Praemium Investment Leaders

Decoding Challenging Market Conditions with Katie Hudson: Insights from over 200 CEOs

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Prepare to navigate your way through today's unpredictable economic terrain with Katie Hudson of Yarra Capital as your guide. She shares her key findings from personal meetings with over 200 CEOs and pinpoints the challenges they face with cost inflation and reduced earnings predictions. Uncover the prominent themes of Australia's latest reporting season and gain a clearer understanding of how price-driven revenue growth and margin headwinds have led to significant downgrades in earnings forecasts.

Katie also shines a light on the shift in investment climate as we transition from a strong beta performance environment to a more alpha-centric one. Gain insight into how this shift is impacting the performance of active managers and the opportunities that come with increased volatility during the reporting season. We also explore the crucial roles of beta and alpha, and the potential pitfalls of value traps as part of a wide-ranging conversation on Australian equities, economic conditions, and investment strategies. Be part of our journey as we decode these challenging market conditions together.

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Damian Cilmi:

Welcome listeners to the Premium Investment Leaders podcast. I'm your host, damien Chilmi, head of Investment Managers and Governors at Premium, one of Australia's fastest growing investment platforms. Today, we're joined by Katie Hudson from Yarra Capital to talk about Australian equities and a little bit about our guest. Katie Hudson is the executive director and portfolio manager focused on Small and Mid-Cap universe. In addition, serves as the firm's head of Australian equities research. Katie has more than 20 years experience in investment markets, including roles as an equities research analyst and portfolio manager. Prior to transitioning to Yarra Capital, katie was a portfolio manager and managing director at Goldman Sachs Asset Management. She previously worked at JM Financial Group, ar Capital, jbwr and started her career at WC. And a little about Yarra Capital. Yarra was established in January 2017 as a boutique investment manager following the management buyout of Goldman Sachs Australian management in Australian equities and fixed income capabilities. The firm has over 75 staff and manages over 19 billion funds under management. Welcome to the show, katie. Thank you very much. Great to be here. Thanks for coming.

Damian Cilmi:

So we're going to talk about Australian equities, as we said, but it's also a timely part of the year because a reporting season for the first half of 23 is just about complete and Katie and the team have already met with over 200 CEOs to discuss their results and outlook. More importantly and this is in a backdrop of some pretty monumental change in markets Levels of inflation we haven't seen for over 30 years, this rates rising quickly by over 3% in a little over six months and forecast for an impending recession. So these big changes have led into quite a lot of volatility and, some would argue, great conditions for fundamental active funds management. So let's get into it. Let's start. We'll talk about reporting season. So it's now complete for the first half and you've met with hundreds of CEOs, as we said, and analysed the results of many more companies, I imagine. So what are some of the key themes and key observations you've seen from this reporting season?

Katie Hudson:

Thanks, Damian. If I was to draw inferences across all of the meetings we've had and it's always hard to draw conclusions, you know, universally but if I was to sort of call out some key themes, I'd say that price has been a very strong driver of revenue growth, but that's been more than offset by margin headwinds. So we've seen cost inflation emerging and the margin headwinds have really meant that overall company results missed expectations. So we had almost 50% of companies miss their results downgrading and so overall we've seen quite significant downgrades over the last month to the point where now earnings forecasts for F23 are around sort of 1% to 2% growth, which is quite a significant step down from where we were before.

Damian Cilmi:

So I imagine it's taken a little bit of time to get through the market all those kind of cuts. So did these observation and commentaries from CEOs. Did they match your thinking about economic conditions in Australia? Has anything changed after all these meetings?

Katie Hudson:

Yeah, they were largely consistent with our expectations and we haven't made major changes to the portfolio in the back of it. Certainly our expectation and we saw evidence of this was that inflation trends were starting to moderate. Things like freight supply chains are normalising, a lot of hard and soft commodity prices have come off quite materially, so a lot of the important drivers of inflation are starting to reverse and we saw evidence of that. So that was probably consistent with where we were thinking. Probably one thing that was probably a little surprising was what was happening to pricing power. So over the last 12 months we've heard a lot of investors calling out we want to invest in companies with pricing power. We're now starting to see the early signs of pricing power fatigue, whether it's some volume responses where elasticity is an issue, and I think that second derivative of pricing power getting the next round of price growth through is going to be much harder for companies and that will be another pressure to margins.

Damian Cilmi:

Yeah, that's interesting, and so you touched on the inflation, maybe moderating. But what are your observations specifically about labour costs? I think that's an interest in area. Have we seen earnings kindness taken into account, those increasing labour costs?

