Whenever stranded assets are mentioned we are likely to conjure the image of a dilapidated oil terminal that no longer has any value attached to it due to alternate fuels or costly environmental regulations. Commercial real estate rarely enters our consciousness and as a result the REIT sector has never had the intense ESG spotlight shone on it by the public or the wider investor base.

How is ESG impacting investing?

ESG focused investing has really ramped up in recent history and has gradually shifted from just the direct operations of a company to now analyzing the impact of all its organs. As a result, firms will have to reflect and act on every part of their operations - whether that includes a manufacturer assessing the carbon intensity of its HQ, a pharmaceutical trying to lessen water usage at its distribution centre or a tech company maximizing the air quality on its campuses. Thus, the real estate occupied by those firms will become increasingly scrutinized and assets that cannot be adapted to the tenant's growing requirements risk becoming obsolete and costly for its owners to hold.

While there are many prisms to look at commercial property from an environmental perspective, the NABERS (National Australian Built Environment Rating System) Energy rating guide is arguably the most comprehensive in its coverage, especially for Australian office assets. Buildings are given a rating on their energy efficiency using a 1 - 6 star system on a relative basis compared to their peers.

While there are similar NABERS ratings on water, indoor air and waste, energy has grown to be the most prolific due to legislative requirements. Under the current system all commercial offices over 1000sqm that wish to advertise for leasing or selling purposes must disclose their NABERS energy rating. Furthermore, in order to attract the government as a tenant the base building requires a minimum 4.5 star NABERS rating. As a result, NABERS has become the leading benchmark for assessing the 'green-ness' of a property.

What can businesses expect to see?

The current landscape in the Australian market is that of institutional investors leading the pack and commandeering more of the higher star rating assets. Morgan Stanley research found that the three biggest listed office landlords had a significantly high performing portfolio with Mirvac (MGR), Dexus (DXS), and GPT achieving a portfolio average rating of 5.5, 5, and 5 respectively for their office assets. This has largely been the result of an active development pipeline helping refresh the age of the portfolio as well as conscious decisions to refurbish older assets to meet modern environmental standards.

Employees are also increasingly expecting their employers to be environmentally conscious - a survey by HR resource company ELMO found that 71% of Generation Z workers would refuse to work for a company that was not seriously dealing with climate change. Furthermore, ambience and aesthetics are also rising in importance with a future workplace wellness study found that 31% of employees lose the equivalent of 60 minutes of productivity if the environmental wellness of their environment such as air quality and other factors were not satisfactory. Increasingly the mental health of employees is being brought to the fore thanks to the pandemic and companies who wish to be seen as socially responsible will need to accommodate this. Employers are taking note - JLL reported that 73% of their APAC based tenants surveyed saying they will be retrofitting assets by 2025 to meet these requirements such as achieving net zero and ensuring the office is a pleasant location to be.

The COVID pandemic has shaken up the office sector in various ways. Vacancies in CBDs have ballooned, with Sydney climbing from 4% pre-pandemic to 13% currently. Companies are re-assessing their space requirements which will certainly be influenced on how successfully they are able to persuade staff to return to the office. With widespread reports of labour shortages, it looks that the balance of power has shifted towards the employees. Employers in a post-COVID world will face the dual challenges of keeping their staff by aligning their actions with the staff's ESG values as well as also providing enticements to lure them back into the offices - no doubt challenges landlords will have a stake in. 

It has become clear that for employers to retain talent and encourage employees back to their offices for physical collaboration, they will need to ensure their assets and workspaces are up to scratch. Feedback from asset owners and leasing agents are that expectations from tenants are shifting to asset owners providing the amenities required by their employees such as coffee shops or breakout areas whereas previously the landlord was only responsible for the capital to ensure the base building was environmentally friendly. The costs of these amenities historically would be recouped through higher rents or lower incentives however the supply/demand dynamics in this market means tenants have effectively externalized a portion of their costs to meet environmental and social expectations to landlords.   

Where are we seeing vacancies?

