Rudi’s View: (In Search Of) The Holy Grail

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

On March 20 and 21 FNArena Editor Rudi Filapek-Vandyck presented respectively to the CPA’s SMSF discussion group, online, and members and guests of the Australian Shareholders Association (ASA) in Sydney, in person on stage.

The video recording of the first presentation is available via the FNArena website and through Youtube: https://fnarena.com/index.php/fnarena-talks/2024/03/22/to-august-beyond/

To make the content of this presentation available to a wider audience, FNArena has decided to also publish a shortened, curated transcript, with limited illustrations from the slides used.

A full copy of the Powerpoint presentation slides is available for paying subscribers via the SPECIAL REPORTS section on the website.

Presentation: To August & Beyond, March 2024.

Welcome. With today's presentation I have tried to combine the short term with the long term.

This idea is also embedded in the title I have chosen. As investors in the share market, we always tell ourselves we are in this for the long term; we know investing is a marathon, rather than a short-term sprint.

In practice, we are constantly being influenced by the short term, also because of the sector and the media telling us all about the short term, what is happening, and what is not happening in the here and now.

Short Term: February Results

Let's start with the short term.

In Australia, we have two major corporate results seasons; in August and February, and a gaggle of companies reporting in between.

Last year, both February and August seasons proved quite disappointing. Twice the market rallied hard leading into each season, and twice results were simply not good enough and all those gains disappeared in full.

The situation at the start of February was not dissimilar. Again, we saw a big rally beforehand, but this time the gains have not disappeared.

Because expectations were low, the stats look ‘ok’. I think it’s probably correct to conclude the reporting season was ‘good enough’, I am not sure whether this also means it was ‘good’.

The macro-outlook has by now changed too.

As investors, we are now looking forward towards, hopefully, a trough in economic momentum, and we are in particular looking forward to central bankers cutting interest rates.

Consumer spending is hopefully holding up, that's the hope, and it is supporting the market broadly.

The big winner from the February reporting season is technology, and that was very much noticeable. We saw big spikes in share prices for some of the technology stocks. Some of those results proved absolutely mind blowing.

It didn't get that much coverage in the general media for the simple reason that technology is supposedly a US phenomenon.

But also, there are many more retailers and consumer-oriented companies listed on the ASX, that were equally meeting or beating expectations, so much more attention went to discretionary retailers.

Another factor is technology trading on above average PE multiples, and everybody, including the media, has a psychological problem with that.

Another sector that performed really well is building materials.

In general terms, the season was being saved by smaller cap companies, not so much the large caps.

The losers in February were the international cyclicals; mining and energy companies.

Those results generally were quite disappointing, and that translated into share prices going backwards. Both the energy and mining sector were at the bottom of performance tables over January and February.

Another sector that simply never seems to get it right is telecommunication, with exception, maybe, of a few small caps.

Plus the one sector that used to be a shoe-in for solid performances is healthcare and again, February did not deliver for healthcare.

Investors will have to be more patient when it comes to healthcare stocks.

The irony here is that what happens in February doesn't necessarily give us any guidance for what lays ahead.

For example, healthcare is seen as one the best performing sectors in terms of profit growth for the years ahead.

In terms of profits generally, the current forecast sees the average earnings per share (EPS) retreat by -5.5% in FY24. For FY25 consensus sees a positive gain of 4%.

The long-term average for Australia is positive growth of 5.5%, thus the general expectation is for below-average growth this year and in the next.

Needless to say, in a polarised market the outlook between sectors is very much diverse.

On the positive side, we find insurance, healthcare, and technology. On the negative side, we find commodities and the banks, for example.

All in all, it’s ‘good enough’ to retain an undercurrent of cautious optimism supporting the market.

The Broader Picture

Another observation is the index gained some 2% in total since the start of the year, some 0.80% all-in throughout February, but in the US gains are generally much higher.

And that difference in performance is not something that only happened this year.

If we zoom out and look at the broader, longer-term perspective, we see a huge gap has opened up between US markets and the local ASX.

