Read the previous week’s Investment matters.
Background
This is the second in a series of stocktakes provided to clients as we approach the end of the financial year. Let’s remind readers of the background for the series.
In the weekly Investment Matters, we often discuss the types of themes crucial in building Australian Equity sub-portfolios. Themes that have received the most attention in recent years include population-led growth, energy transition, companies ripe for takeover, and structural tailwinds.
In this four-week series of Investment Matters, we will look a layer down: the individual security positions. These updates on portfolio companies we might call a year-end stocktake. So to speak. In each company update, we will note:
- What are the opportunities?
- What is the investment proposition, and how has it changed?
- What has been the progress in the past twelve months?
- How does the company fit in the sub-portfolio both thematically and in terms of the sub-portfolio’s construction?
The portfolio construction angle helps explain why we are at the high end of the number of securities positions we typically anticipate having in our standard Australian Equities sub-portfolio.
The market
Following the marketing creates risks
Last week, we noted our contention that the combination of a non-representative benchmark ASX300 index and an Australian economy in transition means that simply following the market in its current form creates higher portfolio risks than necessary.
Instead, risks can be mitigated by a portfolio construction approach that accounts for uncertainty.
The implication for our clients is that today client’s Australian Equities portfolio has the following features.
- We are buying several “baskets of companies” that are exposed to a particular market, commodity or sector rather than a single holding with the same features
- Significant exposure to contrarian positions, those whose dramatic success will require conditions to change, rather than simply investing companies that assume that tomorrow will always be the same as today
- Positively, we are investing in a broad range of companies that benefit from a range of domestic economic growth drivers
- Defensively, we have less exposure to the Big Four banks and Chinese demand for iron ore
We hope to explain our contention that while the overall number of stocks is higher than optimal, if one considers the “basket of companies” as a single exposure, the overall number of positions is optimal for the current market and economic conditions.
Year-End Stocktake: Part Two
Part Two of the year-end stocktake will outline one basket of companies and a set of seven companies that have been selected to benefit from a range of domestic economic growth drivers.
Lithium Basket
Three companies are in the Lithium Basket: Mineral Resources, IGO Limited and Ioneer Resources.
Why is it a basket?
There are many listed lithium miners, developers, producers and processors listed on the ASX. Many of the lithium players also rely on the sale of other minerals, are miners and producers, own a stable of assets, or have by-products that influence operating costs.
The success of this basket of lithium exposures will depend on a combination of:
- Future lithium prices
- Geographical and geopolitical considerations
- Whether value is retained in the miners or the secondary producers
- The importance of secondary income sources
Owning all three companies provides us with optionality relating to all four value drivers.
This reduces the risk of an outcome where lithium prices are high, but our lithium exposure is selling to the wrong supply chain. Or lithium prices are moderate, but success comes mainly from those with the best by-products or production processes.
In total, we assess that 1.5% of the ASX300 is devoted to the broad lithium market using our definitions of value share in each company. Clients’ Australian Equities sub-portfolios have exposure of about 2.5% to lithium, reflecting our positive view on the medium prospects and valuation upside of companies we are invested in.
After a particularly strong FY-23, a year in which we trimmed these successful positions, FY-24 has proven exceptionally weak. The underlying volatility of lithium or spodumene (raw lithium input) prices has been responsible for part of the volatility, the remainder being uncertainty regarding the medium term take up of electric vehicles,
The table below shows the three positions, the total size and a description of the proportion of the value that relates to lithium, along with notes on the other assets the company’s own.
| Lithium Names | % of Australian Equities Portfolio | Share of business value related to lithium (FSL estimate | Other asset, minerals or by products |
| Mineral Resources | 2.00% | 56% | Iron Ore mining, Mining Services |
| IGO Group | 1.75% | 62% | Nickel, Hydroxide production |
| Ioneer Resources | 0.40% | 75% | Boron |
IGO
IGO is a relatively diversified company with not only a circa 50% stake in the world’s best hard rock lithium mine, Greenbushes, but downstream production and a range of nickel assets. The nickel assets, Nova and Cosmos, have been under pressure recently, but we are convinced that the medium-term demand for Australian based supply chains of nickel will generate considerable value.
Using the pie chart below you can appreciate that lithium forms at least 60% of value.
Figure #2: Estimate of net present value across IGO assets – Macquarie Research
First Samuel’s evaluation, using a scenario-based analysis, tends to have a higher value attributed to Kwinana, Nova and Other assets. We also value the duration of the mine life in the Greenbushes asset at a higher value. The net result is that IGO is considered a 62% lithium company.
