Nathan Masalski:
Hello and welcome to our BAEP Podcast for September 2024. My name is Nathan Masalski and I'm one of the account directors at Bennelong Funds Management. Today I'm joined by Chief Investment Officer Mark East, Senior Analyst for Economics and Market Strategy Neale Goldston Morris and Portfolio Manager and Senior Analyst Brad Clibborn.
Gents, thank you for joining us today.
Neale, I might start with you for an update around your current global macro view. In our last podcast, you said that you expected the economic backdrop to remain solid, which would support earnings growth. However, you added that inflation would remain elevated and particularly here in Australia. How has that view evolved since our last update in June?
Neale Goldston-Morris:
Thank you for that introduction and welcome everybody. Yes, there's pluses and minuses to that outcome. The big plus is this, the US economy remains on track. Growth is still strong, running around 3%, that's unchanged. Inflation is coming back steadily, somewhere in the 2s. That's opening up the scope for the Fed to start cutting rates. They probably will start this September and anticipate another couple for the balance of this year and then maybe something next year as well. The US economy does consist of two parts. First of all is services, that's about 90% of the total. That remains very strong. Job growth, very strong, profit growth, very strong, et cetera, et cetera. And that's driving the Dow, the NASDAQ, and particularly the S&P 500. And remember the US share markets combined represents 72% of the globe. Therefore, the US comes first, second, third, fourth, and fifth if you like as far as importance is concerned.
The one bit that is weak is manufacturing. Yes, it's important in a few states, but generally, 10% of the economy. It's struggling, and the reason for that is the bit that's getting worse, which is China. Leaving China aside for second, when we look then at the US, the overwhelming majority remains positive. Earnings growth is mid-teen, that's more than enough to drive the well-managed companies to new highs as hopefully we will see in the next few months. China, on the other hand, is in midst of deflation. The government continues to encourage overcapacity in various industries, massive overcapacity. There's pricing wars across the board, electric cars, solar panels, lithium batteries, et cetera, et cetera, in addition to their housing crash. And because of that, a lot of their provinces are almost near insolvent. So you're getting economy that's increasingly struggling and that's feeding through to commodity demand for steel in particular and lithium, et cetera.
And hence, those commodity prices have been falling and we think they will to fall over time. They've only just entered the overall industry cost curve. In other words, just the pressure is starting to bill for some closures around the place. Those eventually will occur with corporate damage associated with that. In that context then, most of our portfolios are at zero to resources. There's just a small sliver of BHP in the core because of the index weight limits there in that fund, but that's a tiny position. So we're not there in resources.
Bringing it back to Australia, Australia is somewhere in between. Overall growth is still slowing. In the US, I said was three, Australia is one-ish, maybe even a slightly less than that. Earnings growth to corporates is 1 or 2%. So again, much less than the US. But our inflation is slowly coming back, more slowly than the US. And it means we'll get rate cuts, but with a lag of four or five months, something like that to the US. In other words, anticipate rate cuts here sometime around February, March of next year. So still a trend, but a weaker trend than the US.
The emerging problem for Australia is quite simply those commodity prices. The balance sheets or the government revenues, taxation revenues in WA and Queensland are going to be severely hurt. Its coal, iron ore, lithium, et cetera, et cetera have fallen away very heavily. Our Australian exposure is limited to medium-sized companies in niches like Realestate.com, Carsales, HUB24, et cetera, et cetera. These companies are increasing their market shares., particularly, through R&D coming at the leading edge of technology just like our US exposures are in the similar vein. But beyond that, we find it very difficult to have broad exposures to the Australian economy. And to highlight that of 20 leaders, we only have exposures to four stocks. That's 20 leaders by market cap. So not the banks, not the resources or the retailers, et cetera. So it's very, very focused, narrowly based, if you like, in addition to the broad US over weight.
Nathan Masalski:
Thanks Neale for that fantastic overview. Now, over the past month, the Australianr eporting season was the main event concerning stocks on the ASX. Brad, perhaps you could run us through some of the highlights from Reporting Season and any of the key themes that came out over the period.