It happened during the 1990s, when the main drivers were technology, the internet and internet infrastructure, but it didn’t last that long. Eventually both markets converged again, and Australia outperformed for a number of years. That came to an end with the GFC.

The gap has really opened up since 2015.

Reversion To The Mean?

Observation: the gap between Australia and US markets has probably never been this wide, and it has never been witnessed for this long. It’s been going on for 16 years now, and counting.

This raises a lot of questions. As one of popular approaches in finance is to position for reversion to the mean, we should be very excited in Australia.

The local market has a lot of catching up to do and this could potentially translate into many, many years of outperformance relative to the US.

Of course, there are many ways in which this can happen. It can also mean US shares tank and we don't –  and all the scenarios in between.

Interestingly, if we take a very long-term perspective of one hundred years and longer, the performances of US shares and the ASX turn out relatively similar.

Both markets are in the Global Top Three of best performing share markets longer term. It makes the current outperformance of US markets even more remarkable.

So the key question thus becomes: is it feasible we will see a reversion to the mean?

To find the answer, we need to investigate whether there is a fundamental reason as to why the US is outperforming so strongly and for so long.

If we find that fundamental reason, and it remains in place, we might need to conclude there’s no reversion to the mean on the horizon, not until underlying fundamentals change.

The Longer Term Picture

There are many different ways of investing and trying to make money from the share market.

For many people it consists of hopping on and off of stocks, buying and selling, trying to pick the troughs and peaks in share prices.

But let’s just assume, for this exercise, we like to buy and hold for longer periods of time.

Within such framework, the stock I am showing you right now is nothing but the ideal proposition.

Yes, of course, there’s the occasional bout of volatility, and there are sell-offs along the way, but ultimately the share price moves from the bottom left-hand corner on the price chart to the right hand corner near the top.

As a long-term investor, that’s what we want to see. This is the sort of stock we like to hold in our portfolio.

This is Microsoft. Maybe Microsoft is showing us why US markets are outperforming Australia?

Let’s compare, say, with one of our major index constituents. Let’s look at a long-term price chart for National Australia Bank ((NAB)).

I’d like to think if I showed both price charts to a five-year old, the conclusion would be that shares on number one are going ‘up’ and shares on number two not so much.

Hence, NAB shares over 16 years have gone through a lot of volatility, as have Microsoft shares, but, ultimately, they’ve made no real progress over that time.

Could we possibly have found the explanation for the big gap in relative performances between both markets?

At the very least, I think we have discovered something that needs to be investigated further.

Some people might say Microsoft is a technology company. And NAB is a bank. That's your explanation right there.

"The outperformance in the 1990s was simply about technology and we are repeating the same story over and again."

So, let’s stay inside the finance sector in Australia, let’s compare the banks.

I’ve gone back to the bottom of the GFC, 6^th of March 2009.

The worst performer in Australia among the Big Four is Westpac ((WBC)). If you held those shares from the absolute bottom until three weeks ago, you’d had made 4.7% per annum on average, plus dividends, and franking.

If we add dividends that’ll bring total return up to between 9-10% per annum. That’s not too bad, I think most investors would agree.

But we are measuring from the bottom of the GFC. If we measure from a later date, when share price levels were higher, that 4.7% quickly reduces towards zero. All that’s left then, on the long-term average, are the dividends and franking.

Let’s now compare with CommBank ((CBA)).

Same starting point, same length of holding period, and the average return is more than 22% per annum, ex-dividends.

The difference is enormous.

If I then broaden my perspective, and compare with Macquarie Group ((MQG)), not quite apples versus apples, but we are inside banks and financials nevertheless, the average return climbs to 68% per year. Plus dividends on top.

I guess what we are discovering here is this is not about technology versus banks.

Also, allow me to point out:

Westpac is the ‘cheapest’ of the banks. CommBank is the most ‘expensive’, not only at the end of the holding period, but CBA has been the most expensive throughout the whole 16 years.

CommBank pays the lowest yield in the sector. Westpac pays the highest yield. Macquarie sits on both accounts closer to CommBank than to Westpac.

