After the manic-depressive gyrations of the market in the December and March quarters, the 3 months to the end of June provided a period of relative market calm, with consistent yet still very strong markets belying an increasingly fragile economic environment. Weakening global growth, intensifying trade wars, cautious consumers and increased geopolitical risks would normally have served to frighten investors and send markets lower, but in this topsy-turvy environment of central bank driven investing, each perfectly rational concern was promptly overwhelmed by an increased prospect of reduced interest rates, sending the market higher still.
From a results perspective though there wasn’t much to complain about, with solid returns across all asset classes. Defensive investments performed strongly in light of the first interest rate cut from the RBA in almost 3 years, sending Australian Government bonds up 3.5% (bond prices move inversely to interest rates, with prices going up when interest rates go down), while unhedged global bonds delivered an even more impressive 4.5% return, driven by increasing likelihood of US and European Central Bank support for a weakening economy, then supercharged by a falling Australian Dollar (AUD). In light of declining bond yields, listed property and infrastructure also performed strongly, with Australian listed property up over 4%, global listed infrastructure up over 6%, and global listed property up a more muted 1.2% as the contrast of softening economic data countered falling bond yields.
Australian equities rocketed higher for the quarter up almost 8%, boosted by a surprise Coalition victory in the Federal Election and the RBA in rate cutting mode. Global equities also performed strongly - up over 5%, with Europe the primary contributor as investors saw better value in the region. US equities were up over 4%, with less support coming from the technology sector than in recent times. Asian and Emerging Markets were impacted by trade war concerns, with declining global manufacturing demand and global supply chains looking for ways to mitigate the impost of tariffs.
The irony though is that much of this market strength was driven by economic weakness, with Australian economic data continuing to weaken, despite sky high iron ore prices that have now surpassed their previous all time highs in Australian Dollar terms, leading to an earlier than expected budget surplus. The RBA however remains concerned about an inability to drive the unemployment rate lower, leading them to cut rates, and signal the likelihood of more to come, as well as pressing the government to be more active in providing fiscal stimulus through means such as infrastructure spending.
While the US jobs market continued to show signs of strength, US central bank statements showed clear concern around weakening economic data such as retail sales and consumer sentiment, and the ongoing impact of trade wars, with strong indications that rate cuts are now imminent. Europe, Asia, and emerging markets were also impacted by trade wars as manufacturing data continued to weaken, along with stalling import / export volumes. German manufacturing was particularly poor, not helped by weak Chinese import data. Italian economic data weakened significantly as leaders continue to jostle with the EU over budgetary imbalances, with the Italian economy needing a sizeable fiscal boost, but unlikely to receive it due to the EU's lack of trust in the Italian government. The ongoing saga that is Brexit continued with PM Theresa May resigning after the British parliament rejected her deal time and time again. Britain is now leaderless with the Brexit deadline pushed out to October.
Trade wars seemed to be coming to an end early in the quarter as the US and China neared a resolution. However, a sharp turn of events saw President Trump slap more tariffs on China and then also threaten Europe and Mexico with tariffs. Thankfully, deescalation occurred at the end of June with the US and China agreeing not to escalate tariffs any further, with both coming back to the negotiating table. US and Iran tensions rose following the enforcing of US sanctions on Iran, which then saw attacks on Saudi Arabian oil ships and army bases by Iran backed rebels, which ultimately resulted in Iran shooting down a US drone in disputed airspace.
On the portfolio front, our portfolios continued to perform strongly in the June quarter, in both absolute and relative terms, outperforming their respective peer groups, with strong returns across all asset classes. Underlying exposures in Australian equities performed strongly with both Bellmont and Flinders shining. In global equities, Magellan was the highlight with strong stock selection, and defensive positioning in May showing through. T. Rowe Price and Vanguard also performed well, despite benchmark relative returns being hampered by their Asian and emerging market exposures. Very strong numbers from our Australian listed property exposure also helped overall performance. Within the defensive side of the portfolio, PIMCO was the standout, benefiting from its exposure to government bonds, whilst Macquarie and T. Rowe Price also delivered strongly relative to their return targets.
Pleasingly, our Bellmont Consolidated Equities Portfolio continues to perform strongly, with a compound annual growth rate since inception of 14.5% per annum significantly above the 11.0% per annum achieved by the market over the same period. This was achieved in no small part thanks to an outstanding 2019 financial year, with a portfolio return of 24.0% more than double the 11.6% index return, despite very modest underperformance in the June quarter, with our 7.4% return slightly below the 8.0% return of the index.