Katie Hudson:

Yes, I think what we're seeing now is inflation is moving from goods to services. So we've seen a lot of inflation growth for goods. Now we're starting to see it move through to wage rates, and certainly we asked every single company CEO that we met with what are your intentions around labour inflation and wage rates? And four to five percent growth is the new normal. So it used to be sort of one to three percent, and is that also into FY24 as well?

Katie Hudson:

Yeah, absolutely so. That's when it will start to take effect. It's really their intentions about what they're going to do next and that, I think, will be the key area of inflation that will prove to be quite stubborn and will be hard for companies to keep under pressure. So four to five percent, I think, is probably the new normal.

Damian Cilmi:

And that it's a challenging set of conditions for the RBA as well too, if that does play out, where inflation probably may remain a bit stubborn. So we talked about some normalisation. I think has been a concept that's been talked about in this kind of market and it's occurred for a number of reasons. So we saw consumption changes during COVID, we saw big shifts throughout all of that and then some sense normalising. Now, you know, there's this sense of over-earning. I mean there's some value traps out there in the value complex.

Katie Hudson:

Yeah, I think you have to be careful at this point in an economic cycle at leaning too much on price multiples because they can give you the wrong. They can give you the wrong sort of sense of valuation. Certainly there are a number of sectors that we think are still over earning, where that normalisation of earnings still has to play out. Retail, I think you referenced, is one example of that. Retailers had a great COVID. Their sales levels are still elevated relative to historical trends, their margins are still elevated as well and there's some argument to say they're going to go from over earning to a period of under earning if we're heading into an environment where the consumer discretionary pressure is greater, and that's something we're alive to. There's a number of other sectors where we think they're probably still over earning. Agriculture has had a great three years with almost perfect weather conditions, housing construction.

Damian Cilmi:

Because they've got price and volume Correct.

Katie Hudson:

Yeah, exactly, that's exactly right, and we're seeing all early evidence of that starting to come back. We've seen housing construction been very strong. Of course, energy has been really strong as well. So there's a number of sectors in the market where we think the still earnings are elevated and we just want to be careful that you're not leaning into a price signal that might not reflect the fact that earnings still need to come back.

Damian Cilmi:

And I know it's not really your position, but with Smalls versus Large, do your large cap counterparts see value a little bit differently than what you do?

Katie Hudson:

Yeah Well, you've had an environment over the last 12 months where, in 2022, the large cap sector ended the year flat, predominantly because of energy, banks and probably insurance to some extent, whereas the small cap sector was down 18%, and that was from a starting point where valuations were already larger than history. So that's widened further and you've now got an environment where the small cap sector is trading particularly the industrials at a 20-year discount to large caps, at north of 20%.

Damian Cilmi:

Yeah, that is very interesting, and so Conn now starting to look a bit further afield into the forward period. So what do you think will be the characteristics of successful companies in the forward period for your portfolio?

Katie Hudson:

Yeah, I think it's really interesting. There's a lot of discussion at the moment about will we have a softer or hard landing for the economy? Will we have a recession? How deep will it be? We're looking over the horizon to the environment that we're going to be operating in post that, and I think it's really important, that's the investment horizon that we think about when we're picking companies, and I think the environment we're going to be operating is one of low growth. We've had an environment over the last 10 years of interest rate declines being a tailwind that won't be present, and we'll be operating an environment of potentially some pretty significant population growth headwinds for a number of major economies and so, against that backdrop, I think the sort of companies that will win will be those that can generate earnings growth. So, if you think about the last 10 years, there's been a PE or a multiple re-rate on the back of interest rates Going forward. It's going to be about companies that can grow earnings and those companies that can generate market share growth.

Damian Cilmi:

I think and that's what we're focused on- and so when we've historically discussed earnings growth in the last couple of years, it got, can we say, a little perverse in a sense, that it was very out there in the future very long duration, as some would call it. Where do you think the kind of sweet spot will be? Will it be that very long duration growth again, or will it be a little bit shorter?

Katie Hudson:

Yeah, I think it'll be the middle ground. So the companies that really benefit over the last three or four years with those, as you call out, those very long durations, so long duration they don't even have any cash flow earnings Perhaps with discount rate zero.

Damian Cilmi:

So you can make your own value.

Katie Hudson:

Exactly, that's exactly right. But, as we talked about, that interest rate tailwind won't be there, so it'll be companies that have genuine earnings, genuine cash flow and genuine earnings growth. I think that will be the winners going forward.

