Alphinity Sustainable Share (HOW0121AU) Report & Performance

Economic data has improved recently, with GDP expectations rising, resilient labour markets, strong consumption, inflation beginning to fall, and financial markets generally responding well to tighter financial conditions. We continue to see potential risks from the lagged, cumulative impact of Fed rate hikes, but we are also aware that some normally reliable economic indicators are already at low levels and the outlook for growth appears somewhat better than many feared at the start of the year. The US manufacturing Purchasing Manager’s Index (PMI) peaked well above 60 in 2021, and after a two-year downcycle it is now at ~46; while deep in contractionary territory this is approaching levels which have historically been associated with cyclical bottoms.

From a corporate earnings perspective, and after a similar nearly two-year period of negative revisions, there also appears to be some early signs of stabilisation. The second quarter reporting season has so far been better than expected with beats, both by number and magnitude, higher than normal. Nevertheless, generally cautious forward guidance has met with mixed price responses and muted earnings revisions. For example, consensus earnings expectations for both 2023 and 2024 have barely moved over the last three months (+0.1% respectively), although flat estimates are a marked improvement from the previous negative trend of -2% to -3% per quarter. Meanwhile, underlying sector dispersion is relatively wide. Materials and Energy have seen significant negative revisions reflecting lower commodity prices, while Consumer Discretionary, Communications and Tech Hardware are amongst the sectors with positive revisions for both years. More defensive sectors like Property, Health Care and Consumer Staples continue to slip in relative earnings strength. While there are some encouraging signs, and the negative earnings cycle is relatively mature by historical standards, our stock analysis and recent research trips suggest it’s still too early to call a sustained turn in the earnings cycle

From a market perspective, leadership has rotated again this year, mostly back to growth stocks and away from defensives, although there has also been a significant rally in some cyclical industry groups recently (e.g. Autos, Semiconductors, Retail and Transport), which have responded positively to a more resilient growth outlook and rising bond yields.

Narrow market breadth has been another distinct feature, with the so-called ‘magnificent seven’ group of mega-cap stocks, which make up ~27% of the S&P 500 market capitalisation, delivering ~73% of the YTD return through to end July (albeit an improvement from 102% at the end of May 2023). Against this more challenging backdrop, we continue to focus on our bottom-up earnings analysis to manage the changing environment.

During July we continued to add to our positionsin Edwards Lifesciences, following a pullback in the stock despite a strong report, and ING, on strong earnings momentum. This was financed through taking profit in some of our best performing growth stocks (e.g. Mercadolibre, Fortinet, OnSemi & Intuitive Surgical), and also reducing other stocks where relative earnings support is falling (e.g. Chubb, Nextera Energy Partners, Otis and Keysight). Overall positioning has not changed significantly despite these changes, with the portfolio still wellpositioned in strong growth stories, combined with some flagship defensives.

We have recently added to our cyclical exposure where we have established fundamental stock conviction; however, the portfolio overall remains relatively less invested in cyclical stocks. We continue to work hard at identifying opportunities across all sectors as the earnings cycle continues to evolve.

The upcoming August reporting season should provide further insights into the extent of the economic slowdown the RBA has tried to orchestrate since the current interest rate tightening cycle started in May last year. The portfolio remains well exposed to companies that have seen better-than-average positive earnings revisions over the last several months. While there is always a risk, especially late in the cycle, that investors look beyond the current earnings environment and focus on a potential future earnings recovery, in our view it is unlikely that we have arrived at that point yet. A more decisive change in monetary policy, a pivot to a more expansive fiscal policy or a more significant fall in earnings that resulted in a “this is as bad as it gets” argument would typically precede such a change in investor sentiment.

For now, however, strong current operational performance should continue to be well rewarded. We see this as being achieved by a mix of portfolio holdings that also reported well in February – companies like Brambles, QBE, Steadfast, Medibank, Orora and Woolworths – as well as some newer positions in companies that have managed through a challenging industry environment and have come through at the other end in a good position to benefit as headwinds ease.

Last month we wrote about building materials manufacturer James Hardie being one of those companies. Despite going through a potentially destabilising management change last year, and even though US mortgage rates have ticked up again, the company appears to have stabilised and be back to delivering above-market volume growth.

The Fund performed in line with the market in June, and lagged slightly across the June quarter. The best contributors were pallet hirer Brambles, global insurer QBE, advertising platform carsales.com and domestic insurer Suncorp; not owning resource giants South32 or Rio Tinto also helped. Offsetting these however were holdings of resource giant BHP and medical device maker Fisher & Paykel Health; not owning high tech companies Xero and WiseTech also detracted from returns.

The Fund lagged the market a little in May, with a holding in respiratory products maker Fisher & Paykel and Lifestyle Communities both detracting from returns. The portfolio benefitted from no exposure to gold miner Newcrest, while overweight holdings in Suncorp and Lynas Rare Earths also contributed to returns.

In a market with limited overall earnings growth and earnings revisions that, despite some stabilisation more recently, appears to have more risk to the downside than upside, companies which can deliver growth, and especially growth ahead of market expectations, should be well rewarded. The Fund remains well exposed to these types of companies overall and we look forward to confirmation of this as we approach the August reporting season.

During May we further reduced our Bank exposure as increased mortgage competition and higher funding costs will be a challenging combination for the Banks’ net interest margins, especially in a low credit growth environment. We remain less concerned about large credit losses for the banking sector as a whole given large unused provisions that were raised during the Covid period. A moderate underweight to the sector is appropriate, in our view. We have also reduced our exposure to the Resources sector in face of weaker economic data out of China. We remain firmly underweight that sector in aggregate with a maintained preference for iron ore exposure, albeit at lower levels.

