Podcasts Looking outside the Mundane Seven

Damian Cilmi: 0:06

Welcome listeners to another episode of the Premium Investment Leaders podcast. I'm your host, damian Chilmey, head of Investment Managers and Governance at Premium, one of Australia's leading investment platforms. In the last couple of episodes, we looked at some less familiar asset classes, but today we're back with Australian equities. Whilst earning a pretty good performance over the last 12 months, compared to other equity markets, it was a lot behind the numbers. Large caps did all the heavy lifting and, supported by a narrow selection of sectors. Today we're joined by Dion Hershen from Yarra Capital, where we'll discuss observations from the latest reporting season but, importantly, where he sees some of the major themes in the period ahead. About Dion Dion is the Executive Chairman and Head of Australian Equities for Yarra. He leads the Australian equity teams and manages Large Cap X20 and co-manages Emerging Leaders Fund. Before joining Yarra, he was Head of Australian Equities at Goldman Sachs Asset Management and had held fund management roles at Citadel and Fidelity. And about Yarra Yarra Capital was founded in 2017 and is a leading independent Australian fund manager with over $20 billion in assets under management, and they run strategies across Australian global equities, fixed income and multi-asset capabilities.

Damian Cilmi: 1:25

Dion, welcome to the program. Thanks for the opportunity. Damien, thanks for coming. So let's start out with the biggest part of the Australian market always gets a lot of focus out there. So you've got big four banks and iron ore miners. So let's just kind of talk about what's happened with those companies there. Obviously, big Four were the biggest contributors out of index performance in the recent past. But how were they all looking?

Dion Hershan : 1:54

Yeah. So I'll start with just a few observations on the benchmark. We often say if you were to design a benchmark from scratch, it wouldn't look like the ASX200. Yes, it's one of the world's most concentrated benchmarks and, interestingly, the biggest companies sort of fit into two groupings and inside those groupings they're highly, highly correlated businesses. So if you think about the Australian benchmark ballpark, 23% of it is for banks, which is an unhealthy concentration For banks that are, frankly, in the same lines of business, performing reasonably similarly and highly correlated. And then the next other large grouping is obviously they refer to them as diversified miners, but if you look at their earnings mix it's largely iron ore. I'm obviously referring to BHP Rio and Fortescue. Those seven stocks combined are circa 35% of our market and in points of stress they'll behave like two stocks, not like seven. So if you sort of pulled apart what's happening in those two cohorts, it's quite a different story actually. Let's start with banks 23-odd percent of the market.

Dion Hershan : 2:51

Fiscal 24 was an extraordinary year. The big four banks, on approximately 0% earnings growth, delivered a total return to shareholders above 35% and if you look back through history it's almost without precedent. Typically, banks perform well when earnings grow. When earnings grow, dividends grow. It's a reasonably logical equation. The last 12 months was the anomaly. What, in effect, you saw was the earnings didn't grow. They're not projected to grow in fiscal 25. I'm using rough numbers here, but you saw about a 35% PE re-rate for the Aussie banks. Now that could be somewhat rationalised if we were heading into a very strong earning cycle or these businesses had an improving growth profile, but frankly, we can't see that taking place. So there's a lot of, I guess there's a lot of non-fundamental factors that have been moving banks, associated with benchmarks, repositioning, global asset allocators allocating to Australia and banks being a beneficiary.

Dion Hershan : 3:49

But to get to the heart of your question, what's happening with the fundamentals of banks? I think, to be kind, they're pretty mediocre. We're in an environment where the Australian economy is I'll use the phrase limping along and the banks sort of move in sympathy with the economy. And when you look at what's happening with the banking sector, it all starts with credit growth and I think everybody's well aware of how much debt the Australian consumer has accumulated. They're well aware how concentrated that is within housing. So we're at a point of pretty anemic credit growth, sort of in the 3% to 5% vicinity, and that's, frankly, long-term, arguably sustainable. It's close to nominal GDP. But it's what's happening below the credit growth line of banks. That's probably a little bit more disconcerting.