Brad Clibborn:
Thanks, Nathan. Yeah, so for the FY 24 reporting season, we did see results come in slightly better than expected for the past 12 months with marginally more beats than misses. And slightly better margins were the key reasons for those better results. The issue really was that the guidance for the year ahead for financial year 2025 was cautious with 41% of the outlooks below consensus with only 9% coming in above consensus expectations. And as Neale alluded to before, the resources sector is where we saw quite large downgrades in earnings forecasts with 2025 forecasts now revised down almost 20% since June for the resources sector. And we are significantly underweight the resources sector as Neale mentioned as well. The weaker outlook comments also led to more volatility. The average stock move was about the same as what we'd normally see, but we did see a greater number of large moves in share prices through the period, so it was quite volatile.
A major positive theme though coming out of reporting was that the consumer remained quite resilient through FY 24. Although we do continue to see strength towards the older and more affluent customers relative to the younger and lower end consumers. This translated to strong share price performance for many of the retail companies. And our funds did benefit from that with the likes of Breville and Universal Store as two of the stronger performers for the funds in August. However, we do note that the stories for those companies really are more stock specific factors driving their market share gains with strong execution by both their management teams.
On the negative side, we did still see some inflation for many companies in Australia. Particularly, with elevated wages and energy costs. However, we are seeing that quality companies with pricing power and good management have been now worked through a lot of those challenges in getting back towards business as usual withholding or improving margins. Good examples of that across our portfolios, the likes of ARB, Fisher & Paykel Healthcare, CSL, Aristocrat, and Universal Store, where we now see that their past some of the margin challenges that came through COVID.
Overall, while the outlook is for modest growth in the market's earnings, the dispersion in growth expectations amongst stocks and sectors is widening. The resources sector is expected to have a three-year compound growth in earnings of around -2%. While the banks are only forecast to do around positive 2%. Contrast this with the earnings growth expected from the tech sector in the high 30s, the communication sector in the mid-teens and the healthcare sector in the mid to high teens earnings growth. So quite a large dispersion in growth across the market. So that'd be the main summary on results.
Nathan Masalski:
Interesting you mentioned banks in your summary towards the end there. Given your comment on the lack of earnings growth for the sector, I'm guessing that you remain underweight to the banks across the portfolios.
Brad Clibborn:
That's right, Nathan. We are underweight to the banks. And we did mention in our June quarterly that financial year 2024 did see quite impressive returns from the big four banks returning almost 35%, of which about 7% of that was from dividends and 28% from share price appreciation. The interesting part though is of those share price gains, earnings actually declined by around 2% over the year with the price earnings multiples re-rating by around 30%. As a result, we look at CBA now trading at a 40% PE premium to the market on around 24 times earnings. That compares to its history of trading around a market multiple. And when you look at the earnings performance over the last seven years, CBA has delivered less than 1% per annum earnings growth and consensus still only projects around 3% per annum earnings growth over the next few years. So given that large re-rating in the banks with pretty minimal earnings growth forecast over the next few years, it is hard to see continued price appreciation in the bank sector.
And we continue to focus on those companies that have really differentiated products that can invest in their businesses and take market share and grow earnings ahead of the market.
Nathan Masalski:
Great. Thanks Brad. Well, that provides us with great color on both the macro and the top-down view of reporting season. Mark, perhaps you'd like to run through the portfolios and how they fared over the reporting season with some of the key drivers. Perhaps we'll start with the portfolio contributors.
Mark East:
Yeah. Starting with Breville, Breville had a good performance period over August, the result came in above market expectations. A couple of highlights of the result were the company's North American segment, which saw sales re-accelerate to 12% growth after being impacted the previous two halves by the collapse of a key customer, Bed Bath & Beyond in the US. Another highlight was the European business, which saw revenues accelerate from 6% growth in the first half to 12% growth in the second half. Coffee continues to be the core driver of Breville's growth as consumers around the world upgrade from drip or pod coffee to manual semi-automatic espresso machines, where Breville is the global leader. Breville is also seeing signs of a rebasing in their more cyclical food preparation and cooking segments. This rebasing has partly been driven by successful new product launches, such as their new food processor range and the new InFizz SodaStream product.
