rates to when households firstly actually have to pay the higher interest rates. And then secondly, when they react. So because fixed rates through COVID became much larger than normal – so about 45% of people fixed their mortgage, historically that number's more like 15 – that meant that at the end of COVID, the average Australian mortgage rate was 2.3%. It's now currently because of the lag, because so many people are still on fixed rates, the average mortgage paid by Australian households is still only now around 4.9. But we think with a 4.5% cash rate from the RBA, that will mean about a 7% peak in variable mortgage rates. So Australian households have gone from 2.3, currently 4.9, and it's going to go to 7. So we're only about 60% of the way through the impact from higher mortgage rates on consumers.
And then on top of that impact, this time last year we had the low and middle income tax offset being received by households. So that's about a $1,500 cheque that a lot of households received and that got spent. So we're cycling that and we just don't think that analysts have those impacts sufficiently in their numbers. And we've started to see a lot of downgrades from consumer companies as a result.
Holly
So, the thoughts around the earnings being too high for consumer companies, but also a little bit for the market more broadly, got a couple more points you can flesh that out for us on what that means?
Ron
Yeah, so if we take that that first point, basically saying consumer spending's going to be softer, households are going to have to cut spending ‘cause their cost of living's going up. At the same time unfortunately, the companies, they've got wage bills that are much higher, energy bills that are higher, and other costs just generally reflecting higher inflation. So you've got this margin squeeze coming through.
Now clients would say to us, well, you know, we all kind of know about those things. It sounds sort of obvious. I just point out, though, how consensus expectations are very stale. At the moment, half the constituents in the ASX 300 have earnings which is older than 50 days, so earnings forecast by analysts older than 50 days. And roughly 45 stocks, their forecasts haven't been updated for about three months. So there's a lot of companies out there with stale earnings, there's a lot of earnings risks and you know, what it means is we are more inclined to like stocks that we think have maybe come to market and highlighted some of these issues where consensus is, you know, reflecting the higher costs, et cetera. Like CSL is a great example, it's a good timing for many different reasons, but we also know their consensus numbers are closer to correct.
Holly
How does that play through the sector and what are the broader implications of that then?
Ron
Yeah, it's always, it's always tough working out, once you've got your numbers and they're sufficiently different from what you see in consensus, thinking about whether or not it's in the price. And we've got a really useful analog, in that 2011, 2012 was a similar era where we were coming off large stimulus from the government and we had a slowdown in consumer spending. In that case, the average consumer discretionary stock that we followed had earnings down by around 15% in 2011 and stocks were down by about 30%. What's worth thinking about though is in 2011, you know, Harvey Norman and JB Hi Fi were both off 60%. Wesfarmers down slightly, Woolworths in the supermarkets about flat, Super Retail actually by early 2012 was up 30%. So even though we've got a tougher environment, we do think some stocks can do relatively well, particularly if they make acquisitions like Super Retail or Rebel in late 2011. So, you know, that's why we like Wesfarmers for example. It has the ability to grow if there is a downturn to acquire or rationalise industries, and Bunnings is just a resilient company through past cycles. Similarly, Coles and supermarkets, we like Coles, you know it’s just a very defensive company.
Holly
So Ron, based on all that, just as a time to dust your crystal ball off, do you think reporting season's going be a little bit weaker?
Ron
Yes, we think that the consumer it’s obviously going to be tougher. They're going to have to talk about a weaker top line, they're going to have to flag that expenses are higher, and then we think you'll see those same sort of things in industrials companies. Like it's interesting, just recently we saw Ansel come to market and talk about similar sort of things with higher costs, slightly softer top line. So we think more broadly, industrial consensus earnings are too high, which was what happened at the last reporting season. The misses, about 40% of them were due to weaker margins. So we think you'll see the same, you know, and then also you'll see the banks probably have to be still quite cautious in some of their outlook comments.
Holly
So it's fair to say that you have a bit of a cautious, probably negative outlook then?
Ron
Yeah, we're definitely expecting some weakness and as you say, cautious outlook comments. The key really though, at the moment we're just talking about a bit of a pullback, you know, a bit of softness. The key is really employment. So long as people still have a job, they'll keep spending and you don't get a really nasty sort of spiral starting, with people losing their job, and stock standing companies therefore have to cut back even more. So we think unemployment ticks up by maybe 1% over the next 12 months. So again, it just reinforces our expectation for a bit of a pullback, but nothing too severe.
Then you've also got to remember, stocks bottom well before fundamentals. So at some point these consumer stocks are going to be showing interesting buying levels. And then beyond that anyway, I mentioned CSL earlier, you know, that stock now has had a really good pullback. We think it's got 15% grounded earnings growth for the next few years. So even if you're worried about the market, earnings could be 50% higher within that sort of three year timeframe. So we still like stocks like CSL.
Holly
Excellent. Well, it's been great chatting with you today Ron, and thank you very much for your time. Touchstone's most recent Investment Insights, titled Stage Two of Downturn – Earnings Downgrades, is available on their website. Thank you once again Ron for your time, and I look forward to chatting again.
Ron
Thanks Holly.