On current market forecast IGO will generate profit (cash flow) equivalent to its market cap in the next eight years. The Greenbushes asset, the premier lithium asset in the world, will still be producing in 2050. This provides an indicate of the degree to which it is currently undervalued, and the degree to which short-term price concerns are dominating. Patience will be rewarded.
An aside: To own downstream assets or not? Tale of two approaches
The Australian market is convinced that IGO will generate almost no value from its downstream assets shown in the pie chart above as Kwinana Hydroxide. The Kwinana plant is Australia’s first fully automated lithium hydroxide processing plant and is located in Western Australia, near Fremantle and 250km from the Greenbushes mine, the world’s largest and highest-grade source of hard rock lithium.
The plant, developed between 2015 and 2022, cost the JV (operated with Chinese-owned Tianqi) nearly $1bn. Optimisation during the 2016-2019 period saw its final scale more than double. If it was even worth is investment cost it could be worth 15% of the IGO group valuation.
At current share price, the “optionality” represented by this plant is significant, especially considering the volatility of lithium product pricing, and the geo-political landscape that may increasingly require diverse global supply chains. Neither is there value ascribed to the company’s additional plans to develop battery chemical production capacity.
Lithium hydroxide produced at the Kwinana Plant will be containerised and exported from the Port of Fremantle to customers around the globe. Lithium hydroxide is a key component in electric vehicle high nickel battery cathode chemistry.
IGO as a part of the Lithium basket therefore represents the scenario in which owning downstream assets is the correct strategy.
Mineral Resources
Mineral Resources has two additional assets, other than lithium. The first is an excellent Mining Services company that has been the backbone for two decades of value creation. The company is excellent at what it does, with expertise in the deployment of new capital, to create value in partnerships in mining enterprises, and have a genuinely entrepreneurial outlook.
Clients may recall purchasing Mineral Resources stock at very depressed level during covid, this investment was on the back of the belief in this core mining services capacity.
The second operation is in Iron Ore with a small number of high value operation in Western Australia.
Figure #3 and #4: Net present value of Mineral Resources assets, and EBITDA projections
Source: Mineral Resources, Macquarie Research
On the other hand, Mineral Resources has limited exposure to downstream assets, and is unlikely to invest its own funds in their development in the future. Recent moves in 2023 and 2024 have shifted resources away from such a strategy.
Mineral Resources still retains a 15% interest (down from 50%) in the Kemerton Lithium Hydroxide Plant in Western Australia. But instead of supplying Kemerton with Mineral Resources sourced lithium the plant will used Greenbushes’ (IGO) spodumene.
Minerals Resources has a JV arrangement with global lithium player Albemarle covering its Wodgina lithium assets. Mineral Resources and Albemarle have each committed to convert their respective share of Wodgina spodumene concentrate into lithium battery chemicals through Albemarle-owned conversion assets or using third party tollers.
So the combination of the two shareholdings retains upside from lithium prices, retain significant upside if downstream production proves valuable (as little current value is ascribed in the IGO share price) and also retains exposure to a range of clients, one through a JV with a Chinese venture, and the other with supply that could be completely removed from Chinese influence.
Ioneer Resources
The final component of the lithium basket is the much smaller Ioneer Resources. Its flagship property is the Rhyolite Ridge lithium-boron project located in the state of Nevada, USA. With a market capitalisation of circa $330m, and a very small position in the portfolio, Ioneer plays an important role, for two reasons.
The first is that the Rhyolite project offers a fully internal US supply chain for critical projects. For companies sourcing battery material for defence or strategic US industries this could prove hugely valuable.
The second feature of Ioneer is the Boron by-product. Our research over the past decade highlights an increasing use case for Boron, a remarkably widely-used material. Boron is not only critical for plant nutrition, it also has uses in pharmaceutical, detergents, fibreglass, and makes boron fibres for composite materials. Chemical properties that excite us include its future use in magnets and superconducting materials including borophene, similar to graphene.
The mixture of boron and lithium in the Rhyolite Project enhances the projects economics, and subject to final approval regarding environmental issues the project offers a unique value proposition.
Domestic Economy Exposure
Regular readers will recall that we are seeking to limit our exposure to those parts of the domestic economy which are at risk of deteriorating household incomes. This doesn’t mean we are avoiding companies with exposure to the economy. In fact, we believe that in the medium-term equities provide a fantastic risk-adjusted return potential.
The key is having the patience to wait for asset values to be realised and maintain exposure to companies that benefit from the type of limited growth the Australian economy is experiencing.
