Pendal Sustainable Future Australian Shares Portfolio

August 2019


Market commentary

The S&P/ASX 300 fell -2.3% in August as China and the US dialled up the pressure in their trade dispute.
The Australian reporting season painted a picture of a sluggish domestic economy but was, in aggregate, not as bad as many had feared. Discretionary retail spending, in particular, has shown some signs of resilience in recent weeks, helped by better sentiment on house, lower interest rates and tax cuts.
Nevertheless, the market was in a defensive mood in the face of heightened macro-economic uncertainty. Ten year bonds yields fell 30bps in Australia – and 53bps in the US – which generally helped bond-sensitive stocks do well.
This was reflected in the strong performance of the Real Estate sector (+2.4%) – one of the few to post a gain. Goodman Group (GMG, -2.0%) gave up some of it recent gains – while still outperforming. However Scentre Group (SCG, +4.2%) and GPT Group (GPT, +2.9%) both did better.
Healthcare gained +3.4% to be the best performing sector. In this instance, its defensive qualities were augmented by strong results from CSL (CSL, +4.9%) which continues to build upon a strong market position and has seen a recovery in its Albumin volumes sold into China.
Information technology (+0.7%) eked out gains as bond-sensitive growth stocks continued to outperform, led by Afterpay Touch (APT, +15.9%) and Wisetech Global (WTC, +15.6%).
A spike in trade and indications of a recovery in Brazilian iron ore production weighed heavily on the miners. BHP (BHP) fell -11.0% and Rio Tinto (RIO) -8.4%. Gold miners outperformed; however the Materials sector ended the month down -7.3%.
Fears the effect of trade on global growth and demand also weighed on the energy stocks. Woodside Petroleum (WPL) fell -5.8% and Origin Energy (ORG) -3.9%. Santos (STO, +1.0%) delivered a well-received result and managed to buck the trend.


Stock specific drivers of monthly performance relative to benchmark

Three largest contributors

Underweight BHP Billiton (BHP) (-11.0% return)
BHP delivered results in-line with the market’s expectation, generating strong cash flow after a year of high iron ore prices. There are signs that capex will pick up as its rail network in the Pilbara is showing signs of strain – however it was a weaker iron ore price which weighed on the stock in August. BHP is excluded from the portfolio due to its iron ore exposure.

Overweight Qantas (QAN) (+7.0% return)
QAN delivered a decent result despite the headwind of higher fuel costs and softer demand in the domestic market. It also dialled up their capital return by $100m to $600m for the half year, which was well received. At the same time, rival Virgin Australia (VAH) announced that it is looking to close unprofitable routes, helping keep a lid on capacity growth in the domestic Australian market.

Overweight CSL (CSL) (+4.9% return)
CSL delivered a strong set of results, helped by continued growth in its core range of products as well as a recovery of sales of Albumin into China, following a change to its distribution model there. CSL’s investment in plasma collection in recent years puts it in a good competitive decisions, with competitors struggling to boost production to meet strong demand.

Three largest detractors

Underweight Woolworths (WOW) (+6.0% return)
WOW’s result met market expectations. The key takeaway was that there are lower levels of grocery discounting, helping ease revenue pressure. We do not hold WOW.

Underweight CYBG (CYB) (-17.7% return)
CYB’s most recent updates have revealed that margin pressure is not abating as mortgage competition remains intense in the UK. Coupled with the disappointing margin outcome of its merger with Virgin Money, we now see the timeline of our investment thesis pushed out. As a result, we sold out of the position in August.

Overweight Ramsay Health Care (RHC) (-9.8% return)
RHC met the market’s expectation for FY19 but disappointed on the outlook, guiding to 2-4% eps growth as opposed to 8% consensus. We believe that there is a degree of management conservatism here and would not be surprised to see something in the order of 6%, before a better year in 2021.


