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.