Dion Hershan : 4:30

You're in a period of time where margins are very heavily contested. You know the banks and the services they provide are reasonably commoditised. You know the biggest threat to banks probably isn't regulators. These days it's probably mortgage brokers, and mortgage brokers are about 70% share of all mortgages written. They've added a degree of efficiency to the market, transparency of the market and gradually that is eroding the margins for banks. So our view is credit growth is mediocre, margins are still under pressure, but not as much as they used to be in the past. But I also point out that the banks have actually got really strong cost growth. We're at a point now where the costs are growing faster than revenue and even if you take a simplistic lens, that's never a really good equation. So what you're seeing is the bank's profits are going backwards prior to provisioning. The great surprise about where we are in this economic cycle is bad debts, for the banks still look extraordinarily low and there's been no movement on that.

Dion Hershan : 5:24

I would describe it as inching up, but not as fast as people would have expected. There's a few different theories on that, one of which is the pain is delayed. After 13 interest rate hikes, the consumers fill in the pinch. We might talk about that later, but the consumers still got, you know, certainly 4.2% unemployment. So people got their jobs, they're servicing their mortgages, and then the other thing is a discretionary expenditure has been cut back and there's plenty of evidence of that. The other one which I think is a really interesting theory and this is what the banks put forward is some of the riskiest loans you would have observed in different cycles are now in the private credit sector. So if you look at banks today, they're running at about 10 basis points of bad debts. The long-term average is 20. It's hard to argue why we shouldn't be back in the normal or an average level of bad debts but for the fact that it could be delayed and a lot of the riskier credits are now in quite illiquid private credit funds.

Damian Cilmi: 6:14

Yeah, very interesting actually, because we've obviously been thinking a lot about private credit but actually maybe the banking sector being a bit of beneficiary, in a sense, from a debt perspective.

Dion Hershan : 6:26

Yeah, I'd say they've foregone some earnings because that was a profitable loan category, but equally they've probably foregone some bad debts and that's probably lurking in the background now, very interesting.

Damian Cilmi: 6:36

And miners, how are you looking at that? Because, as you said, it's very iron ore. Yeah.

Dion Hershan : 6:41

I'll simplify and just say what's effectively what's the outlook for iron ore. If iron ore, yeah, I'll simplify and just say what's effectively. What's the outlook for iron ore? If you look at BHP Rio and Fortescue, the common thread is they've got virtually no volume growth. You know the amount of tonnes they're putting on a boat's flat to up one or two percent. It's inconsequential. We've been talking about this for three or four years. It's probably becoming a little bit more widespread now.

Dion Hershan : 6:59

But China probably hit peak steel consumption four years ago. It's been plateauing at the billion tons a year. Now the issue there is about 40% of the steel went into housing. Housing markets been in free fall in China for a few years. So it's got both the ugly combination of a weak demand outlook and, frankly, China produces half the world's steel. There's no other country that's big enough to make a difference. People often point to well, maybe India could pick up the slack. The math just doesn't support that argument. Steel industry in China is seven times that of India and India is largely self-sufficient for iron ore. So they're using a lot of scrap, are they?

Dion Hershan : 7:37

No, they've got native iron ore deposits quite low quality but they're still being produced. So to the extent that India's steel production takes off, it's not going to be a great boon for the Aussie exporters of iron ore. So the reality is you've got that sort of ugly combination where demand is soft, inventory is high and there's actually a wall of iron ore supply coming on. Now this is lower cost supply from places like Africa that have been decades in the making. That will probably be enough to tip the iron ore market into oversupply. And if you look around the world, most of the world's major commodities are actually in oversupply at the moment. You see that in nickel, you see it in aluminium, certainly see it in lithium. Iron ore is probably next.

Dion Hershan : 8:17

Now the unfortunate reality is iron ore probably speaks to 10% to 15% of ASX 200 earnings and we're probably. You know the iron ore price is 90. A lot of people think it has corrected. I think if it's a genuine correction it's going to be held a lot lower than 90. Yeah, so from our perspective that makes three major miners a difficult place to invest. I would call out you know BHP's probably got more copper and base metals than some of the others, so that's probably our preferred exposure in the space. Having said that, we think there are better places to allocate capital.