If history is any guide, the current over-supply situation (highlighted by elevated vacancies) will  result in lower rental price growth and higher incentives (in the form of fit out contributions or rent-free periods) which negatively impact the cashflow of the landlords. While this trend was observed in 2020-2021, our channel checks have found that the performance of assets have become increasingly bifurcated. Prime grade assets (Premium & A grade) continue to hold onto higher rents and lower vacancy while the declines in rents has mostly been felt in B grade assets and below. One asset owner has even stated that they are seeing further bifurcation with A grade starting to lose some of its lustre leading to a 'Premium vs everything else' situation. This trend has been accelerated post-COVID with a common theme in the Feb-2022 reporting season being an acute sense of 'flight to quality'. For example Mirvac called out 80% of their vacancies were located in their lower tier assets.

This is not surprising given higher-grade assets predominately have 5-6 star ratings further enhanced with numerous amenities to maintain tenants and their increasingly demanding staff. The Australian listed market and other large institutional owners have been acutely aware of this and have largely been successful in ensuring their portfolios are at the higher end of the NABERS spectrum. Conversely, B-grade assets and below are mostly held by private owners. Typically such owners have less access to capital and as such may struggle to make the necessary investment to upgrade the asset ratings. Refurbishments required to drive an increase in the NABERS ratings require significant capital and often involve asset downtime (from 1 - 2 years). Activities such as replacing the cladding of a building has shown to potentially cost >10% of the asset value itself. As such, we expect more and more assets becoming more obsolete as the capital costs to upgrade older assets are prohibitive especially for non-institutional investors.

Additionally, debt markets are also starting to differentially price ESG factors. In 2021 GPT issued their inaugural Green Bond of $250m and we expect this to be the first of many. Whilst this has not translated to lower cost of debt for green assets yet, expectations are that liquidity pools will become more discerning around ESG which over time should translate to higher cost of debt for ESG-poor assets.

Ultimately while we are concerned about the current oversupply in the market and the uncertainty in the sector's vacancy outlook due to COVID and increased working from home, we are somewhat comforted by the fact that the Australian listed players have positioned themselves relatively well in regards to the sustainability of their asset portfolios. This should partially offset future structural uncertainties as we believe not all the competing supply in the market is fit for purpose and given ESG requirements on buildings are only getting more stringent, we expect the pool of 'ESG-ready' assets to shrink further.

Apparently, Confucius did not say "One Picture is Worth Ten Thousand Words" after all. It was an advertisement in a 1920s trade journal for the use of images in advertisements on the sides of streetcars. Even without the credibility of Confucius behind it, we think this saying has merit. Each month we share a few charts or images we consider noteworthy.

Online sales volumes have retreated in absolute numbers and as a share of total sales as the charts from the Australian Bureau of Statistics and the US Census Bureau show. US government bonds are on track to deliver their worst annual loss, Compound Capital Advisors highlights. Bank of America links the preceeding surge in central bank liquidity with the value of "Big Tech" stocks. A correlation between inflation worries and the relative valuation of small caps is charted by BCA Research. Quantitative Value co-author Tobias Carlisle shows that "unexcellent" stocks have outperformed "excellent" stocks over time. We return to BofA to look at how hedge funds and fund managers have become reluctant to take on risk. And, finally, "The Plateau of Latent Potential" is a chart from the book Atomic Habits that spoke to us.

Online retail sales in Australia (monthly to February 2022)

Source: ABS

Online retail sales in the US (quarterly) as a % of total sales

Source: US Census Bureau

Bloomberg Barclays Aggregate Bond Index, Total Return (1977-2022)

Source: Compound, @CharlieBilello

Central bank liquidity and the market cap of "Big Tech"

Source: Bank of America

Business Inflation Worries & US Small Cap Valuation Indicator

Source: BCA, @Scutty

Comparison of "Unexcellent" and "Excellent" Stock Portfolios

Source: @Greenbackd

Hedge Fund Equity Exposure

Source: Bank of America

Net % of Fund Managers taking higher than normal risk

Source: Bank of America

The Plateau of Latent Potential

Source: @JamesClear, Atomic Habits via @SvnCapital

April Edition

Markets always present a multitude of opportunities and obstacles.  However at any given point in time there are only a select few, around which traders coalesce.  Commentary and action align to these few factors, which then powerfully drive markets. Recognising this, and the rationale for it, or indication of a pivot in market trends helps identify and reprioritise risk. In this way, issues which the market has long ignored can suddenly seem to be the only thing that matters.