In order to provide a stocktake on our domestic economy exposures we need to revisit a quick snapshot on the economic conditions we are investing for:
- structurally higher inflation
- shortfall in private business investment reducing capacity for productivity growth and an environment in which bottlenecks increase,
- increased role of government in the economy, especially for strategic investment. In turn this higher level of spending is funded through higher government deficits increased debt issuance
- higher interest rates (slightly lower than current levels but higher than the past 5-7 years) and excess household leverage limiting discretionary expenditure growth
- more regulation, and higher costs increasing the value of existing assets versus building new assets
- in this period of but weak underlying productivity, a company must be able to benefit from improvements due to technology or demonstrate pricing power to maintain and improve margins
The seven companies outlined below represent more than 16 per cent of the portfolio, and in general have provided higher than market and portfolio average returns in FY24. Details of FY24 returns and the current portfolio size or range is provided below.
| FY24 returns | Portfolio Size | |
| Woolworths | -14% | 2.50% |
| Johns Lyng | -10% | 2.75% |
| Bega Cheese Limited | +40% | 1.00-2.00% |
| Inghams Group | +65% | 2.00% |
| Seven Group | +66% | 3.25% |
| Cleanaway | +12% | 3.00% |
| ARN Media | -30% | 0.75% |
We are interested in “domestic economy” equity exposures in companies that share five features
- Moderate to high quality management that is focussed on cash flow generation rather than accounting earnings growth
- Optionality in existing assets or current plans that move the company towards higher cash flows
- A board that understands the benefits of a moderate level of balance sheet gearing (debt levels)
- Businesses that are currently experiencing industry dislocation that provides us with buying opportunities for strategic assets
- Companies that are currently executing well
This checklist is almost identical to the approach that Seven Group and its management team has pursued. Interestingly it is also the approach that Wesfarmers utilised in the 1990-2015 period, and is consistent with the best period of Kerry Packer’s Consolidated Press Holdings.
So, we are looking for the intersection of companies that benefit from the economic conditions, utilising the management approach outlined above.
Checking in on each company in turn…
Woolworths Limited
The share price has significantly underperformed in FY-24. Woolworths has and does benefit from the current economic conditions, especially an economy that is growing through population rather than wealth and incomes. In addition, it should be continuing to benefit from ongoing inflation.
However, in the recent period it has been beset by weak execution, and the effects of an antagonistic political atmosphere. In addition, whilst its plans for growth and investment are logical and consistent with historical plans, we are concerned that the pace of execution may not adequately respect either the magnitude of the opportunities or the threats of alternative winners.
For these reasons we have recently reduced the position size.
Johns Lyng Group
Johns Lyng Group is Australia’s leading integrated building services provider, delivering building, restoration, strata and energy services nationally and internationally. The Group’s core business is built on its ability to rebuild and restore a variety of properties and contents after damage by insurable events including: impact, weather and fire events.
In the current economic conditions, we are attracted to the nature of demand that Johns Lyng is exposed to. Demand for its services are a function of the accidents and natural disasters that occur in the economy, and the revenue it receives is paid for from the rapidly rising insurance premiums that households have faced in recent years.
As a provider to insurance companies, success is measured by the quality of the service provided, and the feedback the insurance company gets from the affected insurance customer.
As Johns Lyng improves its systems and develops the scale and breath of its offer to the insurance panels, the positive feedback continues, and more work is allocated to Johns Lyng. A virtuous cycle.
In recent years Johns Lyng has embarked on an expansion in the US. We see their offer being able to create value in this market as well.
Bega Cheese Limited
Bega Cheese Limited is an integrated manufacturer and distributor of dairy and other food-related products in Australia. Household names of its products included Bega, Vegemite, Yoplait, Farmers Union, Daily Juice and Big M.
The company operates in Dairy and other food-related products in Australia. The company operates in two segments, Branded and Bulk. In the past 2 years the impact of volatile commodity prices and lagging price increases for its Branded products depressed earnings. The challenges the company faced within the Bulk segment based on the substantial disconnect between dairy commodity prices and much higher domestic farmgate milk prices.
Our view was that the strength of population growth, and the inherent capability to increase prices of the successful brands that Bega owns was underestimated by the market. In addition, the mismatch in milk prices was unlikely to last forever. We began to build our position and were determined to be patient.
Pleasingly the 1H24 results shown the brands had quickly rebuilt margins, and the stock rallied more than 40 per cent. The company remains well placed for current conditions and the management team is sufficiently aware of the power of its assets and brand to deliver value.
Historically the business has had a healthy view of balance sheet dynamics and has the capacity to exploit the current dislocation in Bulk milk over the long-term.
