Schroder Equity Opportunities Fund – WC (SCH0035AU) Report & Performance

The S&P / ASX 300 Accumulation Index rose by 13.8%, while the Schroder Equity Opportunities Fund – Wholesale portfolio rose by 13.9% (Post-fee), outperforming by 0.1% (Post-fee) for the quarter.

Contributors
Virgin Money UK (Overweight) (+83.0%)
Wild oscillations in the share price remain reflective of equity market conditions rather than rapidly changing business fundamentals. As the UK struggles under a COVID-19 impact significantly more severe than many other jurisdictions, we remain troubled by questions over how credit can be kept flowing, interest rates kept at negligible levels and bank shareholders insulated against the spectre of bad debts should efforts to perpetuate asset price gains regardless of fundamentals ever prove unsuccessful. This question, and the leveraged nature of banks continues to temper our enthusiasm for the sector despite apparently attractive valuation metrics versus history. Whilst there is undoubtedly valuation appeal in the business if the book value proves reliable and the litany of abnormal items which management continue to remove from earnings in order to paint a more appealing picture eventually ceases, we acknowledge the attraction in this investment is more in its apparently cheap valuation than in the quality of the business..

Fletcher Building (Overweight) (+52.8%)
Our attraction to the Fletcher Building business has been its potential and highly attractive valuation rather than historic performance. Strong market positions in hardware and building products, particularly in NZ, provide highly sustainable, albeit cyclical revenues. For many years the business has struggled to convert relatively strong NZ housing conditions into improving profitability at the hands of ill-considered offshore expansion and disappointing cost management. We are hopeful renewed management efforts on this front, continuing strong residential housing activity, limited COVID-19 impact and ongoing attractions of NZ as a market (population growth potential, renewable power, competent and stable political landscape) will offer an improving profit picture. In combination with a valuation which would still be fairly appealing should none of this improvement eventuate, we see the odds strongly in investors favour.

Oil Search (Overweight) (+40.5%)
A highly attractive LNG operation with extremely strong cost positioning and reserves have proven no match for collapsing oil/LNG prices and an over-geared balance sheet in 2020. As has been the case in other commodities, the path of energy stocks is likely to remain anchored in the outlook for underlying commodity prices. History suggests energy prices do not always fall and the dearth of investment which low prices have driven, will sow the seeds of higher prices. Having raised capital earlier in 2020 and rectified the excessive gearing issue, the experience for Oil Search investors is likely to be slightly less volatile in future, however, our expectations of improving cashflows as prices recover see the business offering very attractive returns.

South 32 (Overweight) (+21.1%)
The bulk of the value in South 32 lies in high quality, low cost alumina operations and Australian manganese operations. Smaller elements of value across metallurgical coal, aluminium, nickel and South African thermal coal operations (currently in the process of disposal) have perhaps clouded the outlook for what we believe to be an extremely well-managed business. An ungeared balance sheet and attractive valuation metrics position the business well to take advantage of commodity prices we believe are still depressed versus sustainable levels.

Detractors
Afterpay (Underweight) (+47.5%)
Without detracting from the enormous success which the business has delivered in attracting users of its buy now pay later service and the undoubted consumer appeal of foisting costs on retailers rather than consumers, we find the more than $30bn valuation attributed to the business difficult to fathom. As a relatively small revenue business with global potential, a simple story and a customer base which overlaps with the most eager new participants in the equity market frenzy, the ducks have lined up for a stratospheric valuation. Management are obliging with regular and judicious business updates to fuel the adrenaline. Our longer-term concerns remain the already intensifying competitive landscape and the lack of scale economics. Whilst the world remains awash with countless billions seeking to finance technology businesses of any shape and form without regard for profit, we would expect this landscape to depress rather than augment the outlook for future sector profitability

Aurizon (Overweight) (-8.2%)
The hard work navigating the haphazard and often unfathomable approach to regulation in Australia which sees its regulated assets priced to deliver lower returns than many other regulated assets despite at least comparable risk, has created headaches of recent years. As a necessary infrastructure provider to a still essential industry, we have adopted a pragmatic, rather than emotional approach to the business. Even assuming the achievement of aggressive targets in reduction of thermal coal usage (which we wholly embrace), the high quality of the operations which Aurizon services and the logic of prioritising higher quality coal sources as the world finds emission solutions leaves Aurizon’s rail network valuable into the distant future.

ASX (Overweight) (-11.1%)
Software issues which caused a trading outage in November have, perhaps predictably, seen regulators and connected parties raise concerns over the operation of ASX while expressing no such concern over their own (the regulator’s prerogative). Years of relatively flawless operation combined with trading and market plumbing which operate at least as effectively as global counterparts are generally lost in the emotional reaction of participants who endured the trauma of being unable to trade shares for a day or so. They should perhaps speak to a few tourism or hospitality based small businesses for some perspective on what constitutes a real problem. We continue to believe ASX is a well-run business currently rectifying periods of technology underinvestment in years past. This unfortunately takes time and sometimes encounters issues. While we harbour some concerns over the longer-term impact of perversion of fixed income markets from intervention and the unfathomable desire in political circles to continue driving consolidation rather than fragmentation of equity ownership and capital provision, we expect the ASX franchise will endure.

CBA (Underweight) (+29.1%)
Major banks in Australia have far greater similarities than differences; balance sheets which predominantly send deposits and wholesale funding out the other side as housing loans to support the Australian love affair with overpriced property and far lower proportions as business and personal lending. Long history and benign operating conditions have seen the costs of performing this function grow incessantly. While CBA performs these operations at least as well as other major banks and with good technology, the eroding value of a large deposit base in a zero interest rate environment and intense competition for the remaining creditworthy borrowers, make it difficult to sustain its profit and return on equity advantage over peers. Valuation continues to reflect a large and sustainable advantage over peers.