Observation: the cheapest stock has generated the worst return. The highest yield equals the worst return.

We might be onto something important here.

Compare all four of the Big Banks in Australia and I think we all agree, the price chart for CBA looks pretty similar to that of Microsoft, while the other three don’t.

What we see is a sharp difference. What could potentially explain this?

The Quality In Businesses

From Warren Buffett’s recent homage to the late Charlie Munger: Charlie taught me it’s better to invest in wonderful companies at a reasonable price instead of in reasonable companies at a cheap price.

In my personal research, I focus on finding wonderful, great, high-quality businesses. But that’s a very contentious concept: what makes a great company while others are not?

I discovered research conducted in the US and locally by Betashares on this matter.

The central question remains the same: what have companies in common whose price chart looks similar to CBA’s, Macquarie’s, and Microsoft’s over a long period of time?

The research suggests a strong correlation exists between companies that invest and those that don’t, or only a little.

The real gap becomes evident when we compare Nasdaq companies with those in the S&P500, while removing those from the Nasdaq that are also in the S&P500.

As a percentage of sales, investments by those Nasdaq winners are absolutely massive if one also considers how large some of those companies are, like Meta, for example, or Alphabet, or Microsoft.

So… what makes a great company, according to this research, is that it invests, on average, ten times as much as others, on developing new products, on reinforcing the moats, on strengthening market share, on improving and expanding products and services, etc.

This Time Is Different

There’s a tendency in finance to joke about the four most dangerous words ever used: this time is different.

It’s usually in reference to market bubbles and share markets at all-time highs.

But I've been arguing now for a number of years that this time is different.

At the macro-level, we are still operating inside a slow growth environment, and we have been for quite a while.

And probably the key change is that we are living through an almost unprecedented time of technological advances, innovations, and changes.

I believe those dynamics polarise the market, because not every company is adept enough to catch up.

This is also what we see in the share market, where since 2015 share prices have become polarised between the Haves and the Have Nots.

In February, one observation was that companies are increasingly mentioning and referring to artificial intelligence (AI), both in the US and in Australia.

AI has the potential to further polarise economies and companies.

It’s not necessarily going to happen immediately; these are long-winded processes. But as investors with a longer-term horizon, I think this is most definitely something we should pay attention to.

In my own research, I pay attention to the concept of megatrends; trends that remain in place for a very long time. If companies are being driven by such megatrends, it means they have the wind in the sales for a very long time.

As an investor, we need to ask ourselves the question what is more important; the short-term valuation or the prospect to enjoy strong investment returns over an extended period of time?

Valuing Companies

Another element that is changing is how to value modern day businesses.

There are still people in today's share market who think they can simply put a backward-looking PE ratio on all companies, universally, and decide which ones are a good buy and which ones are not.

I say good luck with that, you are very well adjusted to the 19th century. Please, stop using backward-looking PE ratios; you're not doing yourself any favours.

Secondly, accept that valuing a company has become increasingly more sophisticated.

For those who’d like to research this aspect more, I happily refer to Aswath Damodaran, considered the Dean of valuing companies in our lifetime.

Website: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/home.htm

All-Weather Performers

I started my research into high-quality performers on the ASX after the GFC and the subsequent bear market.

In essence, I got interested in figuring out why some companies perform so much better through tough times and downturns while others drop like flies.

Since that time, my research has identified a number of All-Weather Performers in the Australian share market.

Let’s find out how some of my favourite companies compare against Microsoft & Co.

Maybe one observation to make here is that you can have US-type returns in Australia, as long as you have Microsoft-type companies in your portfolio.

And I am not referring to the technology component, but simply to the similarity on these price charts.

Conclusion

What I’ve tried to show you today is there’s a lot we don’t see when we’re focusing on the short-term, but investing is a long-term endeavour and maybe we should pay more attention to the differences in between companies and the different dynamics that rule them?

The share market consists of a small minority of exceptional performers and a large majority of mediocre wannabes.

As an investor, I am happy to stick with the minority.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to My Alerts (top bar of the website) and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website. 

P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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