Damian Cilmi: 8:45

So they're not quite the Magnificent Seven, are they?

Dion Hershan : 8:51

We often refer to them as the inverse of that. They're not a disaster, but they're reasonably mature businesses, and we affectionately refer to them as the Mundane Seven.

Damian Cilmi: 8:58

And so, outside of that Mundane Seven, are you seeing better opportunities out there? Because clearly you're painting a picture for those, uh, for those top seven. What do you see outside of that?

Dion Hershan : 9:10

yeah, so those top seven speak to 25 odd percent of the asx 200. We think the more interesting opportunities are in that remaining 75. Well, what we often point out to people is the larger the company, the more beholden it typically is to the macro. Yeah, so aussie banks are beholden to our macro, iron ore miners are beholden to China's macro, and the outlook for both of those categories we think is pretty difficult.

Dion Hershan : 9:31

Once you look outside the ASX7, or, more importantly, the ASX20, it's pretty fertile territory. You've probably got another 280 companies with some form of liquidity you can actually pick from. They're not all good, but what we often point to is in the ASX20, liquidity you can actually pick from. They're not all good, but what we often point to is in the ASX 20, we can't find one company that's got more than 10% organic revenue growth per year. 20 companies. There's not a tech company amongst them. There's no one growing above 10%. Once you look outside the 20 companies, you've actually got 57 companies that are growing revenue more than 10% per year. So you've actually got smaller businesses. By definition, you've got superior choice. You've got exposure to different sectors like tech, like better parts of healthcare, and you've actually got much stronger growth.

Damian Cilmi: 10:13

So for us, that's fertile territory, yeah, and they're not super small companies either, like outside the 20, you know you're talking about five bill kind of market cap. Oh no, absolutely. Some of them are actually a lot bigger than that. I mean you could be a $15 billion company and be outside the 20.

Dion Hershan : 10:25

So the good news is they're still large, they're still, typically speaking, well-run, well-governed and they're liquid.

Damian Cilmi: 10:31

Yeah, very interesting. And so let's go through some of the industries, because we've got banks and iron ore that we talked about in the top 20. So let's get outside of that top 20. What's some of the industry exposure that you'll pick up through that?

Dion Hershan : 10:48

Yeah, it's worth just framing that. If you look at the ASX 200, in the last two years there's been basically no earnings growth. So the 200 biggest companies, no earnings growth. You look at the next year, it's also projected to have pretty much no earnings growth and a lot of that is anchored by those 20 biggest companies where the earnings are actually going down. Once you look outside the 20, the projected or the consensus earnings growth is about 7% or 8%. So you've actually got superior growth, superior choice. You know the sectors that appeal to us tech might only be 3% or 4% of the ASX 200. It's a much bigger proportion of the X20 part of the market. Equally, financials is important in the ASX 20, but the companies that are outside the 20 that are financials are just a different cohort. They're not all banks, they're not all banks.

Damian Cilmi: 11:33

They're insurers, they're fund managers.

Dion Hershan : 11:33

They're divers. All banks. They're not all banks. They're insurers. They're fund managers. They're diversified financial companies that actually have a promising outlook. So the places we're really actively investing at the moment are infrastructure stocks. There's not many left of them on the list of markets, but what is left looks really interesting to us. We've got quite significant exposure to some parts of healthcare. We're overweight tech and we're also quite overweight what's often referred to as communication services, which is a lot of the marketplaces like SEEK and car sales.

Damian Cilmi: 12:02

Okay, all right. Yeah, interesting, because communication services we used to think about more like in telecoms previously, so kind of a bit more redefined now.

Dion Hershan : 12:10

Yeah, it's a pretty broad category.

Damian Cilmi: 12:12

having said that, I mean there are telcos in there. Sure, yeah, we're underweight in most of those telcos. Okay, interesting, let's have a look at some specific ideas anyway, where you've seen some of that really interesting growth. What are some of those names that really stand out for you?

