The Perpetual Equity Investment Company Limited (ASX:PIC) recently announced its full year results for FY22. Portfolio Manager and Deputy Head of Equities Vince Pezzullo provides a market overview, explains how he is positioning the portfolio as a result and names some stocks to watch in FY23.
FY22 was one of the most unique and volatile years in markets in recent memory, marked by dominant macro-economic themes including rising inflation, war, spiking bond yields and swinging equity markets. As stock pickers that conduct in-depth, bottom-up research on individual companies, we stuck to our fundamental approach centred around quality and value and screened out the macro noise. While this has impacted and may continue to impact short term performance, we have a positive view on generating sustainable returns over the long-term and through the economic cycle. Our active management style and disciplined approach to investing provides the flexibility to adapt to changing market conditions including varying the portfolio’s exposure to equity market risk and identifying companies that we believe are undervalued and will deliver returns over time.
Significant and rising inflation
Initially dismissed by central banks as “transitory”, inflation proved persistent and kept confounding pundits and policymakers alike. As significant inflation pressures began to emerge in supply chains, policymakers hoped that economic indicators in the data would start to demonstrate a return to normal. Instead, inflation proved more resilient, rising sharply through the final quarters of 2021. Early in 2022, any last hope that inflation might return to normal were dashed as war in Ukraine broke out, sending energy and food prices soaring and triggering a new round of supply disruptions. By this point, fears began to emerge that rising inflation expectations might become entrenched in the economy and central bankers turned their attention to rapidly raising interest rates to try and keep future inflation expectations “anchored” at lower levels. The US Federal Reserve began a series of larger than usual rate increases and switched to “Quantitative Tightening”. Domestically the Reserve Bank of Australia (RBA) ditched a long-held pledge not to raise interest rates before 2024 and began to hurriedly implement a series of rate rises.
Sector sell offs
Top Australian Brokers
We saw certain companies coming under pressure, namely the companies trading at rich valuations that had been amplified by the long decline in interest rates. Small caps and growth stocks felt the brunt of the sell off, in particular technology stocks with sky high valuations and little or no earnings. The strong swing to cyclical value stocks that had been underway since late 2020 re-emerged with greater force. In terms of sectoral performance for the market (as represented by the benchmark), Energy led the charge and rose 29.7% in the 12 months to 30 June 2022. This was driven by the invasion of Ukraine triggering sanctions against Russia and major global energy market dislocations following already-elevated levels of oil and gas demand. Information Technology fell -36.4% through the year as soaring interest rates and bond yields responded to a surge in consumer inflation. This also impacted the rate sensitive Healthcare and Real Estate sectors. Declining consumer confidence in the face of rising living costs, and falling durable purchases, also negatively impacted many consumer stocks.
At the end of June, the portfolio composition was as follows: 77.8% Australian listed securities; 17.2% Global listed securities; and 5.0% Cash. The portfolio turnover of 53% for the year was higher than previous years and reflects the active changes to the portfolio as a result of shifting market conditions. We have seen more opportunities in Australia this year compared to previous years where our allocation to global listed securities was higher. Investment in global listed securities remains opportunistic in nature and we believe can add significant value to investors when we assess there is a limited opportunity set in Australia.
We regard CSL as a high-quality stock, but it is trading at a price well above its value. On the other hand, we see companies like Flutter Entertainment Plc, which is listed on London Stock Exchange, and La Francaise Des Jeux, which is listed on Paris Stock Exchange, offering better value for investors as they are dominant in their market segments, have growing margins and excellent balance sheets. Both Flutter Entertainment Plc and La Francaise Des Jeux are long term positions in the portfolio that we have held since 2018 and they continue to be the top global positions in the portfolio. Crucially, as an active manager, we are not fixated on one single valuation methodology or pre-set notion of investment opportunities. We are attracted to any quality business that meets our investment criteria which can include erstwhile growth companies, which are temporarily trading at discounted valuations.
Top contributors and detractors
Over the year, mining and energy stocks including BHP Group Limited, Western Areas Limited, Santos Limited and Jervois Global Limited were amongst the top contributors to absolute performance due to a surge in energy prices and a strong demand in export markets. Global listed securities, Flutter Entertainment Plc and La Francaise Des Jeux made valuable contributions to the portfolio in past years but gave back some gains and detracted from absolute performance in FY22. We trimmed our exposure in Flutter to 3.8% in December and took significant profits, however, we have since re-established a larger position given it became undervalued amidst the sell-off in global markets in April and May 2022.
At the very end of the financial year, markets began a new rotation, punishing cyclical value and rewarding stocks we viewed as quality and defensive. We believe this is because markets started to “look through” current inflation and rate hikes to determine if the aggressive policy tightening by central banks is “too much, too late” and likely to result in a recession. Whilst we consider a recession in Europe and US likely, the jury is still out on whether the technical definition of a recession will be achieved in Australia. Hence, it has proven to be a more difficult investment environment. Whilst inflation may fall in the next year or two as a global economic downturn bites, we believe that some inflation will continue to persist beyond this with lingering supply issues, policy decisions (decarbonisation), demographics and other factors conspiring to push up the cost of living and doing business.
Potential beneficiaries of this cycle
We are confident the portfolio has been set up well in the current environment as it includes:
- Beneficiaries of inflation and the trends mentioned above – this includes Energy and Green Metal stocks (such as nickel, cobalt and rare earths used to reduce carbon emissions and create cleaner energy sources and technology) despite their cyclicality.
- Companies experiencing structural growth that we have been able to acquire at reasonable valuations. We consider companies like Flutter and La Francaise Des Jeux to be of high quality and exhibit defensive characteristics as their earnings are not sensitive to the business cycle.
- Cyclicals – companies trading at discounts to mid-cycle valuation despite being quality companies with solid fundamentals. For example, Insurance Australia Group Limited.
We think this combination of cyclical domestic value stocks and high-quality global names gives our investors the right balance of quality and value opportunities for the next challenging phase of the market cycle.
Value investment forecast
Economic conditions will continue to evolve and uncertainty will continue to manifest in markets. The central banks aggressive attempt to rein in inflation expectations will cause unintended consequences in both economies and the markets. Because central banks have no influence on the supply of goods and materials, they also cannot influence the willingness of companies to invest to expand supply in response to higher prices. This hesitancy is mostly due to companies seeing this as a significant pull forward of demand from fiscal and monetary largesse. We see the only influence central banks can have is on demand, and to achieve a reduction in demand, we will see a tightening in liquidity and financial conditions. This will force many companies to face up to this new reality with many early phase/profitless companies not surviving.
We have long believed that markets are poised for further rotation to a more value-oriented investment environment as COVID-19 disruptions, waning stimulus and war combine to keep consumer price inflation at high levels. However, we must also be willing to pivot the portfolio when the markets are pricing in overly aggressive rate expectations. With fear of a deep and long recession, this will be factored into markets and this will provide opportunities to redeploy capital. In these conditions our focus on value style investing, buying quality companies with strong balance sheets trading at reasonable valuations should continue to do well and offer attractive opportunities for investors.
Originally published by Vince Pezzullo Deputy Head of Equities, Portfolio Manager, Perpetual