In times of change, new market leaders will emerge

Financial regulators like to say that past investment performance is not a clear indicator of future performance. Yet, we investors often look to the past to gain insights into potential future market conditions. There are patterns that can be exploited or traps that may be avoided. However, as we head into 2024, the past may not offer the usual useful insights.

From a macro perspective, central banks' experimentation with quantitative easing―which provided relatively benign market conditions since the Global Financial Crisis--is being unwound, and this "quantitative tightening" presents a new territory for policymakers and investors. Simultaneously, we appear to be approaching a peak in monetary tightening, and inflation appears to be in retreat, but the end game for this battle remains opaque. Recent market actions suggest a turning point is approaching, yet when it comes to timing key events, markets can often be wrong.

Geopolitics also offers few signs of stability. The peace dividend that has prevailed for several decades has abruptly ended, with ongoing developments in the Middle East being the latest addition to broader uncertainty. In addition, a series of national elections in 2024--culminating with a possible second presidential term for Donald Trump in the US--will ensure further drama unfolds.

With all of this in mind, investors will need to adjust their expectations, and portfolios, to account for higher for longer interest rates, the challenges of slower economic growth, stickier inflation, and a testing geopolitical environment. So, in this sea of uncertainty, where can we find a stable port in which to anchor with confidence? For us, we stand by our philosophy of Future Quality--the belief that companies which can grow, attain and sustain superior returns on invested capital, and have all the key quality pillars in place (Franchise, Management, Balance sheet and Valuation), will be the best candidates for capturing longer-term alpha.

While each company will embark on its own, unique journey to Future Quality, there are also common pathways, often driven by structural requirements. Therefore, these companies are less dependent on macro cycles, which we can leverage over the long term. These include the following:

AI Adoption

The emergence of artificial intelligence (AI) was a dominant market force in 2023. We were initially hesitant about joining this party, but our subsequent research has led us to reappraise this position. While we still believe AI contains an element of hype, it has the potential to transform technology for the next generation. It is too early to define the longterm winners from the new business models and use cases being inspired by AI, but there are market leaders already benefitting from the rapid adoption of this new technology that fit our Future Quality criteria. Over recent months, we have added Synopsys, Nvidia, and Meta to the portfolio.

Enablers of the energy transition

There is a need to reduce humankind's reliance on fossil fuels and create cleaner alternatives through renewable sources of energy, but this transition is not straightforward. Increased spending is needed to sustain existing energy production at the same time as mitigating carbon missions. While there is a fruitful pool of investment opportunities on both sides of this equation, the transition is heavily reliant on fiscal spending and political support could prove to be fickle. Portfolio winners in this space have been Schneider, Linde and Chart Industries (sold in Q3 2023).

Normalisation and structural growth in global travel

The travel industry is still in the process of recovering from pandemic-imposed restrictions, with countries at differing stages of normalisation. Yet, when you look at the core consumers of travel, demand remains robust. This is particularly true for younger generations, who place greater value on "experiences". Furthermore, a new travel cohort is emerging from developing countries where rising gross domestic product per capita means more people will be able to afford to travel in the future. Booking Holdings, Amadeus and Samsonite have been positive contributors to the portfolio in 2023.

Providers and enablers of healthcare efficiency

With an ageing population, providing sufficient and efficient healthcare, as well as reducing the cost of such services, will be one of the world's most important challenges going forward. In our view, this demographic test will--and has been--a great hunting ground for investment ideas as healthcare companies innovate to deliver much-needed solutions. That said, some subindustries within the healthcare sector have underperformed of late because of the pandemic pulling demand forward and creating ongoing staff shortages.

We are heading into a changing world, where the more recent past can no longer be relied on to guide our path forward. There are tools we can use to provide a greater degree of certainty. Our Future Quality approach is designed to help us identify franchises that are set to endure. Some of these companies may not have been in the vanguard of market leadership over the last decade. However, in this instance, we can more reliably believe history when it tells us that in times of change, the market leaders at the start are rarely the same as the ones leading us out of it.

As we summarized in our September quarter note, there was a time post the Fukushima disaster when it appeared that nuclear energy was too risky and would be bypassed entirely in favour of renewables. Coal was to be phased out and wind and solar, as well as more marginal technologies like biomass, would increasingly play a central role in keeping the lights on. Zero carbon will eventually disrupt the transition fuels too (a polite term for gas) so that come 2050, the energy transition will be complete.