Dion Hershan : 12:29

Yeah, so, look, I mean, as a firm, we focus on quality companies. Sometimes they're high growth, sometimes they're lower growth, but I guess the common thread for us is there's an inefficiency, there's an opportunity. If we put our capital behind it and we're patient, we hope to get rewarded. Look three or four companies that are a bit more prominent in our portfolios than they have been in the past. A new addition to our portfolio has been Square. The business is effectively a US-listed company. It's got a secondary listing in Australia. I think by virtue of that it's been so far below the radar for Australian investors Interesting. A lot of people would instantly associate that company with Afterpay.

Damian Cilmi: 13:05

Yeah, that's when the original listing came. Yeah, exactly.

Dion Hershan : 13:09

But I guess what's important is Afterpay might be less than 20% of the combined Square group at the moment. Most of what Square has is merchant processing. It's those little white tiles you see in small businesses. They've also got a wonderful I call it a micro-banking product called Cash App in the US which is used by over 50 million people for daily transactions. And then it's got the after pay buy now, pay later category. Put all together you've actually got a high growth business. If you think about it. It's growing its revenues more than 10%. It's growing its profits more than 30%. It is really disciplined. It's got a good balance sheet and, interestingly, in an Australian market that's quite well picked over and, frankly, really expensive. Companies like Square have fallen between the cracks and trades at like 15 times forward earnings.

Damian Cilmi: 13:53

So, just like from a sell-side perspective, who's picking up sell-side coverage on some like Square?

Dion Hershan : 13:59

Yeah, it's almost not almost. Most of the analysts are actually US analysts and they'll be covering trillion dollar tech companies, and this could well be an afterthought for them and it doesn't fit neatly in any category, because in part it's a financial, in part it's tech and in part it's a payment processor. And often where, where as a firm, we do the best and we do our research, is just things are inefficiently priced because they fall between the cracks, they're not obvious.

Damian Cilmi: 14:24

Yeah, really interesting. Yeah, Any other ideas in that space Look?

Dion Hershan : 14:28

another one that we're really excited about to the extent you can get excited about infrastructure is probably APA. Yeah, now APA, now APA. We're in a very odd market where infrastructure assets are heavily sought after in private markets. When companies are put up for sale, they trade at extraordinary multiples in contested bidding processes, but there are a few that it is left on listed markets. Apa's core business is gas pipelines. They're effectively a monopoly provider on major routes on the east coast of Australia. Love it or hate it, gas has got to be with us for a very long period of time and what you've got is really lucrative, moderate growth infrastructure assets with phenomenal industry structures that are just spitting out enormous dividends. So rather than own a property trust or a consumer staple and get a 3% 4% dividend, you can get 6% or 7% on monopoly energy infrastructure, and we feel it's a standout. Again, another company which has had very little attention and fallen between the cracks.

Damian Cilmi: 15:29

Interesting and then within that consumer discretionary space, a lot of stuff got beaten up in there. Is there any opportunities you see through that space?

Dion Hershan : 15:38

Yes, the consumer discretionary is pretty broad. Let's start with just spending a moment on the consumer. There's a degree of consumer fatigue and it probably came later than most people anticipated. I guess what's worth calling out is during COVID, the consumer accumulated a couple of hundred billion dollars of savings. They've now largely depleted that pool of savings. The consumer has effectively been hit with 13 interest rate hikes on $2.5 trillion in mortgage debt. They're big numbers. So what we see in the landscape today is a really high degree of consumer fatigue. That fatigue is concentrated amongst the two bottom income quintiles, that's, people with mortgages, people that are renting, and frankly, they're doing it tough. And as they're doing it tough, the cost of everyday needs or consumer staples continues to go up, whether or not it's power utilities insurance. So that's really crimping discretionary expenditure That'll be with us, in our opinion, for an extended period of time. There's strength amongst high-end consumers but frankly, there's very few ways to play that on the ASX listed market.

Damian Cilmi: 16:39

So traditionally a lot of guys would look at like big brand names offshores, like a Louis Vuitton or something like that. Yeah, absolutely.

Dion Hershan : 16:46

So if you think about listed luxury companies in Australia, frankly there aren't any yeah. So what you're looking at is, you know, the JB, Hi-Fis, the Harvey Normans, the Meyers, the Adairs, which are all in reasonably discretionary categories. We'd be underweight that category today. We did have a number of holdings that probably performed well above our expectations and it was just an opportune time to take profits and come back.

