AusCap Asset Management letter to investors for the month of January 2023, titled, “Not Middle Of The Pack: Why We Back Australian Mid Caps.”
Auscap’s views discussed below are based on factual information available to us at the date of publication of this newsletter. Our views and market conditions as expressed below may change without notice. There is a risk that investments will not perform as expected, which could have an adverse impact on the performance of the Auscap funds. Past performance is not a reliable indicator of future performance. Any advice in the below is general only in nature and does not take into account a particular person’s objectives, financial situation, needs or circumstances. Because of that, before making any investment decision, you should consider – with or without the assistance of a qualified adviser(s) – the appropriateness of any advice in the below to you, having regard to your objectives, financial situation, needs and circumstances. While all reasonable care has been taken to ensure that the information below is complete and correct, no representation or warranty is given as to the accuracy of any of the information provided.
Q4 2023 hedge fund letters, conferences and more
Calendar year 2023 was a good year for the Auscap Long Short Australian Equities Fund, delivering 18.5% net to investors compared to 13.0% for the All Ordinaries Accumulation Index.
The performance of markets over November and December, a period in which the All Ordinaries Accumulation Index gained 13%, demonstrates the folly in trying to time markets. A change in expectations around the future path of interest rates led to a sudden response in markets, with equities gaining in two months what would be a reasonably solid full year performance. It reiterates to us the merit of investing in a range of excellent businesses that are reasonably priced and holding this portfolio for a long time.
Over the long term, we believe the most important factor determining a company’s stock price is the level of earnings generated. This is not the level of earnings in an exceptional one-off year, but the level of sustainable and, preferably, growing earnings. A company with sustainable earnings at a fair valuation might be a reasonable investment, but unless the earnings are growing it is unlikely to be a strong one. The major domestic Australian banks are an example of this. Over the last decade, roughly representing the period since the Auscap Long Short Australian Equities Fund was launched, bank earnings have tracked sideways. The level of earnings has been broadly maintained, excluding the COVID-19 period, but has not grown. This can be seen in the chart below.
The likely outcome and lived experience of this should be relatively obvious, that the companies’ share prices are unlikely to have, and indeed have not, materially appreciated. Unsurprisingly, ceteris paribus, people are not willing to pay more for the same level of earnings than they were more than a decade ago. This can be seen from the share prices of the major domestic banks over this period.
In the short term, there are many factors that can influence share prices. Noise and shifts in sentiment can play a significant role. Investors worry about geopolitical events, movements in interest rates, currencies, global growth, market psychology, news headlines and plenty of other factors. Indeed some of these factors can and do have an impact on near term earnings. Over the long run however, what is going on inside a company is far more important than the short term impact of some of these factors. And over the long run, the most significant driver of the share price is the level of sustainable earnings a company generates. Earnings are what really matter to long term share price performance. And the total return one should expect from a security is the combination of the earnings growth delivered and the dividend yield received. This is the long term expected total return for an individual company bought at a fair price.
This can be seen in many of the businesses we have owned for a long time. It is hard to think of a company that moves more over the short term in response to changes in market sentiment than JB Hi-Fi. And the “short term” we refer to can sometimes be measured in years, not days or months. Its gyrations, as seen below, have historically been significant.
Does this make it a risky investment proposition? While we acknowledge that JB Hi-Fi is unlikely to grow earnings in FY24 on FY23 as the company cycles heightened post COVID-19 expenditure in a rising cost environment, the company has grown earnings every year over the last decade. This is a better outcome than almost any of the 20 largest, and less price volatile, stocks listed on the ASX. Its share price suggests it is a very risky investment. Its earnings suggest the contrary. What is also obvious from the chart above is that earnings are the ultimate driver of the stock price over the long term.
Choose almost any stock and compare its share price with the earnings per share it generates and it becomes clear that over the long term earnings are the most important factor. To use a few examples of businesses we have held for a long time, this is true of CAR Group.
It can be seen analysing Macquarie Group’s share price performance against earnings.
Markets anticipate changes in earnings before they occur. Macquarie’s earnings are expected to decline in FY24 and this has been reflected in the share price. However there are also times when share prices disconnect from their earnings, often driven by positive or negative sentiment towards a particular business. This can be seen below with Reece’s unusually strong share price performance in 2021 and 2022, which greatly outstripped earnings growth. But in the lifecycle of a company these periods are typically short and self-correcting.
So our primary focus is on finding businesses that can sustainably grow their earnings per share over time. The group of businesses that we are confident will achieve this reliably is not particularly large and tends not to change much over time. Then we invest more significantly in the businesses that demonstrate greater value at the current share price, less significantly in those businesses that are priced more aggressively, whilst continuing to closely monitor the businesses where we cannot justify the current valuation at all. There can also be very good businesses that we are not invested in because we have similar and preferred exposures in the portfolio already.