Inghams Limited
Inghams is the largest supplier of chicken in the Australian market and given its status as a lower-cost protein at a time of constrained household budgets, is a solid position within most client portfolios.
In a higher inflation environment, and with a backdrop of rising input costs, there had been some scepticism amongst investment market participants about the ability of the company to pass through higher prices to customers.
However, we believed that as a dominant market player, and given chicken was already one of the most affordable meat protein sources, Inghams would indeed have pricing power. This proved true and company generated strong earning power and a pleasing outlook in FY24.
Leading into FY25, despite the irregular industry disruptions with avian flu, the outlook remains favourable on pricing, although volumes are coming under pressure from household finances. We suggest that these prime assets remain relatively cheap from a global perspective, and have noted strong industry performance in the wake of avian flu in US markets.
We have reduced the size of our stake in Inghams through the year. However, based on the pleasing combination of being well placed economically, and have both the execution and assets well positioned it remain a core domestic exposure.
SGH (Seven Group Holding)
Seven Group Holdings is one of our favourite companies given it:
- has a portfolio of assets with leading market positions (including Caterpillar via Westrac, Coates, Boral)
- offers access to some key structural growth thematics (eg energy transition, infrastructure and mining production)
- excellent cashflow generation and a history of stable to rising dividends
- has an executive team which executes effectively with a focus on delivering long term shareholder value
Figure #5: Seven Group Holdings Strategic Sector Exposures
Source: Seven Group Holdings
There is significant momentum in each of its 3 key assets, an emerging strong cashflow story within Beach Energy (30% ownership) and a myriad of options available to the Group though M&A in order to provide the next leg of growth.
ARN Media
ARN Media is a leading media and entertainment business listed on the ASX operating radio, audio and digital businesses in Australia as well as outdoor assets in Hong Kong. It operates the Gold FM and KIIS FM brands.
Seven Group Holdings has already acquired a stake of just under 20%. This business would be a natural addition to Seven’s media interests, adding digital capability amongst its iHeart Podcast assets. Australians are the biggest consumers of podcast content in the world on a per capita basis.
Throughout FY23 ARN Media has been subject to a range of M&A approaches, schemes, and proposals. Although a weak performer over the year in terms of share price we wo don’t believe the strategic value of the assets has been sufficiently recognised in order to sell the remainder of the small position. FY24 will however be the year in which value needs to be realised, and depending on tax considerations may leave client portfolios.
Cleanaway
Cleanaway Waste Management is Australia’s leading waste management and environmental services provider. Its primary business is collecting, processing and landfilling/recycling municipal, commercial and industrial waste. The company also carries out the safe and proper disposal of more individualised industrial, liquid and health waste.
Cleanaway is well placed in an economy with moderate inflation and growing demand led by population and infrastructure style investment.
Cleanaway generates strong financial returns from its Solid Waste Services division, which accounts for more than 60% of revenue and generates higher-than-average margins. A significant component of the value created is attributable to its landfill assets. We consider landfill assets especially powerful in periods of strong population growth and inflation.
They are scarce assets that require significant pre-investment, and their returns only improve in times of high demand. In recent years, we have seen a significant increase in returns to similar assets, such as Boral’s quarries. We think that Boral’s majority shareholder, Seven Group Holdings, would also see the parallels with Cleanaway
Labour availability
As all high-quality businesses appreciate, it is one thing to have great assets and another to have staff who can productively generate the available returns. Over the past couple of years, Cleanaway has suffered from a general lack of labour availability.
This has been felt in high vacancies, higher voluntary turnover, and a general decline in productivity. For example, one of the keys to increasing productivity is reducing voluntary turnover, which decreased from 21.5% to 20.2% since 2H23 but remains well above management’s targets of low-mid teens.
It is possible that Cleanaway’s productivity metrics will not significantly improve over the next six months, putting further pressure on the margin outlook. In the medium term the cyclical fall in productivity is likely to be reversed.
But these are short-term considerations, and our investment process concentrates on the medium-term asset quality independent of short-term management changes. Short-term concerns like these will likely provide opportunities to add to our position.
The medium-term value is driven by the maintenance of existing assets and the amount growth capex employed. The following chart highlights the increase in growth capex, along with increases in maintenance required. The quality of the growth capex remains high, with significant resources devoted to new sustainability investments.
Summary
This week’s investment sought to highlight the logic and investment fundamentals we are creating in out lithium basket. Once again the impact of baskets are to increase the number of stock clients see in their portfolio, in a purely numeric perspective, but not from a thematic perspective.
The stocktake also highlights the economic outlook for our domestic economy exposure by referencing how current conditions, mix with the type of management and asset features we are looking for in creating an overall exposure.
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.