Investment Insights: The ups, the downs,

and the future of the economic cycle

Touchstone Asset Management

November 2023

This article looks at some of the current challenges faced by the consumer market and explores macroeconomic trends affecting the market.

As primarily bottom-up investors, we can often get an edge by talking to a company's customers, suppliers, and management teams to assess quality - which is not always done well in the market. And this bottom-up work often leads to the formation of strong top-down views. For example, in 2021 we were confident that inflation was strengthening and would come in above market expectations and lead to higher interest rates. Now, our view is that inflation has peaked, but will remain elevated for some time.

Along with inflation and its impact on consumer spending, there's a lot of global macroeconomic volatility impacting the market.

An update on consumer spending

Let's start with a quick recap of the most recent reporting season.

This brought about a wave of volatility in the stock market, with one in every eight stocks experiencing movements of over 10% in response to their results, which is twice the usual average. This period was characterised by price-to-earnings (PE) expansion, explaining much of the market's upward movement. Investors seemed willing to look through some of the soft results by cyclical companies and buy them regardless, leading to PE re-rating. But they also sold defensives that had earnings misses - which could be seen in the earnings revisions. The average earnings upgrade was only 2.7%, and the average downgrade was around 9%.

The reporting season proved to be a tough one for consumer stocks, marked as the worst in 13 years. More than half of consumer companies downgraded their earnings by over 10%. Several factors played a role in this underperformance, as we had expected.

A significant part of the impact can be attributed to the peak effect of the transition from fixed to variable mortgage rates. Additionally, the phase-out of low and middle-income tax offsets, which provided households with tax refunds, created headwinds. As households steadily deplete their savings buffers, the effects rippled through to earnings. The struggle was evident not just in the earnings reports, but also in high-frequency retail spending data from Kepler, which showed a drop as steep as 12% year-on-year and real per capita consumption plummeting by as much as -5%; an unprecedented decline.

In terms of categories, electricals were particularly weak, but there were some doing quite well, such as those that thrive in good weather conditions (e.g. Wesfarmers, thanks to Bunnings' results).

Inflation is staying high

While inflation may have peaked, it is expected to remain elevated for some time across the globe.

We are particularly concerned about the situation in the US, where fiscal spending continues at an unsustainable rate, and is contributing to higher bond yields. While those yields are rising, it is not solely due to inflation. There's a shortage of demand for bonds, which propels interest rates upward.

The current conflict in the Middle East, while socially devastating, also has strong financial impacts. Tensions lead to higher oil prices globally, further increasing cost of living. We were already positive on oil because we thought supply would be under pressure, but again, that just gives us confidence with a higher oil price that inflation will remain elevated.

So, what does this mean for Australia?

We believe wages growth will remain strong here, because of our relatively rigid wage setting mechanism. We also believe energy prices are expected to remain high, so we're in a similar situation where inflation, while it may have peaked out, should remain quite high. And as we saw recently, the RBA implemented another rate hike.

At the household level, the pressure is at its peak, with the transition from fixed to variable mortgages and the depletion of savings buffers taking its toll. Approximately 60% of households have already exhausted their savings, a figure expected to rise to 80% by the year's end.

Overall, as we expected, we saw a per capita recession but not an outright recession, and we can hopefully look forward to better conditions as we move through 2024.

A bit on banks

For a while, we've held the view that the banks' margins were too high and would come down. The recent  reporting season appeared to confirm this view, with pre-provision operating profits broadly disappointing as bank margins were squeezed. Offsetting this, credit costs continued to surprise positively, resulting in earnings that mostly met expectations.

We still see a lot of competition in the sector and rising costs impacting in the year ahead. We also forecast an increase in bad debts, as losses begin to normalise from its current very low levels. This will likely result in lower earnings for the sector over the next 12 months.

We have owned NAB, and we think that's the pick of the bunch - relatively less exposed to some of the concerns we have and looks more reasonable. But if anything, across our portfolio, we make a lot of being index unaware, and this is a great time where we think there's more opportunity out of sight of the major sectors of banks and resources, into some of the other areas where we see more quality on offer at better value.

The end is near (for the economic cycle)

Despite the challenges, there are still opportunities in the market for investors who choose wisely. And while it's felt like a long, volatile cycle, we are nearer to the end than the beginning.

