K2 Australian Absolute Return (KAM0101AU) Report & Performance

The K2 Australian Fund returned 3.82% for the month.

During      the      month      the      Treasurer      appointed      Michele      Bullock      as      the     9th Governor    of    the    Reserve    Bank    of    Australia    (RBA).    She    will    commence   in mid-September        and        will        oversee        the        implementation        of        the       recently announced    Review    of    the    RBA.    The    Treasurer    has    insisted   that   Australia should         have         the        world’s        best        and        most        effective        central        bank.        He acknowledged      that      Australia      is      facing      a      complex      and      changing     macro environment     and     monetary     policy     must    be    sufficiently    equipped    to    make the      right      calls      in      the      interests      of      the     Australian     people.     So     what     could change?      It     seems     unlikely     that     the     RBA     will     suddenly     embrace     a     more hawkish     perspective.     In     fact,     in     a     recent     speech,    Bullock    stated    that    the RBA       had       been       more       willing       to       accept       a       more       gradual       return      to      the inflation        target        than        peer        developed        central       banks.       This       would       help explain        why       Australia’s       cash       rate       is       more       than       1%       lower       than       peer nations      despite      having      an      inflation      pulse      that      is      more      than      2%     faster. Furthermore,    Australian    mortgage    holders    are    significantly   more   exposed to         variable         interest         rates         than         developed         peer        nations.        Fixed        rate mortgages        accounted        for        more        than        30%        of        Australia’s       outstanding mortgages     in     2022     and    the    RBA    estimates    that    by    2024    more    than    20% of      these      will      have      rolled      into      variable      rates.      This      is      one     of     the     known knowns.    An    unknow    known    is,    as    disposable    income    squeezes,    what   will households determine to be non-negotiable expenses?

One    non-negotiable    expense    that    Australian    households    have   historically prioritised      is      the      servicing      their      mortgage.      And,      as      was      highlighted     by Helia    Group    (HLI)    during    the    month,    this    continues    to    be    the    case.    HLI   is Australia’s    leading    provider    of   lenders   mortgage   insurance   (LMI).   HLI   is   at risk      if      a      mortgage      that     has     a     LMI     policy     moves     into     the     default     phase. Problems    occur    when    the    outstanding    loan    is    higher   than   the   value   of   the property        secured        by        the       mortgage.       Despite       high       mortgage       servicing requirements,      elevated      living      costs,      and      declining      property      prices,      HLI continues    to    register    a    low    level    of    claims    and    delinquencies.    In    fact,    HLI is      reducing      the      value      of      it      prior      liability      claim      reserves.      This     backdrop should     be     supportive     for     the     forthcoming     June     half     year    earnings    of    the Funds      holdings      in      Commonwealth      Bank      (CBA),      Bendigo     and     Adelaide Bank        (BEN)        and       to       a       lesser       degree       Kina       Securities       (KSL).       We       are underweight            banks            but            believe            that            CBA,            BEN            and           KSL           are demonstrating that the lending business is sustainable.

The K2 Australian Fund returned -0.37% for the month.

During the month there were a number of important data releases in Australia. Firstly, the CPI for May was 0.4% lower than April or 5.6% higher than a year ago; this was better than expected. Secondly, the number of Australian underemployed workers in May were 12% more than this time last year. Finally, the number of job vacancies in May were 10% lower than last year. Furthermore, we are mindful that a number of Australian companies are over-earning and are, therefore, enabling a new source of competitive threats. A number of younger companies have been able to utilise the latest iterations of technology and now have the potential to compete with scale. It therefore seems likely that tradable and non-tradable inflationary pressures are peaking. All up, these outcomes should provide the Reserve Bank of Australia (RBA) with some flexibility towards tightening monetary policy. Eventually, the RBA will be comfortable moving to the sidelines, and this should signal that Australia’s economic activity is broadening. This would be very favourable for Seven Holdings (SVW).

SVW is one of Australia’s leading industrial companies with operations spanning industrial services, energy and media. Over the past few years SVW has also demonstrated a disciplined approach to allocating capital. Between 2013 and 2016, SVW conducted an on-market buyback where it acquired 27 million shares at an average price of $5.82. Then in 2017, SVW issued $375 million of equity at $11.20 to acquire 53% of Coates Hire. Again in 2021. SVW placed $500 million of equity to institutions at $22.50 following its initial acquisition of 23% of Boral. This activity has enabled SVW to build exposure to a number of Australia’s strategic growth avenues such as the infrastructure rollout, mining production and transitional energy.

The Fund is well positioned for a cyclical improvement in economic activity. There are some green shoots sprouting within the residential property market, housing prices are stabilising, auction clearance rates are improving and population growth has resumed. Dwelling construction activity is still subdued but a less volatile phase of monetary policy would surely cause some uplift in approvals for dwelling activity. The best lows performing holdings for the Fund this month were BHP Group (BHP) SVW and Macquarie Group (MOG), Detractors to performance were MAAS Group (MGH) and Peopleln (PPE).

