The outlook for equities is unclear

Airlie Funds Management

July 2022

The outlook for equities is incredibly unclear. We have talked prior that markets are at the crossroads after a +10-year bull market - inflation and interest rates are on the rise and so central banks are reversing course after a decade plus of super easy policies. The early result of this, and exacerbated by the Ukraine invasion, is a return of market volatility. After being super strong in the March quarter, even commodity prices are now weakening, putting further pressure on the Aussie market. As fabled investor Peter Lynch says - "If you can only follow one piece of data - follow the earnings...".

Given profit margins overall are at record highs; stimulus is unwinding; costs pressures abound; and consumers will likely have less disposable income - then an easy bear case for the direction of earnings can be outlined.
Consensus earnings one to two years out are probably too high. However, this bearish view must be balanced against valuations that have been very quick to price in higher rates, and company balance sheets that remain strong (although we need to monitor this vigilantly). For consumers, the most recent (two to three years) cohort of mortgage borrowers may provide some bad debt and hence headline angst but generally consumer balance sheets are in reasonable shape. High levels of personal and mortgage debts is balanced by high savings, solid home equity, and current strong employment conditions.

PORTFOLIO POSITIONING

Sector exposure1

As bottom-up stock-pickers, we invest on company fundamentals: seeking conservative balance sheets, businesses that generate good returns and are managed by competent people. However, from a top-down perspective we want to avoid "unintended bets"; i.e., positioning the portfolio in a way that leaves it vulnerable to certain macro events playing out. The key macro event to watch this year is inflation. There is no doubt in the near term that inflation will continue to increase: most of the companies we speak to are seeing significant input cost (and increasingly labour) inflation, and have signalled their intent to pass this on in the form of higher prices. Since we think inflation is heading up in the near-term, it's important to make sure our portfolio owns businesses with pricing power, that can protect margins and pass on higher costs to end consumers. We have analysed our portfolio through this lens and think we are well positioned. Businesses like James Hardie, Woolworths, Wesfarmers, Macquarie, the banks, Aristocrat and CSL should all benefit from (or at least not suffer from) higher inflation.
 

The market has been quick to reprice those businesses whose valuations had benefited from the "lower-for-longer" interest rate tailwind of the last decade, chiefly high PE structural growth stories, loss-making tech companies and REITs. We believe there are additional nuances to consider. We are avoiding businesses with high ongoing capex needs, as inflation makes it more expensive to stand still, and businesses with material exposure to floating-rate debt. Meanwhile, we spend our time sifting through the wreckage of heavily sold-off companies for opportunities where good businesses have been mispriced with respect to stock selection for the portfolio, we weigh four factors when considering an investment:

Financial strength: We want to own businesses with conservative levels of gearing and strong cash flows. While corporate balance sheets are in great shape across the board, with average net debt to EBITDA for ASX200 companies of 1.8x (well below the 10-year median of 2.5x), our portfolio has an average net debt to EBITDA of 0.3x.

Further, 38% of our portfolio companies are in fact net cash. We believe this sets us up for strong future returns, whether through dividends, special dividends, buybacks, investment or acquisitions.
Business quality: We focus on businesses that can generate good or improving returns on their invested capital (ROIC). The reason is simple: higher returning businesses require less reinvestment to grow earnings, so more cash is available for shareholders. We believe a business can only sustain a high ROIC over the medium term if it has something special: barriers to entry, pricing power, favourable industry structure and/or a strong product that resonates with customers. When you invest in the ASX200 index, the median pre-tax ROIC is 14% (this excludes financials and REITs). By contrast, the pre-tax ROIC of our portfolio (ex financials and REITs) is 20%. This reflects our process, which selects for high (or improving) ROIC companies.

Management quality: We look for alignment with shareholders, whether that be through significant management shareholdings, or appropriate long-term incentives. The ultimate model of alignment for us is owner- managed businesses, where the original founder remains in control. We believe these businesses tend to outperform over the long term, and owner-managed businesses comprise c30% of our portfolio, compared to 10% of the ASX200.

Valuation: We believe the returns a business generates drive the value of the business, and seek to invest where the above factors are underappreciated in the prevailing market share price.

Funds operated by this manager:

Airlie Australian Share Fund

Important Information: Units in the fund(s) referred to herein are issued by Magellan Asset Management Limited (ABN 31 120 593 946, AFS Licence No. 304 301) trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation. This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

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