For some time, we've been talking about our expectations for earnings downgrades. In mid-late 2022, the market had 12 months forward EPS growth of around plus 8%. That's fallen by 14%. Expectations are now for EPS to decline in 2024 by around -6%.

Notably, the downgrades have been largely due to resources. Industrials have actually been surprisingly resilient, so we still think there'll be further modest weakness in earnings, perhaps low to mid-single digit downside. But what will be different is that the downgrades are likely to come from the industrials.

How we're positioning the portfolio

Our approach is to own the higher quality cyclicals - preferably those that have used the period of weakness over the past couple of years to improve their businesses, in anticipation of rates peaking and the next cycle commencing. For example, we invested in James Hardie this year, which has been a good call. While we knew the company could be impacted by higher US interest rates, those rates now mean less building. So, if anything, there's more of an undersupply of housing in the US as we move through the next cycle - a little bit of pain now, but potentially more upside later.

Another sector we are overweight in is energy, with companies like Ampol showing strong performance due to our positive outlook on oil.

There's been a lot of talk recently about the impact of GLP-1 drugs like Ozempic on healthcare stocks. It's meant that some of the healthcare stocks, which are in the bucket of defensives and are high quality companies, are now particularly cheap. We think in some instances they've been dealt with too harshly. In the longer term, we don't think health care stocks will be impacted by GLP-1 drugs, and therefore, oddly enough, it's actually the defensives that are quite often looking attractive now.

CSL, for example, is the top ranked stock in our universe on our quality value matrix. Even if we take the extreme view as to the uptake and adherence to all correct protocols by people that take GLP-1 drugs, CSL may see some competition in parts of its portfolio, but there'll be minimal impact. At a recent investor day, CSL's management forecasted double-digit earnings growth, with increasing return on capital. So, there's still positive feedback from the industry.

Overall, the market looks relatively reasonably valued, perhaps even marginally overvalued. So, when you put all that together, given we know the market will look through the last part of the earnings downgrades, we're now starting to think about what we want to own for the next cycle.

Funds operated by this manager:

Touchstone Index Unaware Fund

The content contained in this audio represents the opinions of the speakers. The speakers may hold either long or short positions in securities of various companies discussed in the audio. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the speakers to express their personal views on investing and for the entertainment of the listener.

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ESG in 10: Episode 12 -

What is AMR and why is it important for Investors?

Fidante Partners

November 2023

Funds operated by this manager:

On the road: is India starting to live up to its promise?

abrdn

November 2023

Funds operated by this manager:

Aberdeen Standard Actively Hedged International Equities Fund, Aberdeen Standard Asian Opportunities Fund, Aberdeen Standard Australian Small Companies Fund, Aberdeen Standard Emerging Opportunities Fund, Aberdeen Standard Ex-20 Australian Equities Fund (Class A), Aberdeen Standard Focused Sustainable Australian Equity Fund, Aberdeen Standard Fully Hedged International Equities Fund, Aberdeen Standard Global Absolute Return Strategies Fund, Aberdeen Standard Global Corporate Bond Fund, Aberdeen Standard International Equity Fund, Aberdeen Standard Multi Asset Real Return Fund, Aberdeen Standard Multi-Asset Income Fund

10k Words

Equitable Investors

November 2023

November Edition

Funds operated by this manager:

Equitable Investors Dragonfly Fund

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Acceleration of innovation now spells danger for investors

Insync Fund Managers

November 2023

A new app, 'Threads' built by Instagram, which enables the sharing of text updates and joining public conversations, recently reached 100 million users within an astonishing five days.

'This is a powerful demonstration of the lightning speed at which innovation is accelerating,' says Insync Funds Management (Insync)'s Head of Strategy and Distribution, Grant Pearson. 'Make no mistake, the frantic pace of change now spells danger for investors.'

For context, Facebook took 4.5 years to reach 100 million users, Instagram took 2.5 years, TikTok achieved it in nine months, and Chat GPT took two months.

'The reason this means big trouble for investors is that they could be in the right company today and, as little as weeks later, be in the wrong company,' Mr Pearson says.

The pace of innovation does not just affect pure technology plays.