The K2 Australian Fund returned -1.94% for the month. There       are       a       few       indicators      that      are      sending      mixed      signals      about      the prospects         for        Australia.        Firstly,        global        commodity        prices        have        been edging     lower.     Secondly,     China’s     economic     activity     appears     to     be    losing momentum.     Thirdly,     Australia’s     inflation     pulse     is     not    receding    as    quickly as      peers      nations.      And      finally,      Australia’s      key     political     figures     have     lost sight    of    the    need    to    drive   productivity   and   are   instead   tilting   their   narrative and      actions      towards      growth      in      real      wages.      Higher      real      wages     without productivity     gains     would     no     doubt     cause     the     Reserve     Bank     of    Australia (RBA)      to      become      more      hawkish     at     the     worst     possible     time.     More     than 800,000      Australian      mortgages      are     in     the     process     of     swinging     from     low fixed      interest      rates      to     substantially     higher     variable     rates.     The     RBA     has already      tightened      monetary      policy      twelve      times      this      cycle.      Any      further upward           movements          will          obviously          have          a          bearing          on          household spending.    

We    are    also    beginning    to    see    some    signs    that    businesses    are becoming     less     courageous     with     hiring     intentions    and    it    seems    inevitable that    Australia’s    unemployment    rate    will    rise   into   2024.   The   key   question   is whether         the         softening         in         consumer         spending        will        coincide        with        an eventual     rebalancing     of     the     labour     market    and    allow    the    RBA    to    stay    on the sidelines. During    the    month    a    number    of    US    listed    companies    indicated    that    strong demand      for      generative      artificial      intelligence      and      language      models     was underpinning     future     revenue     prospects. 

   As     a     result,     share     prices     of     the 100     largest     Nasdaq     listed     companies    rose    8%    for    the    month.    Australia’s Technology    sector    was    also    strong    rising   4%   for   the   month.   It   is   important to     note     that     the     largest     100     Nasdaq     listed    companies    trade    on    25x    next years’    expected    earnings.   

The    Australian    Technology    sector    on    the   other hand      trades      on      more     than     40x     earnings     yet     delivers     less     than     half     the ROE of the US peers. The        best       performing       holdings       for       the       Fund       this       month       were       Ryman Healthcare          (RYM),          MAAS          Group          (MGH)         and         News         Corp         (NWS). Detractors      to      performance      were      Macquarie      Group     (MQG),     BHP     Group (BHP)    and    Nick    Scali    (NCK).    During    the    month    the    Fund    acquired    a    new position    in    Lynas    Rare    Earths    (LYC).   The   median   holding   of   the   Fund   has a    market    capitalisation    of    $7.3    billion    and,    using    expectations   for   the   year ahead,      has      a      PE      of      13.4x,      an      ROE      of      15.4%      and     a     dividend     yield     of 3.8%.

The K2 Australian Fund returned 1.38% for the month.

The          Australian         economy         is         expected         to         deliver         meagre         economic advancement         over         the         coming        year;        consensus        estimates        are        that Australia’s       GDP       growth       will       be       just       1.7%.       It       is       also      likely      that      these estimates    will    continue    to    fade.    The    last    time   economists   were   so   bearish about      Australia’s      economic      fortunes,      excluding      the     COVID     phase,     was during       the       Global       Financial       Crisis.       It       is       also       worth       noting       that      today Australia’s      2     year     bond     yield     is     3.16%     whereas     the     official     cash     rate     is 3.85%.       

 The         last         time         the         inversion        was        so        extreme        was        back        in September     2012.     Inflation     expectations     back     in     2012    were    moderate    so unsurprisingly,        the        Reserve        Bank        of        Australia        (RBA)        started       easing monetary     policy.     Unfortunately,     today     we     are     not     so     lucky.    The    inflation rate        for        the        year        ahead        is        expected        to        be        4.7%.        Hence,       although economic      conditions      are      sanguine,      the     RBA     is     unlikely     to     aggressively reduce    interest    rates.    That    said,    we    also    believe    that    the    RBA    will    not    be in     a     rush     to     tighten     monetary     policy     much     further.   

  The     labour    market    is finally          showing          some          early         signs         of         rebalancing;         the         number         job advertisements    are    now    well    below    last    years’    level    and    this    is   typically   a precursor     to     a    lift    in    the    unemployment    rate.    It    would    appear    to    us    that    a soft landing is still probable in Australia. We    are    also    starting    to    see    some    contraction    in    the    PE    dispersion   for   the ASX     200.     The     PE     of     the    cheapest    top    quartile    company    is    currently    26x whereas      during      the     COVID     phase     it     averaged     30x     and     pre     COVID     the average        was       17x.       The       PE       of       the       cheapest       top       quartile       company       is currently        15        points        higher        than        the        most        expensive       bottom       quartile company.      During      COVID,      this      dispersion      averaged      17      points      whereas pre-COVID     the     average     had     been    10    points.    There    is    finally    competition for       growth       so       the       dispersion       in       valuation       metrics       should       continue       to contract.