We have however built positions in James Hardie and Cochlear during the past months. We previously had concerns with Hardie’s ability to manage margins and continue taking market share in a soft US house siding market that is increasingly competitive. While the overall market environment remains challenging, housing starts have stabilised at lower levels in recent months. More importantly however, James Hardie has managed the weak environment well from a cost and sales perspective resulting in a better than expected margin outlook and likely further earnings upgrades.

Cochlear is benefitting from the dual tailwinds of a post-covid recovery in implant surgeries and the successful launch of its latest generation sound processor, the Nucleus 8. Processor upgrades are typically released every five years and the latest version, which is smaller and has better connectivity than its predecessor, should enable Cochlear to not only gain share of new patients but, importantly, also trigger strong demand from N6 and N7 users that will now be eligible for an upgrade, funded by their health insurers.

The Fund performed essentially in line with the market in April, and there were few companies of note on either side of the ledger. The most meaningful positive contributors were health insurer Medibank Private, housing provider Lifestyle Communities, pallet company Brambles and auto advertiser carsales.com; the only meaningful detractor was owning resource giant BHP.

Despite ongoing macro uncertainty, the portfolio has continued to exhibit better earnings revisions than its benchmark with March quarter updates from Brambles, Medibank Private and Woolworths some of the highlights. Indications of stronger-than-anticipated increases in mobile pricing plans across the telecom sector has also benefitted Telstra.

The mixed news out of China, especially the suggestion that there might be a Government-mandated cap on steel production, has seen weakness across the commodity price complex. The portfolio remains underweight this sector and we trimmed our iron ore exposure somewhat as near term earnings upside has become more limited.

Artificial Intelligence (AI) has been an issue bubbling away for some time but it has been brought to prominence this year by the release of ChatGPT. There are few companies for which AI will not become relevant over the next few years. It has the potential to provide great productivity improvement, but there might also be negative outcomes for society. To that end, Alphinity has teamed up with Australia’s premier scientific research organisation, CSIRO, to conduct a study into how it can be used responsibly. We will talk more about this in coming months.

We trimmed the Fund’s exposure to the Bank sector earlier in the year to close to a neutral position as mortgage pricing competition intensified. This trend appears to have continued and we trimmed our exposure further, even though strong balance sheets and attractive dividend yields should cushion the fallout from a faster than expected normalisation of net interest margins.

We remain confident in our ability to identify companies with stronger earnings prospects than forecast by market participants. We believe this will ultimately be rewarded by investors, notwithstanding continued volatility in market sentiment.

The Fund performed in line with the market over the March Quarter. The material contributors were a diverse mix of health insurer Medibank Private, packaging company Orora and pallet pool provider Brambles, retailer Super Retail Group and insurer QBE, although these were partially offset by our positions in Lifestyle Communities and National Australia Bank. Not owning Aristocrat Leisure or gold miner Newcrest, both precluded by the Fund’s Charter, also cost some performance.

Following a brief period of individual company earnings focus, macro factors are again dominating the headlines. And following an even briefer period of market nervousness investors appear to have decided, for now at least, that the main upshot from the US regional banking calamity is further arguments for the US Federal Reserve and other central banks to end the current rate hiking cycle. The rationale behind this view is that reduced credit availability will now do some of the work higher interest rates would otherwise have had to do. Our own central ban ’s decision to not raise interest rates further in April is likely to have been at least partly influenced by this thinking.

As rising interest rates have been the main headwind for global equity markets a peak in interest rates is, everything else being equal, clearly positive. However, things are seldom equal. As we have argued for some months now the focus for equity investors should move from whether rates have peaked, or are close to peaking, to how long they will stay around current levels and how significant the impact on the economy, and in consequence, corporate earnings, will be from the sharp hikes we have already had.

The Fund outperformed the market nicely in February, helped by strong returns from some of our key positions. The best contributors to overall performance came from health insurer Medibank Private, sustainable packaging company Orora, global general insurer QBE, and insurance broker Steadfast, pallet company Brambles Industries, and not owning Rio Tinto or gold-producer Northern Star. The only detractors of note were our positions in Lifestyle Communities and BHP.

The February reporting season was a welcome break from the many macro factors that had been dominating individual share price performances. The Fund had a good month with most portfolio holdings which reported delivering strong results, positive outlook statements and, as a consequence, strong share price performance. Some of the highlights were pallets pool company Brambles, global insurer QBE, retailer Super Retail Group, packaging/distribution company Orora, logistics specialist Qube, airline Qantas and asset manager Macquarie Group, in addition to The Lottery Corporation, Medibank Private and Woolworths. While the earnings drivers naturally varied amongst this very diverse group of companies, common features were strong operational performance, the ability to manage cost pressure from higher input costs through a combination of operational efficiency and pricing power. We added to our positions in both Woolworths and Medibank Private after their 1H results with increased confidence in their renewed operational momentum with diminishing challenges from Covid disruptions and November’s cyberattack respectively.

In the banking sector, only CBA reported first half earnings while the others released 1st quarter updates. CBA delivered a strong set of numbers but also indicated that increased competition and a gradual rise in funding costs will start to impact margins in the second half. We continue to like the banks for their positive margin leverage from higher interest rates and strong balance sheets. However, we have trimmed the sector to a more neutral sector weight while monitoring for further evidence of their earnings resilience.