Lazard Australian Equity Team – Quarterly Letter AUG Letter from the Manager 2021 The Australian Equity Team’s quarterly letter discusses Exhibit 1 the biggest issues we are seeing in investment markets Value Factor Returns Relative to Index today. This quarter’s letter looks at: ASX S&P500 1. Performance over the full financial year 2020/21, Q3 2020 -3.2% -2.0% 2. How our portfolios are now positioned, and Q4 2020 9.3% 9.3% 3. The modern slavery issues at Ansell. Q1 2021 -2.2% 10.8% 1. Financial Year Review Q2 2021 -2.7% -3.4% The financial year ended June 2021 has been one of Total f21 0.6% 14.7% most frustrating and disappointing for us since the YTD 2021 -4.9% 7.1% year ended June 2008. As of 30 June 2021. Frustrating, as the sharp rotation towards value in Table 1: Equal-weighted value factor returns over f21, from UBS, Goldman Sachs and Macquarie Bank. the weeks following the 9 November 2021 vaccine Each quarter is the average returns from these different sources. announcement by BioNTech and Pfizer was not sustained into the second half of the financial year in Australia, despite rapid upward earnings revisions for Disappointing, as some of our international cyclical holdings did value stocks (including many of our holdings) and the not perform as well as many domestic cyclicals over financial year much larger and sustained value performance in the 2021. This was most disappointingly for our energy holdings. US. Rapidly recovering energy prices drove S&P500 Energy Index One value sector for which prices recovered were the returns to over 42% over just the first six months of 2021, making banks, which helped the MSCI Australia Value index this the best performing GICS sector in the US (and globally) by a over the financial year 2021—just the four major large margin. banks accounted for 53% of this index at end of June In contrast, the ASX200 Energy Index fell and recorded a -1.4% 2021. total return in the same six-month period1. This was despite an Following five years of underperformance for the average earnings per share (EPS) upgrade of ~110% across our banking sector, we took the opportunity to reallocate Woodside Petroleum, Whitehaven Coal and Oil Search holdings an additional 10% of our portfolio into this sector (c/f 20% for the ASX200) to end June 2021, for example. At over the second half of 2020. After accounting for July 2021 spot energy prices, furthermore, EPS run-rates are a the bank recovery, the remaining value stocks in the further 60% to 500% higher than even those 30 June 2021 EPS MSCI Australia Value marginally lagged the market, expectations. As an inevitable consequence, these three stocks however, in contrast to events in the US. traded at an (simple arithmetic) average 20-25% spot free cash flow (FCF) yield in July 2021, which incidentally implies that if Exhibit 1 shows equal-weighted factor returns (an all the other stocks in our portfolio had no free cashflows at all, the average of the quarterly factor total return data from portfolio spot FCF yield would still be almost 5%. UBS, Macquarie Bank and Goldman Sachs)—the divergence between the US and Australia was very While we do not expect present spot thermal, coking and wide over 2021 YTD, although even in the US the LNG prices to be maintained in the long run, it is nevertheless value recovery ended in mid-May 2021. noteworthy that in September 2020, Whitehaven Coal may turn out to have traded at an enterprise value of less than 1x forward earnings before interest, taxes, depreciation, and amortization (EBITDA). LR33518 2 It is our strong view that while the energy sector price recovery in Exhibit 2 Australia may have been delayed, it is not cancelled. Valuations did not mean revert One stock that has particularly disappointed over financial year ROE (%) 2021 has been AMP, which now trades on 11 times next year’s 40 consensus earnings, which represents a 42% discount to the ASX 80th Percentile Forward P/E market, on 0.86 times book value and about 1 times net tangible Harmonic Mean of 80th Percentile Forward P/E assets (NTA), despite the fact that close to half the NTA presently 30 generates no earnings (due to A$0.73ps of gross cash and A$0.40ps of equity investments, less A$0.60ps of corporate debt). 20 Returns to portfolios with high active share tend to be lumpy. Over the last 20 years, about one fifth of our portfolio positions have been sold in the context of take-overs or other corporate 10 ASX 20th Percentile Forward P/E events, yet this has not been the case over the last two years. In July Harmonic Mean of 20th Percentile Forward P/E 2021, however, Spark Infrastructure and Oil Search have disclosed 0 being the subject of take-over bids, while Athene Group have taken 1997 2001 2004 2007 2011 2014 2018 2020 a 15% stake in Challenger Financial and has applied to APRA for As of 30 June 2021. approval to acquire a further 3%. 