'All companies could be affected as they all rely on technology of some sort,' he says. 'If their competition embraces new technology better and faster, a dominant company today may find its revenues and profits under immediate threat. And let's not forget brand new competitors for firms that technology has opened the gates to.'

Mr Pearson says that while in the past investors had months or even years to discover an emerging technological breakthrough, assess it, seek views, and then act; now they have next to no time and the skills required to do it are often outside the investment industry.

'In fact, the average life span of successful businesses is being compressed into less than 10 years duration,' he went on to say. 'This is disruption accelerating at the same time that time frames are compressing.'

Annual increases in computing processing power are now many hundreds of times faster than previous computers which are themselves under five years old.

'Look out further, say six years, and it's even more profound,' he says. 'Google's latest Sycamore Quantum Computer, testing now with operational status by 2029, is an astonishing 241 million times more powerful than today's fastest supercomputers!'

In other words, Sycamore can solve in seconds a problem that takes today's fastest supercomputer 47 years.

'This first iteration of Sycamore is only the 'Model T' of what is to come,' Mr Pearson says. 'The alarming thing for the investment community is that we are only at the very beginning of this acceleration. It is akin to sitting in a roller coaster as it has just tipped into its near vertical first run.'

Couple this extraordinary increase in power with the advances in AI and Mr Pearson says gargantuan change is afoot, change that will revolutionise our world and turn most industries upside down, along with investor returns.

'Fund managers and researchers need to quickly create robust means to assess and counter the acceleration of technological change and shrinking time frames, to reduce the threats to returns, as well as better understand which companies will deliver the decent performances of tomorrow,' he says.

'Our industry has a reputation for being slow to change, with egos routinely getting in the way of adapting. Investors need to check carefully that their fund managers are very clear as to how these factors impact their investment processes if they are not to be blindsided and saddled with disappointing returns.'

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

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Where nature meets business: The TNFD framework.

Tyndall Asset Management

October 2022

Funds operated by this manager:

Tyndall Australian Share Concentrated Fund, Tyndall Australian Share Income Fund, Tyndall Australian Share Wholesale Fund

Renewable energy stocks: changing winds?

Firetrail Investments

October 2023

Disclaimer

This article is prepared by Firetrail Investments Pty Limited ('Firetrail') (ABN 98 622 377 913, AFSL 516821) as the investment manager of the Firetrail Australian High Conviction Fund (ARSN 624 136 045), the Firetrail Absolute Return Fund (ARSN 624 135 879), the Firetrail Australian Small Companies Fund (ARSN 638 792 113) and the Firetrail S3 Global Opportunities Fund (ARSN 653 717 625) ('the Funds'). Pinnacle Fund Services Limited ('PFSL') (ABN 29 082 494 362, AFSL 238371) is the product issuer of the Fund. PFSL is not licensed to provide financial product advice. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited ('Pinnacle') (ABN 22 100 325 184). The Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') of the relevant Fund are available via the links below. Any potential investor should consider the PDS and TMD before deciding whether to acquire, or continue to hold units in, the Fund.

Links to the Product Disclosure Statement: WHT3810AU, WHT5134AU, WHT3093AU, WHT7794AU

Links to the Target Market Determination: WHT3810AU, WHT5134AU, WHT3093AU, WHT7794AU

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Stock Story: ResMed

Airlie Funds Management

October 2023

ResMed is the global leader in sleep and respiratory care primarily focused on the development and sale of positive airway pressure devices and accessories for the treatment of obstructive sleep apnoea (OSA). ResMed's share price has fallen 30% since the release of its FY23 results in August largely in response to concerns GLP-1 (Glucagon-Like Peptide-1) drugs may reduce its addressable market. In this article, we discuss the business in more detail and why we think the GLP-1 concerns are overdone.

What is Obstructive Sleep Apnoea (OSA)?

Obstructive sleep apnoea is a chronic illness that occurs when the muscles that support tissues in the back of the throat relax during sleep, blocking or narrowing the upper airway. This obstruction leads to impaired breathing for a short period (usually 10-20 seconds), which results in lower oxygen in the blood. The brain senses the impaired breathing, causing the individual to subconsciously rouse from sleep in order to reopen the airway. The severity of OSA is characterised by the number of events per hour: Normal < 5; Moderate 15-30; Severe > 30.