Damian Cilmi: 17:11

Yeah, Okay, Very interesting. And what about margins with a lot of these Australian companies? I know we can talk about obviously in the discretionary side, but in a broader sense, how are companies managing their margin profiles?

Dion Hershan : 17:28

So I'm generalising, but margins are absolutely under pressure. If you look at a reporting season that finished a few months ago, what you'd observe is, on average, companies hit sales forecasts but they missed margin forecasts by a very significant amount. We're in a really interesting period of time where we've often described it as almost the end of pricing power for this cycle. What we found is a lot of companies pushed price really hard. It's now got to a point where there's a degree of consumer fatigue, so their ability to keep repricing for the same product and service is absolutely compromised. But at the same time, the only certainty in Australia is costs keep going up.

Dion Hershan : 18:05

Yeah, and again, if you're talking about the major inputs for a listed company, it's labour, it's utilities, it's rent, it's insurance, and the phrase we often use is JAWS, and JAWS is the gap between your revenue growth and your cost growth. The majority of companies in Australia have now got what we refer to as negative JAWS and when we looked at it quite recently, of the 11 sectors in the ASX 200, nine of them had margins go down last year and there's some miraculous hope that margins will recover into fiscal 25. And I certainly have my doubts.

Damian Cilmi: 18:38

Yeah, so is there a lot of lock forward pricing suggesting that there is going to be margin growth next year.

Dion Hershan : 18:45

Yeah, so if you look at consensus earnings expectations again, it depends on which part of the market you're referring to After two years of significant earnings decline, it's almost like a V-shaped recovery in margins and I put that down to sort of blind optimism and hope, not reality. There'll always be companies that can, but the overall market. We don't expect that to be the case. No, it's very interesting.

Damian Cilmi: 19:10

Turning to healthcare, this has been a really interesting space. Glp once a lot of discussion on this over the last 12 months, Whilst not having any say direct beneficiaries. In a sense, from an Australian perspective, there's a couple of companies that really got beaten up by GLP-1s. Maybe we should just do a quick recap on GLP-1s, what they are and then, I suppose, the impact in Australia.

Dion Hershan : 19:35

Yeah, so to start with, I'll give you my very primitive understanding of how these drugs work, but effectively they are well-established and proven drugs that have been used for type 2 diabetes for decades. In recent years they've broadened the application of them and they're largely being used for weight loss, and a lot of people view these as a miracle drug that was going to end again global obesity, which I think was too bold of a statement. And then they have broad-based and universal appeal and a lot of people then immediately jump to the conclusion well, if you've cured global obesity, surely you won't need gyms, surely you won't need absurd things like no one will need a hip replacement, no one will need a sleep apnea device. So what markets tend to do really, really well is overreact, and they overreacted to these glp1 drugs and worth keeping in mind. Of these glp1 drugs there's a lot of numbers going around, but if you're not a diabetic, they are a luxury good. Yeah, in the us they cost there'sa waiting list now as well, huge waiting list in the us. It's over ten thousand dollars a year to go on to these drugs.

Dion Hershan : 20:35

And what's really interesting is for people that go on the drugs on average and I'm simplifying things. After 12 months they've lost 15% to 20% of their body weight. But after 12 months, 60% of people stop using that drug. Yeah, and that could either be because of the side effect or the cost. What has also been proven is, when they go off those drugs, almost all, or sometimes more than the weight they lost, they regain. So almost all, or sometimes more than the weight they lost, they regained. So it's not back, they're back to square one. Yeah, but obviously probably significantly poorer for the experience. So I don't think there's again. They're a wonder drug for people with diabetes. They're a wonder drug for a person who's morbidly obese. But we do question whether or not they've actually got mass appeal. What's interesting about that is sleep apnea is a well-established disease. Circa 15% 20% of the world's population have got it. Very few people have got it or are actually doing something about it. If you've got to do something about it.

Dion Hershan : 21:24

Resmed's the number one brand for sleep apnea devices. It's one of the largest positions in our portfolio. In some respects there was guilt by association 12 months ago when everyone thought GLP-1s were taking over the world ResMed. It didn't quite halve in share price, but it got pretty close and with the benefit of 12 months of rational thinking.