During the GFC, the market seemed only to care about balance sheets. In recent years it has been pre-occupied with innovation and disruption. Today, we are grappling with the most fundamental changes to international relations since the end of the Cold War. These risks have always been present, yet the reprioritisation of these risks is changing the flow of funds, between nations, between asset classes, and within the underlying sectors of asset classes.   

Small cap investing: Top down has become paramount

A trend of the last decade has been the grouping of stocks into ever more diverse 'baskets' (often known as an index). Today these 'baskets' are sold by securities dealers as a product. Stocks can be grouped by industry, quantitative factors or thematic association. In the past, the profit motivation behind these classifications formed part of a two-step process.

1. Identify companies exposed to sectors and factors expected to benefit from ongoing or forecasted tailwinds.
2. Assess the actual and prospective performance of these companies relative to expectations and peers and select the best stocks.

When investors purchase a basket from a dealer, they are de-emphasising stock selection.  

In recent years we have observed a shift in Australian Small Companies market dynamics. Increasingly, money is deployed with a greater emphasis on macro-strategy (i.e. step one above); yet seemingly without significant focus applied to the fundamental performance of the underlying businesses (step two).

The outcome is a growing number of companies exhibiting a divergence between their share price performance and operational performance. The most obvious demonstration of this has been the increasing correlation of stocks within certain baskets. For example, the correlation of Australian Technology stocks to the US NASDAQ index. This correlation ignores the fact that each Australian tech stock has its own fundamental and operational opportunities and challenges distinct from the success of Nvidia, Facebook, Netflix or Tesla.

In contemporary markets, it seems that share price performance depends on being allocated to the 'right' group of stocks rather than actual business performance. This has been particularly evident in the last two reporting seasons. We saw many companies fail to deliver on expectations.  Yet their share price performance was more powerfully explained by broader market trends than their underlying performance. It is important to note that this relates not only to profit but outcomes have also been skewed for looser metrics, such as revenue.

The willingness of markets to overlook operational performance of individual stocks is not sustainable.  However we do not dictate how the market chooses to reward speculation. Markets are expressions of emotions as well as logic and we cannot expect them to be rational. What we can look for is catalysts which might change sentiment and behaviour. At this point in time, there are several. None of these are new, yet suddenly they have become relevant.

Looking ahead

We believe identifying and responding to change faster than the market is key to successful investing.

So much has changed since March 2020 and the market is still adapting.  The assumption that markets will resume their pre-covid trajectory ignores the profound changes that have occurred.  The following trends are reshaping market dynamics in our view.

1. Demographics

The ageing global population has been apparent for a long time however its adverse impact has been offset by globalisation and trade, which delivered to enterprises the gift of a huge increase in the pool of available labour. While its sustainability has always been questionable (particularly due to the ageing population in China) it has not registered as a concern for markets. The escalation of tensions in global markets brings the challenges of a shrinking workforce into sharper focus.

2. ESG

Awareness of Environmental, Social and Governance issues is challenging the status quo. For example, the current US Trade Representative Katherine Tai has been vocal in raising ESG issues at the World Trade Organisation, arguing that trade policy must take the environment and workers' rights into account. Whilst coming from a different angle, this approach is a continuation of the more assertive trade policy adopted by the previous US administration. Trade frictions will not only impact labour markets but will also alter the flow of capital through financial markets. When President Trump first pushed back against free trade the market seemed less concerned. Now it is clear that scrutiny of trade relationships is bipartisan. The market must now reprioritise this risk.