The K2 Australian Fund returned -2.66% for the month. During    the    month,    the    Governor    of    the    Reserve    Bank    of    Australia    (RBA), Philip           Lowe,           had           to           make           two          appearances          before          government committees.       

There         was         active         debate        around        the        merits        of        RBA’s meaningfully            tighter            stance            of            monetary            policy.           Governor           Lowe continually     reiterated     the     dangers     of     inflation     becoming     ingrained     in     the public’s    psyche.    Lowe    also    reinforced    that    the    RBA    was    highly   attuned   to the    fact    that    880,000    fixed    rate    loan    facilities,    with    an    average    balance   of $400,000,     would     mature     this     year.     Offsetting    this    to    some    degree    would be     the    additional    $300    billion    that    households    had    saved    since    the    onset of       the       pandemic.       However,       the       RBA       is       concerned      that      demand      side factors    continue    to    play    a    role    in    the    elevated    level    of    inflation   and   tighter monetary policy could assist in the rebalancing of the economy. Australia’s       December       half       reporting       season      was      a      little      disappointing.

Nearly     half    of    the    companies    in    the    ASX    200    saw    downward    revisions    to next    years’    EPS    projections.    However,    the    magnitude    of    the    downgrades were        minor;        the        median        revision        was        just       -0.5%.       Some       of       the       key takeaways    from    the    reporting    season    were    the    intense   competition   within the       mortgage      lending      industry,      the      margin      protection      strategies      of      the grocers        and        petrol        retailers,        and        the       costs       escalation       for       the       major resource     companies.     Despite     a    few    headwinds,    the    valuation    metrics    for the     ASX     200     are     still     relatively     attractive;     on     next     years’     projections    the PE         is         14.4x         and         the         dividend         yield        is        4.5%.        The        major        resource companies    continue    to    trade    on    10x    forward    earnings    whereas    the    PE   of the larger industrials is closer to 17x next years’ earnings.

The K2 Australian Fund returned 6.95% for the month. For      the      past      75      years      Australia      has      measured      inflation     on     a     quarterly basis.      Last      year      the      Australian      Bureau      of      Statistics      finally     moved     to     a monthly         CPI         measure.         Unfortunately,         the         monthly         CPI         reading        for December      was      8.4%      stronger      than      a      year      ago.      The     Reserve     Bank     of Australia      (RBA)      has      been      highlighting      that     Australian     business     leaders have      indicated      that      costs     of     doing     business     have     risen     and     that     prices would     need     to     follow.    

As     a     result,     it     would     appear     that     some     industries are      now     aggressively     focussed     on     margin     accretion     to     the     detriment     of their     customers.    Airlines,    grocers    and    petrol    retailers    look    to    be    the    main culprits       and       their       actions      are      having      a      meaningful      impact      on      inflation gauges.     We     would     prefer     that    business    leaders    counter    short    term    input cost     increases     with     long     term     productivity    solutions.    Supply    chains    have decongested,    ”just    in    case”    inventories    are    no   longer   needed,   and   worker mobility         is         recommencing.         Accordingly,         a         number        of        industries        will increasingly     be     exposed     to    an    improved    level    of    competition    and    market share          will          ultimately          cede          from          the          complacent         to         the         focussed.

Macquarie Group (MQG) is a company that typifies this opportunity. MQG        is       a       specialist       provider       of       financial       services;       two       thirds       of       the activities     have     an     annuity     bias     and     a     third     are     more    market    facing.    The annuity      style      activities      are      mainly     asset     management     and     banking     and have      both      displayed      strong      growth     attributes     in     recent     years.     Over     the past    decade    MQG    has    more    than    doubled    its    assets    under    management to     nearly    $800b.    Despite    this,    MQG    is    still    a    relatively    small    player    in    the US$100t+       industry.     

MQG’s      banking      activities      are      also      relatively      small; MQG’s      Australian      mortgage      book      has      been      growing      by     20%pa     and     is now     over     $100b     but     is     still     less     4%    of    the    market.    MQG’s    market    facing operations    employ    around    4,000    staff    whereas   global   peers   like   Goldman Sachs         and        JP        Morgan        have        48,000        and        290,000        have        employees respectively.     Hence,     we     envisage     that     MQG,     despite     is    recent    success, can       continue       to       grow       quicker       than       its      largest      competitors      and      do      so without disturbing the balance of the market. The         best         performance         contributors         for         the         Fund         this         month         were Macquarie     Group     (MQG),     BHP     Group     (BHP)     and     Seven     Group     (SVW). During     the    month    the    Fund    acquired    a    position    in    Westpac    Bank    (WBC). Dexus     (DXS)     was     sold.     The     median     holding     for     the     Fund     has    a    market capitalisation of $12.1 billion.