Dion Hershan : 21:44

What's becoming increasingly obvious is GLP-1s aren't for everyone either cost, side effects or access, as you described. What also became really clear was the people that were using GLP-1s. It wasn't necessarily curing them of sleep apnea, but what it was doing was increasing their awareness they might actually have sleep apnea. It's often referred to as the funnel, and what they've been able to prove is more people are becoming aware of sleep apnea, more people are getting devices for sleep apnea and then, even if you are on GLP-1s, you're still using a sleep apnea device mostly and you're still reordering masks. So in some respects it was a huge inefficiency. Resmed halved and then has almost doubled from that, but we still think the outlook is promising and we also think what's going to become obvious over time is that will coexist well with GLP-1 drugs.

Damian Cilmi: 22:32

Yeah, yeah, that's really interesting around that there about the awareness bit. So has ResMed put anything out about, like you know, hits awareness? You know their growth profile as a result of all of this?

Dion Hershan : 22:44

Yeah well, it's one of those old sayings they put up the scoreboard and the scoreboard is. In the last 12 months they've had really strong growth in devices, really strong growth in masks in countries where GLP-1s have taken off really, really quickly. So the reality is?

Dion Hershan : 22:56

I think it's like 7 or 8 million people in the US on GLP-1s now, and they've had really strong growth in ResMed. Resmed's put out a tonne of medical research which they have either conscripted or published. That's often dismissed as self-interest, but what you can say, though, is a number of independent studies have now brought the conclusion that these two things will coexist.

Damian Cilmi: 23:16

Yeah, no, that's really interesting. And then obviously the opportunity because of their share price decline and overdone like that there. So it's very interesting and great for research and active management. We touched on something just quickly around infrastructure, but just kind of broaden it out like that impact of private markets and what it means to public markets. So first thing that you kind of touched on, australia used to have a lot of infrastructure stocks and maybe the composition of markets even changed as a result of those kind of coming on. So there's a point on that there. But what are you seeing about the impact of private markets impacting your space in public?

Dion Hershan : 24:00

markets. It's having a profound effect and it's having it in both directions. What you're seeing is the depth of capital in private markets and the fact that it's easier to stay private for longer is obviously holding back the quantity of IPOs. We've gone from doing 20 to 30 IPOs about $50 million a year in Australia to one or two in recent years. Now that's in part because the quality of the company is trying to go public, but largely it's because there's so much private capital. So it's affecting issuance. No doubt about that. What it also is doing is it's causing a lot of companies to go private.

Dion Hershan : 24:33

And you think about it. There's a significant tax associated with being an ASX listed company the level of overhead, the listing fees, the bureaucracy, the way the boards have to function, the cost of insurance. In some respects it's easier to be private than it is public. The other thing is private companies can typically have far more aggressive capital structures. So if you look at Airtrunk, which was recently privatised, the capital structure of that business probably had debt ratios twice the level of NextDC, and that is very common for infrastructure-style companies or even property companies held in the private market. So what is that doing? That's making public companies frankly, targets and you know, in the infrastructure space you described before, sort of one by one they've been picked off.

Damian Cilmi: 25:20

Yeah.

Dion Hershan : 25:21

Yeah.

Damian Cilmi: 25:23

And it's probably there's still a lot more to go in that space. You would have thought Well.

Dion Hershan : 25:27

I think there's very few infrastructure companies left to go, but there are another. I think. What we're also learning is the definition of infrastructure keeps stretching, yes. It used to be an airport or a bridge Yep. Now it's a data centre. Now people are saying it's pathology assets, you name it Yep. But that speaks to just how much latent capital there is in private markets.

Damian Cilmi: 25:45

Yeah, there isn't private markets. No, that's true. Okay, Dion, that was fantastic. We whipped around a number of industries there, got some good outlooks for that. Obviously, in the X20 space, there's a lot of good opportunities there, keeping you guys busy and long may it continue and thanks for coming on the show. Thanks for the opportunity, Danny.

Praemium: 26:09

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