The bright spot in the Australian market

One of Australia’s best performing fund managers over the last decade has warned of tough times ahead for investors, and believes those same conditions will support another decade of market dominance for growth-biased investment styles.

“The Australian economy will be low growth over the next decade even with a reliance on resources, tourism and education,” says Jason Orthman from Hyperion Asset Management.

According to Mr Orthman, the problem is that Australia’s historic growth sectors are dependent on China powering ahead – again.

Jason Orthman’s small-cap fund was the best performer over that past decade according to research by Mercer. Attila Csaszar

“We believe China is susceptible to a higher than expected slowdown in its growth rates due to the structural imbalances in its economy.”

Mr Orthman’s small cap fund was the best within its peer group over the last decade, according to Mercer numbers before fees, and the fund manager thinks shifting global currents will shape returns out to 2030.

For example, if China’s economic and construction super-cycles prove once-in-a-generation events, then popular parts of the market could suffer.

“The Australian market is lopsided with a high exposure to banks and resources. The long-term outlook for both is poor and the quality of the overall Australian index is very low,” warns Mr Orthman.

“We don’t believe banks will generate any meaningful earnings growth over the next decade and commodity prices are too high and will mean revert closer to their marginal cost long term.”

Opportunity knocks
However, there’s still lots of opportunity to successfully invest locally or overseas. “The one bright spot in the Australian market is a collection of world class healthcare companies. Even in a global context their business models, market shares and competitive advantages are world leading,” Mr Orthman said.

In particular, he likes how healthcare businesses reinvest heavily for new product development. In turn, this can deliver profit growth whatever the stage of the economic cycle.

The companies that offer the strongest long-term returns tend to have defined priorities, with a long-term skew. “Often the companies we like are owners, founder-led. So they’ve actually got a lot of skin in the game,” Mr Orthman said.

“But if you’re a professional executive, you’re often beholden to the board, and short-term incentives. If you’re a founder you have the credibility and support of the board to invest for the long term.”

Mr Orthman is worried that unusually soft GDP growth, inflation, and interest rates are here to stay.

“The old world of only relying on the movement of cash rates to influence growth and inflation is over. Inevitably others will follow the path of Japan and will need to experiment with new tools. Australia will too,” he said.

Given the policy obstacles ahead, another top-performing fund manager, Andrew Hokin from Smallco Investment Management, is equally drawn to international earners.

“Policy mix can be fluid. We are bottom-up stockpickers looking to identify companies that can grow in different economic settings,” he said.

“Our growth style means a significant portion of the portfolio contains companies that generate a large amount of their revenues in international markets.”

Companies with foreign earnings, the best example of which is CSL, have performed well for local investors.

We always think of Australia being quite an innovative nation,” said Pendal Group’s Paul Hannan, who co-manages its microcap strategy, citing technology and agriculture. “That creates an investment destination through that. I don’t see much changing.”

That’s no different in private markets, said his colleague, Noel Webster. “Your capital is chasing innovation and that’s not going to stop, and Australia is not going to be lost in that. A lot of it’s going to be private capital because that’s where a lot of opportunities are coming from with disruptive business models.”

Another successful theme has been the outperformance of growth-oriented companies, partly as a result of price-to-earnings multiples expanding as investors pay more for expected growth given the weak economic backdrop.

“Our view is we’re in a permanently low growth world. We have been since the GFC. Interest rates are moving down and reflect that we’re in a low growth world,” said Mr Orthman.

If he’s right, sharemarket investors who lean towards highly rated growth stocks over value styles will outperform.

“We think it’s appropriate to have a high P/E dispersion between high and low quality businesses. In fact, we think it can continue expanding,” he said

This article was originally published in the Australian Financial Review.

January 28, 2020

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