This is a neat narrative but it's looking increasingly likely that the scale of the transition may just be too great to reach net zero in less than 30 years. After all, the global population continues to grow and there is a very strong correlation between population size and energy demand - we all require energy for life's basics and per capita consumption continues to rise. The inequalities of energy consumption apparently don't matter; wealthy countries with low population growth consume far more power per capita than poorer ones. We can either try to grow a bigger pie, or be fairer with the one we have, and if it's a bigger pie we need, then the scale of transition is extremely daunting.

Excessive demand can lead to many problems, and we will need to walk a fine line between environmental preservation and deprivation. The Australian Broadcasting Corporation recently featured an article entitled, "How can we support the transitions to renewables without further damaging the environment?", which highlighted the 'dark side' of the rush to electrification - pollution and degradation.

An example is the controversy surrounding the Upper Burdekin Wind Farm in Queensland. Windlab, a company associated with Andrew Forrest and at one time had the support of Apple, has been criticized for the scale of land clearing and endangerment of several threatened species including koalas and rock wallabies. It's an odd circularity akin to that infamous line from the Vietnam War era, "we had to destroy that village in order to save it".

Where does nuclear fit in? Besides being a low-carbon source of power, it offers several other advantages over most other renewables: long life; high reliability/efficiency; competitive life-time cost; less intensive use of raw materials; and lower physical footprint. In this piece, we focus on the small footprint that nuclear power generates relative to other power sources. Coal has been a foundation for modern economies, providing 'safe', stable baseload power. Nuclear has the same ability and can do so in a uniquely small area for its potential.

In an article published on OurWorldInData.org in 2022, author Hannah Ritchie detailed the relative land use intensity of different methods of power generation.1 The lifecycle assessment, i.e., complete land use including mining, found that nuclear power at 0.3m2/MWh is the most efficient form of power, including renewables (Figure 1).

Onshore wind is almost as efficient at 0.4m2/MWh if only the land used by the windmill is counted and not the entire wind farm. This is because land in between windmills can have other uses, such as agricultural production or grazing. The total area needed can be very large and may require the clearing of vegetation, hence the large range. As the Burdekin project shows, this can disturb the natural state of a large area although it would be hard to argue that the land is completely sterilised.

As turbines grow in size and technology advances, there is likely to be some improvement in m2/MWh though vary through a wide range.

Figure 1: Relative efficiency of power generation relative to land use

Offshore wind offers several advantages over onshore installations, namely an ability to install larger and more efficient turbines, and land use ceases to be an issue (ex the need for raw materials). The limiting factors for offshore wind tend to centre on finding suitable wind resources, seabed condition, locations near population centres, visual impacts, access to fisheries and impediments to marine navigation and aircraft. There has been some controversy regarding the potential impact on whales, and while this issue has recently been a hot topic in the US, to date there is no evidence that connects offshore wind farms to the injury or death of whales.

Nevertheless, these utilities are enormous, sprawling structures, where for example, the proposed Illawarra (4.2GW) and Hunter (5GW) projects offshore NSW cover areas of 1,461km2 and 1,854km2, respectively (Department of Climate Change, Energy, the Environment & Water, DCCEEW). To give some context, that is roughly the same size as Fraser Island (K'gari), the world's largest sand island. Another way to look at the scale is to consider that the Illawarra project would stretch over about 50km of the coast and the Hunter up to 90km, or a combined 6.5% of the state's coastline (Figure 2). The windmills themselves will be around 270m high and at 15MW each, around 600 would be needed to meet the stated capacity of the combined area.

Figure 2: Proposed area for the Hunter (top) Illawarra (bottom) offshore wind projects

Solar PV's great advantage is that for the most part, it uses existing infrastructure (rooftops). The Australian PV Institute states that there are over 3.6m PV installations in Australia totalling more than 32.9GW of capacity with most systems between 6.5kW and 9.5kW, i.e., suburban roof tops. Our basic analysis indicates that the area used by all PV solar in the country is only about 146km2 and 2m2/MWh assuming a somewhat generous average of 400W panels and no secondary impacts from mining. On a life-cycle basis, Ritchie estimates that number to be 3m2/MWh for rooftops but 19m2/MWh for on-ground commercial facilities.

On-ground commercial solar arrays don't piggyback on existing structures, so their land-use is real. Hence, they are amongst the least efficient forms of power generation in terms of their footprint. The largest proposed solar PV facility in Australia is Sun Cable in the Northern Territory. At 20GW, it would cover 120km2, almost as much area as all other PV installations in Australia, but be located on pastural leases used to graze cattle. Large as it is, Sun Cable is remote and is almost meaningless in a country the size of Australia.