3. Geopolitics

Relationships between the world's great powers were evolving prior to the pandemic. Tensions were evident due to conflicts in Syria and Crimea. Since the shocking invasion of Ukraine there has been a call to action. Today global leaders are not only worried about the equitable distribution of the benefits of trade, but also the security and resilience of their economies. Our own Prime Minister has recently committed to support development of 'Just in Case' rather than 'Just in Time' models for critical supply chains.

Aligning national security with industrial development is a significant contrast to decades of globalisation. It will require substantial investment and impact trade relationships, labour markets and capital markets. The weaknesses of globalisation have always been obvious. The sudden need to address these weaknesses has become a priority which is rapidly changing the investment landscape.

4. Market structure

The pandemic forced economic change at a scale and breadth almost unimaginable to contemporary financial markets. GFC-era measures were enhanced and expanded to ensure the resilience of financial markets. There was also increased validation for the role of Government in the economy. The US Federal Reserve has put in place massive backstops to ensure the liquidity of the market for US Treasuries and the core banking system. Yet today, with extra ordinary guard rails around banking and risk-free assets, there may be scope for a lower strike of the famous "Fed Put" on markets.

5. Experience

The current cohort of market leaders have enjoyed their dominant position for an extended period. Software as a Service and the Cloud are no longer new concepts and markets have had time to become more discriminating about which companies they are going to support. After a period of time, all start-ups progress from 'promising' to having a demonstrated track record. Good or bad. The incipient pivot from judging the best known and loved start-ups of the last decade on what they promise to deliver relative to what they have delivered is inevitable yet will seem sudden.   

In summary, plenty has changed…

These five themes will force markets to reprioritise their risk assessments. None of these risks are obscure or unknown, however changing events is triggering a reassessment. The market tends to focus on a relatively small number of issues.  So when these change, price movements can seem extraordinary.

Therefore, we adapt

There are important implications for investors in Australian Small Companies. Over the last half decade investors converged around a growth thematic supported by the theory that low inflation, low interest rates and market-friendly central banks would remain enduring features. As a result, investing in baskets of stocks aligned to this theme became as important if not more so than  understanding the actual performance of underlying businesses.

Changes in the inflation and monetary outlook also challenge the significant weight of money aligned with the established macro-strategic positioning. Investors can adapt by re-evaluating the outlook for the businesses they are invested in on a case-by-case basis, then refocusing on those businesses which they consider enduring or alternatively finding new investments which can be beneficiaries of change. 

Author: Sinclair Currie, NovaPort Principal and Co-Portfolio Manager

For decades Australian investors have been encouraged to look beyond their backyard for investment opportunities.  Holding an overweight exposure to the Australian market leads to an unintended skew towards the financial and mining sectors, which together comprise 53.41 per cent of a highly concentrated market as shown in Table 1 below. An allocation to international markets broadens a portfolio's exposure to global leading companies in the IT and Healthcare sectors, which are underrepresented in Australia.

Table 1: Index Weightings

Source:  https://www.spglobal.com/spdji/en/ as at 28 February 2022

This is a sound long-term strategic approach. 

However, at this juncture and after a decade of low interest rates across developed economies, we are now starting to see indications of a turn in the market cycle. Higher inflation and normalising interest rates are expected to remain a feature for the short to medium term. For several reasons outlined below, these factors are aligning to make Australian shares a compelling tactical investment opportunity on a relative basis in the medium term.

1. Relative valuation

Despite the 8.22 per cent fall in the S&P 500 since the beginning of 2022 and after a decade of outperformance relative to global equities more broadly, US equities are still trading at P/E multiples close to their historical averages. The S&P 500 for example, has a forward P/E of 18.5 times, down from 22x at the start of the year and now in line with its long-term average of 18.6x. The derating is most apparent in the tech sector with mega caps such as Amazon, Alphabet, and other FANG+ stocks which were responsible for much of the index return over the past decade. 

As the US market surged over this period, the Australian market lagged on a relative basis. Based on a Global Fund Management survey (Chart 1 below) it appears that global fund managers are repositioning away from US equities with a preference for more attractively priced investment opportunities.