Cash flow for the result was strong as management were able to reduce inventories as supply chain disruption eased and this returned the balance sheet to a net cash position. Management have continued to invest in new product development despite an uncertain consumer backdrop. And as we see their revenues re-accelerate over the next couple of years, they'll reinvest more into marketing, new product development and entering and developing new geographic regions. We expect an announcement of Breville entering a new region in the next 6 to 12 months, which should be a positive. So yeah, we continue to see a strong growth outlook for Breville over the next few years.
Another strong contributor was Fisher & Paykel Healthcare, had its AGM in late August. And part of that AGM, it increased its FY 25 full year earnings guidance and provided first half guidance of 18% revenue growth and around 45% earnings growth, which was above market expectations.
Fisher are seeing strong growth across both its hospitals and home care segments and across most sort of major products and regions. And this strong performance has been supported by some successful new product launches. Investment in their specialized anesthesia sales force is also delivering strong growth for their hospital business. Seasonal hospitalizations related to flu, RSV and COVID, which have been relatively elevated in the year to date, that's also contributed to the strong performance for the company so far.
A strong gross margin also has boosted earnings result with strong volumes and a focus on planned efficiency and productivity driving the strong result here. So we continue to see a strong outlook for Fisher & Paykel and it remains a key position in the portfolio.
Nathan Masalski:
Oh, great, Mark, thank you for that. Brad, was there anything you'd like to touch on from a portfolio detractor perspective over the course of reporting season perhaps?
Brad Clibborn:
Yeah, Nathan, I might touch on a2 Milk, it's one we touched on in prior podcasts as well. It did detract from returns in the month, their FY 24 result was in line with expectations. They delivered at the upper end of guidance with 7% revenue growth and 9% EBITDA growth in the second half of FY 24. And that was driven by continued strong performance in both their China and English label infant formula products. However, the market did respond negatively to their FY 25 guidance for the year ahead. Where they've guided to mid-single digit percentage revenue growth with stable margins. And that's below the market that was looking for high single digit revenue growth with some margin expansion. There was some disruption called out by a2 by their main supplier Synlait that occurred in July. This has meant that a2 is running low on inventories for early stage China label infant formula products. And that that they've guided that that could impact revenue growth. Particularly, in the first half of FY 25.
On top of that to catch up a2 has flagged that they will air freight product from New Zealand up into China to try and catch back up on inventory positions and limit the actual market impact. But there is a cost to that that's offsetting the margin expansion that they would've otherwise enjoyed.
Synlait has subsequently announced that their shipping and manufacturing are returning to normal and suggests that the supply disruption is likely to only be a short-term issue. Ultimately, it doesn't change our view on the structural earnings growth outlook for a2. Their a2 China label sales now represent just under 5% market share, and we expect that share to continue growing strongly driven by their brand awareness, distribution expansion into the lower tier cities and over time product ranging expansion as well.
Nathan Masalski:
Any final thoughts that you'd like to share before we wrap that up for today?
Brad Clibborn:
Yeah, maybe just one wrap up point from me, Nathan. I think it's important to reiterate that our investment philosophy and process remain unchanged. Over the long term, share prices follow company earnings. So our focus really remains on building a portfolio of those high quality companies that have strong long-term earnings growth prospects and where we believe those earnings prospects are underappreciated by the market. We look for companies that have a track record of investing in R&D, in new products and investing in their brands so they have strong pricing power and an opportunity to take market share globally over time. The companies that Mark talked to earlier like Breville and Fisher & Paykel are great examples of that.
The portfolio delivering that earnings growth above the market is ultimately what's going to drive the long-term returns for our investors. So if we look at the portfolios today, we generally expect the annual EPS growth over the next two to three years to be in the low double-digit percentage range. And that compares to the ASX 300 that has a forecast earnings growth of around 5% per annum or less over the next few years. So the portfolios do have quite superior earnings growth prospects, and ultimately that's what we believe is going to drive the returns going forwards.
Nathan Masalski:
Fantastic. Thanks Brad, the investment team who provided a significant amount of information today. However, for more details on stocks, investors can go to our most recent June quarterly report or to the new monthly investor reports that include further commentary on markets and both a portfolio review and a portfolio outlook. Thank you to everybody for listening today and thank you to our investors for your continued support.