The end result of this process is that the Auscap Long Short Australian Equities Fund, which has now been managing investor capital for over 11 years, is a high conviction portfolio. Its highest weights are our highest conviction ideas, with very little consideration given to how the fund looks compared to the broader market. This means that the fund can at times act quite differently to the broader market. Because it is a concentrated portfolio, it may at times exhibit more volatility than the market, albeit we would stress that we do not believe higher volatility equates to the portfolio being riskier than the market. We define risk as the prospect of permanent loss of capital on an investment, not how much a share price fluctuates. Most of our holdings are leaders in their field with long financial track records, competitive advantages over their peers and conservative gearing, with many being in a net cash position. Whilst individual stock prices can be volatile, the earnings volatility for the majority of the businesses we own has historically been quite low.
Our focus on finding high quality businesses that are growing earnings over time has also led us to focus on businesses primarily outside of the largest listed businesses, where we see limited opportunity for growth. The S&P/ASX 20 has delivered less than 4% earnings growth per annum over the last decade.
Therefore the Auscap Long Short Australian Equities Fund’s portfolio tends to consist predominantly of companies that are in the ASX300 but outside of the ASX20, with our investment sweet spot frequently being the mid cap universe. These are often quite significant businesses, with profits typically in the hundreds of millions of dollars per annum. These businesses can be substantial enough to be leaders in their field and therefore enjoy the superior financial return profiles that come with great economies of scale, whilst still having plenty of opportunities for organic growth because they have not yet saturated their market. NIB Holdings is a good example of this. It is an ASX100 business with a market capitalisation of $3.6bn and net profit after tax of $198m in FY23. It has market leading metrics in the private health insurance industry, but it still only represents a 9.6% market share in its core Australian Residents Private Health Insurance market, with multiple attractive adjacencies to underpin many years of organic growth. Its earnings growth plus dividend yield will determine the long term returns it generates for our investors.
In fact, the performance of the mid capitalisation index over the last two decades has demonstrated why we find it a fertile hunting ground for great investments. Over the last decade the ASX Mid Cap Accumulation Index has seen 7.5% earnings growth per annum. This contrasts with the All Ordinaries Accumulation Index and the ASX20 Accumulation Index which have delivered earnings growth of 4.3% and 3.0% per annum. It also contrasts with the Small Ordinaries Accumulation Index which has delivered growth of just 2.5%. It should be of no surprise that these differing earnings growth profiles are strongly correlated with the total return delivered by the different indices, summarised in the table below.
Many of the largest companies in the domestic market are so dominant in their sector it is difficult to grow significantly organically. Conversely, many smaller companies are at a competitive disadvantage relative to larger peers or are yet to achieve consistent profitability, which is reflected in their frequently lower earnings growth and poor total return performance over time on an aggregate basis. Over one year the difference in these annualised return figures might not appear significant. But over time the difference in the total return compounds to a very meaningful disparity in returns.
In fact, since 2013 the ASX Mid Cap Accumulation Index has risen 193%. This compares with the All Ordinaries Accumulation Index and the ASX20 Accumulation Index that have returned 119% and 104% respectively. The Small Ordinaries Index has been the poor performer, returning 79%. Yet there are very few mid cap focused funds in the domestic market looking to take advantage of the superior returns on offer.
Launch of the Auscap Ex-20 Australian Equities Fund
A high conviction fund, which typically concentrates capital in the fund manager’s best ideas, is popular with many investors. It does mean that the fund can exhibit greater volatility than the market and can at times move differently to the market. A large part of this comes from the fund having quite different sector exposures to the All Ordinaries Accumulation Index against which it is measured.
Some prospective investors have expressed that they would prefer a less concentrated fund offering. In response to feedback, we are delighted to have launched the Auscap Ex-20 Australian Equities Fund in December. It is a long only mid cap focused fund, with a primary universe of stocks in the S&P/ASX300 Index and excluding stocks from the S&P/ASX20 Index. It is sector aware, meaning we expect the sector exposures of the fund to typically be within 5% of its benchmark. The concentration of fund holdings will be lower, with a greater number of companies in the portfolio. We expect the primary determinant of returns relative to the index will therefore be stock selection, rather than sector exposure. The response to the fund launch has been positive. We look forward to taking advantage of the compelling opportunities available in this universe of the Australian stockmarket to generate returns for our unitholders in the new fund. If you would like further information on either fund, please reach out to Lauren Murphy at distribution@auscapam.com.