80th and 20th percentile forward P/E ratios for the ex-resources ASX100 index Source: UBS. Where then are we at the end of this frustrating and disappointing 12-months? As always, the future is uncertain, and given the presence of Exhibit 3 COVID-19, its various mutations and the consequences of the Valuations did not mean revert MMT-style policy interventions over the last 15 months, probably 3 more so than usual. We can be more definitive about the state of ASX100 (ex-Resources) Forward 80th vs 20th Percentile P/E Ratio (Dec 1997 to June 2021) markets, however, and list two important features of the financial landscape as concerns the Australian stock market. 1. The Two–Tiered Market 2 As noted above, style returns over financial year 2021 converged, but valuations did not mean-revert. In other words, valuation spreads did not significantly widen further, but neither did they narrow from the record levels as at end of last financial year. This 1 can be seen in Exhibit 2. Dec-97 Jun-01 Jun-05 Jun-09 Jun-13 Jun-17 Jun-21 The record valuation gap reached in the September quarter of 2020 As of 30 June 2021. moved broadly sideways over the remainder of financial year 2021, Ratio of 80th to 20th forward P/E ratio across the ex-resources ASX100. with a drop in November 2020 followed by a 80% percentile Source: UBS. forward P/E record in April 2021. Relative developments over the past 12-months can be more easily discerned by examining at 86 times forward PE (Exhibit 6) set new all-time record-high the ratio of the 80% to 20% percentile forward P/Es, as shown in forward P/E ratios as of end June 2021, both in absolute terms and Exhibit 3. The November 2021 value rally and the overall sideways relative to the S&P/ASX 200 Index. movement of the valuation spread are very clear. On a 47 times forward P/E the ASX Health Care sector, for Examination of prior wide valuation spreads suggests that the example, trades at a 138% premium to its own 31-year history, behavior over financial year 2021 was not unusual near peaks, a 147% premium to the current MSCI AC World Health Care when the volatility of the spread often rises. This volatility drove index and a 173% premium to today’s S&P500 Healthcare relative returns as shown in Exhibit 4. index—in other words, the Australian Health Care sector level Consistent with the observation that the growth bubble remains would have to fall 63% for it to trade at the same expected P/E as tightly inflated, are S&P/ASX 200 Index sector multiples. Both the the US index today. S&P/ASX Health Care sector at 47 times forward price/earnings (PE) (Exhibit 5) and S&P/ASX Information Technology sector 3 2. The US Market Backdrop Exhibit 4 Volatility drove relative returns The US stock market has now reached the highest valuations recorded over the 100 years for which we have records (a (%) 8 Changes to Dispersion and Relative Performance conclusion based on different indicators, including the Tobin’s over the last 3 quarters of F21 Q ratio, and the percentage of stocks trading at more than 10 times revenues) —depending on whether one takes an optimistic 4 or pessimistic view, long-run analysis tends to project very low to significantly negative annual returns for the next decade. 0 This comes at a time when the market is facing higher risks than usual, including inflation fat tails, bond prices on significant -4 Change to Dispersion (%) negative yields, anti-trust/regulatory actions against very SAF Relative Performance (%) large index weight companies, corporate tax rises and more -8 redistributive policies. Oct-20 Nov-20 Dec-20 Jan-21 Feb-21 Mar-21 Apr-21 May-21 Jun-21 In addition, speculation and financial frothiness—whether that be As of 30 June 2021 Monthly Select Fund excess returns relative to the ASX200 Accumulation index, junk bond credit spreads at record lows, covenant-lite lending at and changes in the 80th to 20th percentile forward P/E ratio across the ex-resources ASX100. 90%+, Reddit/meme-stocks, SPACs, crypto-currencies/Dogecoin, Source: UBS, Lazard, FactSet loss making IPO’s at greater than 80%, record insider selling, record IPO volumes, record margin debt, record retail stock market participation, record budget deficits or record US broad Exhibit 5 money growth—is at levels only to be compared to perhaps the High multiples in tech sector late 1920s or late 1960s.