The area of installed solar PV in Australia is just one-tenth that of the Illawarra wind project yet has almost 8 times the installed capacity. Naturally there are other things to consider, such as the higher capacity factor of offshore wind (e.g., ability to generate at night) that make installed capacity an overly simplistic measure. Using average global capacity factors for offshore wind of 40% (35-45% range over 2010-2022) and 12% for rooftop solar in Australia (i.e., non-commercial), solar PV would still have 2 times the capacity of the Illawarra project - 4GW vs 2GW - for the same operational life.

At the other end of the spectrum are hydro systems, mainly due to the mining footprint and the flooding of valleys for water storage. A slightly unusual system is solar that uses mirrors to concentrate solar energy on a tower to create heat. Land use is very intense, averaging 22m2/MWh, which suggest that these systems are somewhat extravagant and that better alternatives exist.

Nuclear suffers from very few of the problems discussed above. Firstly, the raw size of the nuclear power plant itself is relatively small and the move to Small Modular Reactors should enhance this feature. A 1GW nuclear power plant covers approximately 3.5km2 while a coal plant of the same size is almost twice that. Neither can compete with gas, however, at 0.5km2. Pity about the CO2. There is a case to make that the sites of shuttered coal-fired power plants would make good sites for new nuclear ones in that grid infrastructure is in place and further land clearing is unnecessary.

Secondly, the mining of uranium does not take much space relative to the output of a nuclear power plant and hence m2/MWh is miniscule. Land disturbance for coal mining is famously large and ash disposal contributes to land use. The scale of coal consumption depends on plant design, efficiency and the rated calorific value of the target fuel, so there is no rule of thumb. However, the World Coal Institute estimates that at 38% efficiency and 75% availability, a 1GW coal plant would burn 2.5Mtpa bituminous coal and 6.5Mtpa brown coal. Compare this to a nuclear power plant of the same size, which uses about 27tpa uranium, requiring perhaps 0.5Mlbs U308 and ore input of maybe 400ktpa depending on grade and recovery. Mining for silica, aluminium, copper and zinc contribute negatively to solar and wind.

Thirdly, nuclear power plants are highly efficient, with plant availability of more than 90% over long life spans. These are key factors in life cycle analysis because they result in nuclear power plants producing many more TWh of power over time than other power plants, i.e., a bigger denominator.

All this is underscored by the COP28 meeting held in the UAE at beginning of December, which again highlighted the role nuclear power could play in the drive to decarbonize. More than 20 countries signed a declaration to triple nuclear capacity by 2050. It included major economies such as the US, Japan, South Korea, France and the UK, though not Germany (nor Australia for that matter). This represents a stunning turnaround for the nuclear industry and is reflected in the surging uranium spot price, which is now US$87/lb. We continue to believe that nuclear energy will play an increasingly important role in providing the world with clean power and maintain significant positions in near-term uranium producers, Boss Energy and Paladin Energy.

Author: David Haddad, Principal and Portfolio Manager

Globally equity markets performed strongly in January. In the US, the S&P 500 increased +1.6%, the Nasdaq rose +1.0%, whilst in the UK, the FTSE100 declined -1.3%.

In Australia, the ASX All Ordinaries Accumulation Index rose +1.1%. Energy and Financials were the best performing sectors, whilst resources was the weakest performer, as sentiment towards the Chinese economy weakened.

Inflation data both domestically and offshore continues to moderate, which in our view indicates the bulk of the heavy lifting by central banks in terms of interest rate hikes has now been done. The US economy appears to be ahead of Australia in terms of getting on top of inflation, hence we expect the US will see interest rate cuts before Australia over the next 12-18 months. In bond markets, following two months of very material declines in bond yields, January saw a slight increase as economic data pointed to a still strong global economy (despite the aggressive tightening by central banks). In the US, the 10-year bond rate climbed +17 basis points (bp) to close at 4.01%, whilst in Australia the 10-year bond rate rose +6 bp to also finish at 4.01%.

As always, February is a very busy month with the vast majority of the fund's holdings reporting results for the six months to 31 December 2023. The upcoming reporting season will provide visibility into how the companies are performing operationally. Whilst we have seen a recovery in equity markets in recent months, we continue to be very optimistic about the outlook for small/mid cap stocks on the ASX given their cheap valuations and material underperformance over the last two years.

To reiterate, our focus in 2024 will be identifying quality businesses trading on attractive valuations, where we believe material earnings upside exists.