Market Outlook

• August’s reporting season certainly reflected the fact that economic growth and consumer demand has slowed over the past twelve months, however it was not as bad as many feared would be the case. While the overall market declined, this was driven more by macro uncertainty over the US-China trade dispute – which saw the MSCI World TR index fall -2.33% in August – rather than an overly negative reporting season.
• Around 42% of companies which reported downgraded their earnings guidance for the next twelve months, versus an historical average of just over 30%. Conversely, only 10% upgraded compared to the historical average of just under 20%. The greatest pressure came in areas such as steel – which saw earnings estimates for the next twelve months fall 15% – and also in media (down -13%) and telcos (-10%). Very few sectors of the market saw aggregate upgrades – and where they occurred, they were small. Consumer Discretionary (+1%) and health care (also +1%).
• In aggregate, earnings expectations for the ASX200 for the next twelve months fell 3%, which reflects an environment in which housing construction has slowed and where weaker house prices have weighed on consumer demand.
• That said, price action tended to reflect the both the view that broad outcomes were not as bad as some had feared. There is also a broad expectation that stimulus – in the form of cuts to interest rates and taxes as well as the possibility of more fiscal spending – could help underpin demand and prevent further falls. Signs of an improvement in the housing market are helping in this regard.
• Hence media and steel – the two sectors with the largest downgrades – both outperformed the market and posted positive gains in August. Building materials did likewise, despite downward revisions. Discretionary stocks also did very well as companies like JB Hi-Fi noted in their outlook that demand and sales had started to tick up again in recent weeks.
• All in all growth remains muted, however further signs of an uptick in the domestic economy could drive stock specific opportunities given how cheap many domestic industrial cyclicals are. We retain our exposure via positions in Qantas and Nine Entertainment among others.
• We are mindful that both growth and defensive yield stocks have had a strong twelve month run on the back of falling bond yields. Yields are likely to remain depressed for a period – now is not the time to go aggressively underweight. However these stocks are unlikely to replicate the same degree of outperformance over the coming year unless Australian bond yields fall to near zero. Our preferred growth stocks include CSL and Xero, while we continue to like Transurban and Atlas Arteria among the defensive yield stocks.


New stocks added and/or stocks sold to zero during the month

Sell to zero in CYBG Group (CYB)
The portfolio is liquidating its small position in CYBG, owner of the Clydesdale and Yorkshire Bank and Virgin Money brands in the UK. The investment thesis is grounded in the view that the company’s ability to deliver earnings growth on the back of increased loans and material cost savings was not reflected in valuations. We also see the risk from Brexit as relatively asymmetric, in that a lot of the negativity had already been priced in. That said, we have been mindful of this exogenous risk, which is why the position has always remained relatively modest. Recent updates from management have revealed that the combination of the additional loan book acquired from Virgin Money, coupled with strong mortgage competition, continues to weigh on group lending margins. This has pushed out the timeline of our thesis and, while CYB continues to offer a decent yield, we are redeploying this capital into other opportunities, including a new position in Metcash.

Buy new position in Metcash (MTS)
Metcash is a wholesale distribution and marketing company. The introduction of new management with a strong focus on cost control and revenue growth in the last three years, combined with the sale of non-core assets, has allowed the company to manage a good turnaround despite the structural challenge that increased competition has posed for the Australian supermarket industry.
MTS’s recent underperformance reflects consensus downgrades for FY20 following their FY19 result. Some of this is driven by a moderating outlook for its hardware business, however we believe it also implies an overly negative outlook for its IGA wholesale business and the supermarket sector in general. There are signs the grocery price deflation – a key headwind for supermarket earnings in recent years – is easing on reduced promotional discounting across the sector. At the same time we believe that MTS’s Diamond Store Accelerator programme will help it generate a better than expected share of sales. There are also signs that its cost reduction strategy could also exceed consensus estimations.
From a sustainability perspective, Metcash has been utilising its IGA Community Chest Trust Fund for over 30 years to support the local communities reached by its widespread store network. The company has a focus on diversity and gender equality with key initiatives including reporting on gender targets, strong representation on the board (66%) as well as being cited as a WGEA Employer of Choice for Gender Equality. Other sustainability initiatives includes reporting on Modern Slavery as well as reducing waste and responsible sourcing of products particularly for its private label brands.
MTS trades on 12.9x price-to-next-12-month consensus earnings versus 19.6x for COL. While we believe that MTS should trade at a discount to COL, we see MTS as below its intrinsic value and implying a very depressed valuation for the supermarkets business. Given its greater upside in terms of cost control and leverage to signs of a reduction in grocery price deflation, MTS is our preferred exposure in this sector.

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This monthly commentary relates to the Pendal Sustainable Future Australian Shares Portfolio, a portfolio developed by Pendal. The portfolio composition for any individual investor may vary and the performance information shown may differ from the performance of an investor portfolio due to differences in portfolio construction or fees.
Performance figures are shown gross of fees and are calculated by tracking the value of a notional portfolio. Past performance is not a reliable indicator of future performance.
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