AFR:‘Getting punched in the face’: Investors brace for iron ore falls as China tensions linger

‘Getting punched in the face’: Investors brace for iron ore falls as China tensions linger

Normal text size Larger text size Very large text size Fund managers are bracing for continued pressure on iron ore prices, with China’s moves to curb steel production to limit air pollution poised to squeeze share prices of big name miners and threaten federal government tax revenue.

August Monthly Newsletter

  • The Atlas High Income Property Fund had a very strong month gaining +6.3% as real estate assets continued to recover from their falls in 2020. Twelve months ago, the prevailing view was that most real estate and infrastructure assets would be become “stranded assets”, permanently collecting a fraction of expected cash flows. This view has proved incorrect, with most trusts collecting rent due from tenants managing their businesses through the pandemic and infrastructure assets operating at close to full capacity when restrictions are lifted.
  • We were pleased with the financial results presented in August from the companies we own in the Fund. The common themes were profits recovering, rents being collected, and positive management commentary on the outlook for 2022. There was no repeat of the GFC-era debt crisis in 2021 for the listed property sector as due to conservative gearing and long debt maturities, no trusts were forced sellers of assets over the past 12 months.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2022.

Key Themes from the August Reporting Season

The highly anticipated August 2021 company reporting season for Australian listed companies concluded earlier this week. While certain companies in the travel industry, such as airlines and airports, continue to generate large losses, the month of August showed that large Australian companies are in very good health overall. Indeed, the sum of dividends declared over the last month surpassed the previous all time record set in August 2019!

In this week’s piece, we look at the key themes coming out of the reporting season that finished on Tuesday, along with the best and worst results and the corporate result of the season.

Better than expected

Given the gloomy backdrop of 2020, ongoing uncertainty around COVID-19 and further lock-downs in late 2020, general expectations were cautious going into reporting season. Even companies such as Sonic Healthcare, which had a record year conducting 30 million Covid-19 tests globally, were unwilling to provide earnings guidance. While the profit results in February 2021 were generally quite positive, some of the COVID-19 winners from 2020 were expected to struggle in 2021. The market was also concerned that the economy could face a negative shock as JobKeeper finished at the end of March.

According to UBS, 41% of ASX 200 companies beat their guidance, and over 70% of companies lifted profits compared with the prior comparable period in 2020. Companies beating guidance generally were COVID-19 beneficiaries that saw continued sales momentum (Wesfarmers and CSL) or saw profit margin expansion from improvements in their markets (Amcor and Suncorp). Better than expected corporate profits saw the ASX 200 hit an all-time high of 7628 on the 13th August, an unthinkable situation in March 2020 when the prevailing view was that in 2021 Australia would be in the grip of a deep recession!

Show me the money

The main theme of reporting season was the significant increase in dividends being paid to shareholders. August 2021 saw a record $40 billion in dividends being declared by Australian companies, beating the previous record of $28 billion set in August 2019. This corporate largess is due to a combination of record iron ore prices (BHP, Fortescue and Rio), strong sales from consumers being locked down and being prevented from travelling (Woolworths, JB Hi-Fi and Wesfarmers) as well as much lower-than-expected bad debts (Commonwealth Bank).

In addition to higher dividends, buy-backs were a feature of this reporting season with CBA ($6 billion), NAB ($2.5 billion), Woolworths ($2 billion), ANZ ($1.5 billion) and Telstra ($1.3 billion) announcing measures to reduce their share count and boost future earnings per share. CBA and Woolworths buy-backs will be conducted off-market rather than as direct purchases on the ASX and then cancellations. Here their investors will receive a combination of a tax-efficient capital return and a fully franked dividend which will see excess franking credits transferred from corporate balance sheets into the hands of investors. Furthermore, Wesfarmers announced a $2.3 billion capital return. This wall of money will find its way into the bank accounts of investors over the next two months, which along with companies buying back their shares on market should support the ASX throughout the rest of 2021. NAB shareholders should be less happy, as the bank is now buying back shares on market at around $28, which were issued in May 2020 at $14.15. Sell low and buy high, poor capital management!