Chart 1: Absolute net% OW positioning by investors

2. Longer path to higher rates

Annual inflation rate in the US accelerated to 7.9 per cent in February of 2022, the highest in 40 years. Energy remained the biggest contributor (25.6 per cent versus 27 per cent in January), with gasoline prices surging 38 per cent (40 per cent in January). Other countries including the UK and Eurozone are not far behind. As a result, in many jurisdictions, bond markets have priced in a path of interest rate hikes particularly over the short term to temper the spike in the cost of goods and services. Higher interest rates will push up borrowing costs for businesses and households and slow economic growth. 

According to the Reserve Bank of Australia (RBA), a divergent path in Australia looks likely with inflation barely within their 2 to 3 per cent target band and wage inflation modest. Australia is also less impacted - but not immune - to rising energy costs as we are a net exporter of gas. China, our largest trading partner, is also seeing lower price growth with annual CPI at 1.5 per cent. Also, in contrast to other markets, China is taking a stimulatory approach to their economy adding liquidity rather than withdrawing Quantitative Easing. This should be a net positive for commodity producers.

Chart 2

Source: Bloomberg as at 28 February 2022

3. Sector composition

The dominance of banks and mining stocks in the Australian market could present opportunities for stock pickers at this point in the cycle. Concerns over rising interest rates over the medium term could increase banks' net interest margins as the gap between lending rates and deposit rates widens allowing greater scope to increase margins. Rising rates also reflects a stronger economic environment which leads to greater demand for credit and lower bad debts. Insurance companies also benefit as they can invest in bonds with higher yields. Australian Banks are well capitalised and are expected to maintain their dividend payout ratios, which are high relative to other companies in the market.

As a major commodity producer, Australia is a beneficiary of rising gas prices, higher demand from reopening economies as well as higher agricultural prices. Commodities often have a positive correlation to inflation and play a safe haven role in inflationary environments and a hedge against falls in equity markets. Compounding the problem is the conflict in Ukraine which is impacting the supply of energy and other metals. A rise in demand combined with a reduction in supply could lead to a commodities super cycle.

4. Dividends and franking

Australia's imputation system lends itself to higher payout ratios than global peers. Companies are incentivised to return capital to shareholders when there isn't a compelling opportunity to reinvest earnings. This reduces the risk of management teams pursuing capital-intensive projects that may not be in the best interest of shareholders. The average dividend yield for the ASX 200 is 4 per cent which is significantly higher than the 1.3 per cent average of the S&P 500. If stock market gains are more muted in 2022, with lower capital returns than we have experienced over the past decade, a higher franked dividend could prove attractive given the lower risk profile than growth focused stocks. 

Summary

The big winners of the past decade have been long duration global growth stocks. Much of their returns have been driven by higher earnings expectations, due to the pull forward in demand caused by the COVID pandemic. Contrast this to banks or commodity-related companies where long-term growth rates are not be expected to be materially different to the current rate. In a climate of higher interest rate expectations, it is these higher growth stocks who are expected to suffer on a relative basis as the earnings outlook for other sectors improves. 

Despite the expectation of monetary policy tightening in Australia, inflation is relatively controlled thus far and short-term interest rates are generally favourable due to a slower than expected interest rate hiking cycle relative to other global markets.

Travel. Remember that? Long plane flights, new places, new people, new ways, new sounds. Whilst many of us look forward to travel once more, is it time to invest in travel? At Insync we believe yes but...... it all depends on how and where.

The Experience Megatrend, of which travel is a component, is one of 16 megatrends in the Insync portfolio. Like a giant tidal wave, megatrends tend to be very large, long lived and unstoppable. Therefore, it is unusual for us to sell out of stocks benefitting from megatrends. However, after an extended period of lockdowns and travel restrictions from a one-off global event reaching into the very heart of travel, it had become clear to us that the nature of travel was going to change in the post Covid world. We sold out of the pure play travel companies and studied deeper into what was probable in the years to come in travel. 

The extent of the fall in travel has been unprecedented as seen in this next chart. Destinations worldwide lost a staggering 1 billion fewer international arrivals in 2020 than in 2019. This compares with the 4% decline recorded during the 2009 global economic crisis (GFC).

