Simon Mawhinney, Chief Investment Officer of Allan Gray Australia, recently presented at the annual Allan Gray Investment Conference in Cape Town. He provided a backdrop of the economic landscape in Australia, followed by a closer look at where he sees value in the Australian market.

He noted that Australia has historically been a great place to invest and cited a number of possible reasons for this.

“Over the last 116 years Australia has been the second best performing sharemarket in real returns measured in US dollars, returning an average of 6.7% per annum compared to an average of around 5% per annum from the world index¹. Australia’s rich endowment of natural resources, stable government and entrepreneurial spirit have all helped, but what do we think the next 116 years have in store?

“It may not be as good as the past, as we won’t hold second place forever, but even if we revert to long-term global averages that’s a great outcome.

“On the surface Australia seems to be in a strong fiscal position.” Mawhinney pointed out. “Government debt to GDP is significantly lower than many other countries. Many people cite this as a sign of a stable and essentially well-equipped government, able to deal with any economic turmoil. The reality is a little bit different. Whilst this is the case today, there are some pressures building and the trend in Australia is that the fiscal deficit will likely result in debt to GDP growing from here.” argued Mawhinney.

“Granted, we are in a much better position today than many other countries, but you can flip the coin and talk about some of the stresses in the Australian economy and some of the things that give us cause for concern.

“Australia has very high residential property prices, which have probably surpassed every other country. Property prices growing faster than inflation is simply impossible to maintain over the long term. You can’t have a salary that rises with inflation and property prices that rise faster than inflation; in the long run something breaks.

“When we look back some years from now, we’ll say, with the benefit of hindsight, that this was an extreme bubble that everyone could see from a mile away.” cautioned Mawhinney.

“As a result of very high property prices, household debt to GDP has risen considerably and now is at 185% of GDP .”² Mawhinney continued. “Australian households are the most indebted households in the world.

“Yet loan delinquencies in Australia have been very low. House prices in Australia have risen, businesses have performed well and there has been very little bad debt. Non-performing loans are very low and impaired loans only represent 0.33% of the total loan book³. This is extraordinarily low and delinquencies are likely to get worse from here, which would challenge bank earnings.

“With this in mind, where do we see value in the Australian sharemarket?” asked Simon Mawhinney. “On average, we don’t. We think the sharemarket is expensive.”

A difficult time for value investors

“Let’s look at where we are today.” Mawhinney continued. “With low interest rates in the rest of the world investors have chased yield. The companies best positioned to pay a high yield were those that were able to maintain relatively stable, or growing, earnings. Growth companies and defensive companies have done well. In Australia those companies are in healthcare, utilities, infrastructure and banking, though traditionally and perhaps paradoxically, we would not classify banks as defensive companies. The Australian experience has been somewhat unique.

“With all this money chasing a particular type of company we are facing extreme trending and momentum. The companies that haven’t benefitted from this trending since 2009 are companies that are cyclically–exposed, or are currently facing cyclical headwinds.

“In Australia the energy companies including oil and gas; materials; other non-energy related resources; and some services companies have been particularly hard hit.

“These account for less than half of the overall sharemarket, which is why in aggregate the sharemarket is expensive. But this does leave pockets of value, let’s say around one third of the sharemarket, that’s just extraordinarily cheap. As contrarian investors we look for value and it’s in these cheaper areas of the market where we often focus our portfolio.

“This situation cannot continue forever. Eventually the expensive shares will fall and the cheaper shares will rise. We don’t know exactly when this will be, but we have positioned our portfolio to benefit.

“Compared to the ASX 300 Index, currently we are very underweight Financials. High single digit credit growth has fuelled residential property prices over the last 20 plus years which has led the banks and other related companies to perform well. We think this will end so we’ve chosen not to invest in sectors exposed to this. Conversely, we are very overweight materials and energy, predominantly in oil and gas, gold (to a lesser degree now, but it has been a big part of the portfolio) and aluminium.

“Contrarian and value-oriented investors like us have faced headwinds from the recent market trending, but we believe that will change. Despite the challenges we have managed to outperform the market nicely over the short and long term since establishing our business in Australia. Our outlook for the performance of the portfolios is optimistic as we begin to experience some long-awaited tailwinds. Our portfolios are well positioned to benefit when they come.”

 

¹Source: Triumph of the Optimists, 101 Years of Global Investment Returns”. Elroy Dimson, Paul Marsh and Mike Staunton; Iress; Australian Bureau of Statistics.

²Source: Australian Bureau of Statistics, Reserve Bank of Australia (RBA)

³Source: Australian Prudential Regulation Authority (APRA)

 

Simon Mawhinney holds a Bachelor of Business Science (First Class Honours) with majors in Finance and Business Strategy and a Postgraduate Diploma in Accounting (University of Cape Town). Simon qualified as a chartered accountant in 1998 and is a CFA Charterholder.