Management Choices

Some in the financial press have criticised the levels of dividends being paid to shareholders, saying that it is a sign that management teams are not reinvesting capital in growth projects or making acquisitions that will grow earnings in the future. However, the record of Australian companies successfully making significant investments during times of excess profits is not good. Both Rio Tinto (Alcan 2007 and Riversdale Coal 2010) and BHP (US shale gas 2011) made value destructive acquisitions during previous iron ore booms. Similarly, hardware retailing superstar Wesfarmers foray into the UK hardware market in 2016 resulted in an ignominious retreat two years later. While competition concerns would preclude the big four trading banks from using their excess capital to buy smaller regional banks, their record in using capital to grow in adjacent areas such as wealth management is poor. Similarly, Australia’s banks’ moves to showcase their domestic banking expertise in the UK, USA, and Asia are littered with painful lessons. When management is confronted with the choice of returning capital to shareholders or making an exciting acquisition presented to them by a slick investment banker, we generally prefer to see excess capital going to shareholders, which is what Australian companies have mostly decided to do in 2021.

Mergers and Acquisitions on the Table

Against this background of caution by most Australian companies towards making a major acquisition, August revealed that foreign corporations pension funds are quite happy to pay up for Australian listed companies. Over the month, we saw deals such as NYSE-listed Square’s $39 billion scrip-based deal for AfterPay, Santos’ $21 billion merger offer to Oil Search, a $22.8 billion offer for Sydney Airport and a $5.2 billion bid for Spark Infrastructure. Similar to the quantum of dividends discussed above, these takeovers are likely to support share prices as the proceeds find their way into investors bank accounts in the coming months.

Rising Labour Costs

Despite dire predictions made in early 2020, the combination of stimulus plans, strong corporate profitability and close to zero immigration has seen the unemployment rate fall steadily, with the rate falling below 5% in June for the first time in ten years. Low unemployment is likely to lead to rising wages. In August, major employers such as Woolworths and BHP discussed that higher labour costs are expected to impact profit margins in the future. Similarly, low unemployment levels in the US have increased CSL’s input costs, with the biotherapy company having to pay blood donors more for the blood plasma collections. Also, CSL saw reduced plasma volumes which were attributed to government stimulus cheques stopping donors from turning up at the company’s collection centres in the USA.

Best and Worst

Over the month, the best results were delivered by WiseTech, Suncorp, Domino’s Pizza, James Hardie, and Amcor. Despite the uncertain macroeconomic background, these companies reported strong earnings growth ahead of expectations and an optimistic outlook for 2022.

Looking at the negative side of the ledger, we will ignore travel-related companies such as Qantas, Sydney Airport and Flight Centre as their financial results are due to government-mandated lock-downs rather than poor management decisions. Altium, Magellan, Link Administration and Cochlear reported results that were poorly received by the market. The common themes amongst this group are high price to equity (PE) companies that delivered profit results below expectations, combined with forward profit guidance not consistent with high growth companies.

Result of the Season

While some companies have done well out of the COVID-19 pandemic, it is difficult to think of a company that has flourished as well as the global pathology testing company Sonic Healthcare. In the most outstanding result of the reporting season, Sonic demonstrated one of the reasons we like the company. Pathology is a volume game, and laboratories have high fixed costs, but profit margins increase when much higher volumes flow through that same lab. Profits were up a staggering +150% to $1.3 billion with 30 million COVID-19 tests performed across 60 global labs. Additionally, Sonic’s base pathology business has grown and is now ahead of pre-pandemic levels. While the company only increased the dividend by 7%, we were pleased to see management use the windfall generated by the pandemic to pay off $1 billion in debt, thus halving the company’s outstanding debt level previously built up to acquire laboratories in the USA and Europe. Building a global network of laboratories has proved to be a prescient move in 2020/21. The next leg in this pandemic story for Sonic is likely to be COVID-19 serology testing (immunity status).

Our take

Overall, we were reasonably pleased with the results from this reporting season for the Atlas Concentrated Australian Equity Portfolio. In general, the companies that we own reported improving profits and indeed, for a number of companies in the portfolio, 2021 delivered record profits that were mainly used to reward shareholders.

The Portfolio returned 29% for the 12 months ending August 2021 which was over 2% above the benchmark. As a long-term investor we are also interested in delivering income to investors, we look closely at the dividends paid out by the companies that we own and whether or not they are growing. We look to “weigh” the dividends that our investors will receive. Our view is that talk and guidance from management are often cheap, but actually paying out higher dividends is a far better indicator that a business is performing well. Using a weighted average across the portfolio, our investors’ dividends will be +50% greater than for the previous period in 2020. This increase demonstrates confidence returning to Australian corporates after the uncertainty brought on by the pandemic. On this measure, we are pleased with how the recent reporting season went.