While the market environment in the 2019 financial year was anything but stable, the same could not be said for our portfolio. Overall portfolio turnover for the year equated to approximately 29% - extremely low by actively managed share portfolio standards - especially given that we rebalance the entire systematic side of the portfolio annually - and in line with our philosophy of being long term investors. Unusually for us though, for the second consecutive quarter we ended up selling completely out of one of our holdings on the satellite / non systematic side of the portfolio, with TPG Telecom (TPM) this time the company that we waved farewell to.
TPG Telecom (TPM) has been one of the real Australian entrepreneurial success stories, with canny founder and CEO David Teoh guiding the company from humble beginnings in 1986 as a computer assembly company (TPG actually stands for Total Peripherals Group), to become the second largest ISP in the country today, with $2.5b in revenues, a market capitalisation of over $6b, and an outstanding track record of earnings growth. While we remain enamoured with management and certain foundational elements of the business, in recent years the company has been facing increasing external headwinds, with enormous margin contraction from the compulsory transition of their previously lucrative residential ADSL business to the NBN, the government ban on the use of Huawei equipment crippling their plans to build their own mobile network, and finally the ACCC rejection of the company’s proposed merger with Vodafone Hutchison Australia in May, on the basis of a likely lessening of competition in the mobile market (a completely ridiculous proposition in our opinion). While management have shown themselves to be more than capable of managing the cut and thrust of normal business competition, it’s a tough ask for them to continue to do so with both hands tied behind their backs by government and regulators. Should external conditions change we would be delighted to re-assess our position, but for now, no longer able to be ‘virtually certain’ that the company's earnings will be materially higher in 5 and 10 years, we felt it prudent to sell our remaining holdings, and watch on from the sidelines.
Despite continuing to deliver the sort of earnings growth that most companies could only dream of, the portfolio’s weakest performer for the for the full financial year in both percentage and dollar terms, was Dominos Pizza (DMP), falling 25.1% for the year, including 13.3% in the last quarter alone. Just a few years back Dominos was one of the most sought-after stocks on the market - trading on an eye-watering P/E multiple (don’t worry - we didn’t own it at that point!), and consistently delivering astronomical earnings growth as they relentlessly focused on improving the efficiency of their operations, and rolled their refined model out across Australia, Japan and Europe. While in the last couple of years the company's earnings growth has still been solid, its recent trend of falling short of management’s own more optimistic growth forecasts (unlike many in the market, we care what a company’s earnings are, not what others forecast them to be!), coupled with their presence as a major player in the scandal-riven franchising industry has seen the company very much fall out of favour, with their P/E falling to less than a third of its level just a few years earlier. While there is no doubt that the company’s rate of earnings growth moving forward will be slower than its breakneck pace of the past, the highly motivated and capable management team coupled with the enormous markets that they operate in gives us confidence that earnings are still highly likely to be significantly higher in 5 and 10 years time. With the current weakness in the share price, we will be watching carefully in coming months for any opportunities to add to our existing modest 2.3% weighting.
While Dominos Pizza (DMP) was our only holding to fall more than 20% for the full financial year, we were pleased to have 13 holdings that delivered positive returns of more than 20% over the same period! Chief among them was Fortescue Metals Group (FMG), which generated an incredible 142% return for the full financial year, including a stellar 39% return in the June quarter alone, as the AUD iron ore price continued its inexorable record breaking rally. Following closely behind though was Magellan Financial Group (MFG), which generated an almost as impressive 115% return for the financial year on the back of exceptionally strong investment performance and growth in their funds under management. Interestingly though, it was health insurer NIB Holdings (NHF) that took the gong as the best performing stock in our portfolio in the June quarter, with a 46% return as concerns about a proposed labour government slug to industry profitability fell away after the coalition’s shock election victory. Impressively, despite operating in a highly competitive, heavily regulated, mature industry, NIB has managed to grow policyholders at above the broader industry rate consistently for more than 10 years. In 2018, despite having only 7% market share, they represented 45% of the total growth in policyholders across the entire industry! This impressive track record, combined with their fast growing adjacent businesses has enabled the company to grow their earnings at more than 15% annually over the last decade, and when combined with the impressive management team gives us great confidence in the company’s future.
While there is no doubt that markets will continue to lurch from mania to pessimism at irregular and unpredictable intervals, we remain very confident that our portfolio of high quality, attractively priced companies are well positioned to grow their earnings, and the value of our portfolios solidly over time.
Note that actual portfolio performance will differ from model performance, based on entry and exit date, rebalance frequency and other factors. Performance numbers quoted are after IM fees, but before brokerage and performance fees.
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