Damian Cilmi:

And I think your major thesis is probably for a softish landing in Australia, and so you kind of talked about population growth is beneficial, some good sectors I know that you've been talking about lithium in particular as well. So Australian equities, they're not too bad. The Australian economy you've seen it being, you know, generally quite positive compared to world.

Katie Hudson:

Yeah. So the Australian economy, we think, should fare relatively better. You're absolutely right. You called out population growth. We're now starting to see net migration sort of heading towards 2% again. The starting point is pretty good around employment, around national income. Obviously we've got very strong export prices for most of our commodities. Australia is also really well positioned around the energy transition. You know we're the largest exporter of lithium. It's a huge industry for us now. You know large natural gas exporter. We have really strong copper deposits. All of those commodities will have major roles to play in the energy transition. So you know, from a relative perspective Australia actually looks okay. What's interesting is particularly for the small caps that I look after. They tend to be more exposed to Australian companies. They tend to be net employers.

Damian Cilmi:

As in the local economy, in a sense.

Katie Hudson:

Yep, they have much bigger exposure from the earnings perspective to the Australian economy. So, counter-intuitively relative to where they should sit, they should fare relatively better. And you know, one of our other sort of macro themes is we think the Australian dollar will head north. If that's the case, the small caps should do better as well, because they tend to be net importers.

Damian Cilmi:

Very good news for travellers as well. So, looking ahead, is there any positive leading indicators that you're seeing that instill you with confidence?

Katie Hudson:

Yeah. So obviously the relative position of the Australian economy, I think, is one to definitely call out. You know, I think we're largely through the interest rate cycle, so I think from that perspective, you know we're late in that stage. What was interesting is I think the boards and management of companies in Australia were probably a little more confident than we expected them to be. You know, they've had their balance sheets, are in great shape, most companies have travelled through COVID better than they expected, and so I think there's a willingness to invest and grow and start to get and do M&A and start to get back on the front foot again. So you know, there's definitely some lead indicators there that I think are cause for optimism. Australia is feeling the pressure from an economic point of view but navigating reasonably well given the circumstances.

Damian Cilmi:

And, being in the small space, you would probably see IPOs, which virtually grounds for a halt over 22. Is that looking a little better in 23?

Katie Hudson:

Yeah, with the market holding up well, with some companies starting to do M&A and do capital raisings and those going well, we're starting to see the lead indicators of some IPO activity, which is non-deal road shows, coming into the diary. It's early stage but, yes, that lead indicator is starting to show signs of life.

Damian Cilmi:

Very busy, then I can imagine for you.

Damian Cilmi:

And so, just kind of wrapping up, we said at the top that many of the conditions around volatility, a lot of uncertainty as well about hard or soft landing interest rates, nearly finished or they've still got more to go. There's a lot of different opinions out there and I suppose within that kind of vacuum, if you will, there's you know it sounds positive for active management. So do you think I'm going to ask this another way as well? Do you think that we've seen peak passive, as some have called it?

Katie Hudson:

Yeah, now I've obviously got a vested interest in this conversation so I'm going to acknowledge that up front, if you're enough.

Katie Hudson:

But it is interesting to think about the last 10 years has been really just a big beta play. You know, beta was the driver and in that environment there's not much value attributed to alpha. And I think that when you have a strong beta environment, I think it does give rise to passive index and we've seen that obviously over the last 10 years. I mean, even the small lords has a very high percentage of its ownership. Now passive index and quant and we see that every day in the way stocks are performing. But you think about going forward, beta is going to be much lower. In a low growth environment there's been a lot more volatility. I think the you know, the directional bet is not one way, as it has been.

Damian Cilmi:

It could be a bit sideways as well. Yeah, absolutely yeah.

Katie Hudson:

So I think that is a really good environment for active management, for stock selection being important again, and you know, I wonder whether you know we may see that active management and you know people trying to access alpha in a lower beta environment may actually step up again.

Damian Cilmi:

Yeah, Now very good times, I can imagine. So imagine it's been a interesting reporting season that's kept you on your toes and, hopefully, portfolios all in good shape and you're excited about the years ahead.

Katie Hudson:

Yes, thank you. We're pleased to say we had a really good reporting season from a performance perspective, Like from our you know, from our investment lens, we're looking over the long term and finding a lot of opportunities in this volatility.

Damian Cilmi:

Excellent, I will leave it there. Thanks for coming in, katie.

Katie Hudson:

Pleasure. Thanks, daniel. Sorry if I injured myself with a low volume in the frame, but I'll leave them there. Thank you, thanks, thank you.

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