Continuous Positive Airway Pressure (CPAP) devices are the accepted standard of care for treating OSA, delivering a stream of pressurised air through a mask to prevent the collapse of the upper airway during sleep. ResMed is the largest manufacturer of these products and we estimate the company currently has ~80% market share with its major competitor Philips out of the market for the past two years due to an FDA-imposed product recall. 

Large, undiagnosed addressable market

The OSA market is large and mostly undiagnosed. According to the company, there are 936 million people globally with sleep apnoea and 424 million of these suffer from severe sleep apnoea. The size of the addressable market is evidenced by the fact ResMed had grown its device revenue at over 9% p.a. in the six years prior to the Philips recall (FY13-FY19). Recent growth rates have been even higher. ResMed estimates that penetration currently sits at 20% in the US and well below this percentage globally, which implies a long runway for future device and mask sales. 

Figure 1 - ResMed device revenue (US$)

Source: Company filings

One of the highest-quality companies on the ASX

As with any new position, we tested ResMed against our key investment criteria and consider the business to be high quality based on the following factors:

• Financial strength: ResMed has a strong balance sheet with less than 1x ND/EBITDA 
• Business quality: ResMed has a dominant market position (~80% share), sells defensive products that improve patient quality of life and are reimbursed by Medicare/health insurers in the US, and earns high returns on capital (22% average over last 5 years). 
• Management quality: We consider ResMed a "founder-led" business. Founder Peter Farrell is Chair Emeritus, and his son, CEO and Chair Mick Farrell, has presided over an exceptional track record in product development and market share gains in his 10+ years as CEO. 

GLP-1 concerns and valuation

ResMed has historically traded on a forward multiple of 28x PE but is currently trading on less than 21x PE due to market concerns about GLP-1 drugs reducing ResMed's addressable market. 

Figure 2 - ResMed NTM Rolling PE

Source: FactSet

GLP-1 drugs (branded as Ozempic, Wegovy and Mounjaro) act by mimicking hormones that are released into the gastrointestinal tract in response to eating. These drugs were initially developed to target type 2 diabetes by stimulating more insulin production but have evolved to potential applications in weight management and cardiovascular indications. Given obesity is a key risk factor for OSA (see Figures 3 and 4), there is a view that significant weight reduction from taking GLP-1s may result in reduced demand for CPAP therapy.

Figure 3 - OSA severity by AHI (>5 mild) and (>15 moderate)

Figure 4 - Prevalence of sleep apnoea in morbidly obese patients who presented for weight loss surgery evaluation

      
Source: Goldman Sachs Research

While we are not medical experts, we consider the significant de-rate to be an overreaction for the following reasons:

• GLP-1 drugs have been around for almost a decade in managing blood sugar, and other competing therapies such as oral devices and bariatric surgery have not been able to displace CPAP as the standard of care. We note CPAP also has the advantage of being able to track patient adherence and compliance through cloud-connected devices. We believe this data is valuable to third-party payors.
• While we acknowledge weight gain is a leading risk factor in developing OSA, it is not the only cause. Based on our conversations with sleep physicians and the company we estimate one-third of OSA patients are not obese. While the remaining two-thirds of the patient pool is highly likely to test GLP-1 drugs (as they become more accessible and affordable) we don't expect adherence to be 100% given the potential for side effects such as nausea and the impact on lifestyle. We also don't expect GLP-1s to fully eliminate OSA in all cases (the drugs may simply reduce severity). As a result, we think it's more likely you could have a scenario where a combination of GLP-1 drugs and CPAP therapy are prescribed as treatment.
• Finally, these drugs with an average retail price of ~US$1,000/month are currently unaffordable for most patients. Pricing will need to come down significantly to attract broader reimbursement and mass adoption.       

Conclusion 

Overall, we think the uncertainty as to the potential penetration and success of these drugs in treating OSA has created a rare opportunity to invest in one of the highest quality companies on the ASX. While we are unlikely to pick the bottom, we believe the company is trading well below its intrinsic value.

By Vinay Ranjan, Senior Equities Analyst

Funds operated by this manager:

Airlie Australian Share Fund

Important Information: This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision about whether to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

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