Unquestionably, an individual's deep desire to travel is hardwired into human DNA- a developed and privileged means of human wandering. Whilst we cannot know how long the pandemic will last, we are certain that when it is once again safe to travel, people's desire to travel will boom once again. 

However, the pandemic has changed the playing field around traveller behaviour and habits, and this impacts the businesses involved with travel in a myriad of ways.

New expectations have emerged, prompting travel providers to take heed and reassess how they cater to those shifting demands. Therefore, the winners - those that can deliver high ROIC and sustainable growth, in travel post-covid, are not yet clear.

Some recent trends in travel habits we have been observing include:

• Closer - Domestic tourism has shown positive travel uplift. Travellers go for 'staycations' or vacations close to home. How much this will endure once international travel reopens fully remains to be seen. 
• New concerns - Health & Safety measures, getting home in a lockdown, along with cancellation policies are consumers' main concerns. Businesses are however adapting. 
• Get away - Nature, Rural Tourism and Road Trips have emerged as popular travel choices due to geographical restrictions and the quest for open-air experiences.
• Last minute - Last-minute bookings have increased due to volatility of pandemic-related events and the travel restrictions.

The one area that is highly likely to change structurally, and in a negative way, is corporate travel. As many businesses have now transitioned into a hybrid work environment, with remote working and meeting tools normalising, there's no question that businesses will look to lower costs and travel risks. 

Mckinsey estimate that business travel will recover to only around 80% of pre-pandemic levels by 2024. This is important to businesses such as airlines and hotels et al, as business travellers represent a large and profitable part of the travel sector.

Notwithstanding the human desire to travel, we will see fundamental changes in travel patterns compared to the pre-Covid world. Cruise ships, airlines and hotels might seem like the obvious way to invest in a travel rebound. However, these companies are the higher risk, higher reward options and are a lot less profitable through the cycle. They are capital intensive and highly leveraged by nature. For travel booking engines the future remains unclear. Should a new deadlier viral variant emerge post the delta variant, the recovery would be pushed out again with 'pure' travel stocks facing a sudden price setback.

Insync is focused on identifying profitable winners in the travel megatrend in the post Covid world. Sometimes the winning companies are the less obvious ones. Estee Lauder and Walt Disney represent two examples of highly profitable businesses in the Insync portfolio that are beneficiaries of the recovery and long-term resumption of secular growth in experiences and travel. 

Estee Lauder is a highly profitable company benefiting from the wellness and beautification global megatrend. The pandemic with its restrictions and uncertainties has not slowed Estee's rise. Premium skin care continues to grow at multiples of global GDP with the online channel representing circa 40% of their sales in key markets. 

Travel retail represents 25% of Estee's sales, and this is during the pandemic. In places where travel has resumed, such as China, sales have also recovered quickly. What is remarkable is that despite the collapse in global airline travel consumption the travel channel for Estee has been resilient, declining in only one out of the past six quarters through the pandemic. 

Walt Disney's global entertainment focus has produced a variety of interwoven income streams that has seen it do well during the pandemic, and importantly for the recovery, things look even brighter. 

Walt Disney is also a major beneficiary of the Streaming Megatrend, building as many subscribers in 2 years that Netflix took 10 years to achieve.

It is also a major beneficiary of a rebound in the Experiences Megatrend. Disney has a loyal following of customers with parents trusting the brand to provide clean, safe entertainment for their children. Families can plan a vacation at a Disney theme park as their ideal getaway. As a result, Disney has a history of raising prices with no slowdown in customer demand. By example, a Disney World Magic Kingdom Park ticket has more than tripled in price since 2001 (well above inflation), yet every year attendance has continuously increased with the exception of 2020/21 coronavirus lockdown. This trend is highly likely to resume as lockdowns ease. 
Disney also provides a much lower risk way from a recovery in cruising, it is a small and integrated part of their overall offer on experiences. A lot of people that are booking Disney cruises are also booking vacations to Walt Disney World as part of a package.