Market Performance for FY2023

Index

ASX 200 Accumulation Index (Australian Shares): +14.78% return

MSCI All Countries World Index (International Shares): +18.13% return

Our Market Recap

Despite recent media headlines focusing on one of the sharpest interest rate hiking cycles in history, global share markets generated positive returns for the 2023 financial year. This highlights the fact that the share market is not the economy. When expectations are overly pessimistic, a less negative outcome than anticipated can result in positive returns. Therefore, timing the market becomes extremely challenging and we believe that meaningful compounded returns are best achieved through a patient, long-term approach to investing.

Within the Australian market, the best performing sectors were IT and resources. This marked a reversal from the 2022 financial year where IT was the worst performing sector. On the other hand, healthcare and consumer staples, historically stable sectors, were laggards from the index having been top performers in prior years. Global markets were driven by huge returns from large cap technology stocks, among the emergence of ChatGPT and artificial intelligence. The group of stocks which have been dubbed “the magnificent seven” (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla) accounted for majority of the total index return in what has been an incredibly concentrated rally so far in 2023.

Looking ahead, we anticipate a significant inflection point for the market in the next 3-6 months. As more economic data becomes available, we will gain a clearer understanding of the impact of the Reserve Bank of Australia’s fight against inflation. While certain pockets of distress have begun to emerge, overall household demand remains robust, and the labour market remains tight. At this juncture there is reason to believe that the RBA may continue to raise rates, possibly resulting in a cash rate closer to 5% by year-end.

Considering these factors, we continue to manage portfolios with a degree of caution. We hold an underweight position in the property and consumer discretionary sectors and an overweight position in defensive sectors such as healthcare, staples and telecommunications. These defensive sectors are comparatively less exposed to economic fluctuations and as a result should be better poised to weather any downturn that could occur in the short to medium term.

Spotlight on the Property Sector

Despite our current defensive positioning, we are cognisant of the fact that market sentiment will turn at some point, and we are working hard to find the next group of ideas. One of the multiple areas that we are doing more work on is the property sector to which we have held very little exposure for an extended timeframe, on the basis that interest rates had been held artificially low and would have to rise which would then have a negative impact on valuations.

Outside of purchasing an individual property directly, Australian investors can get indirect exposure to property through listed or unlisted property trusts. Listed property trusts, or real estate investment trusts (REITs), trade on the stock exchange, so you can buy units in the trust just like you do with any share or exchange traded fund. With this liquidity comes more volatility, and REITs can trade above (at a premium to) or below (at a discount to) their underlying value. Unlisted property trusts do not trade on the stock exchange and investor’s money is often locked up for a period, while the value generally remains more stable because it is not being repriced daily by the market. Under these trust structures, investors pool their money together for the manager of the trust to invest in a portfolio of assets, typically multiple properties. different trusts will often have different themes – industrial properties, retail properties, healthcare properties, office properties, etc.

Now comes the concept of capitalisation (cap) rates and their impact on property values. Cap rates are essentially the rate of return an investor will demand to be compensated for taking the risk of investing in property. Simply put, if a property (or portfolio of properties) generates $50,000 a year of income, and you apply a cap rate of 5%, the value of the property is:

$50,000 (income)
———————- = $1,000,000 (property value)
5% (cap rate)

If the cap rate expands to 6%, the value of that property is now:

$50,000 (income)
———————- = $833,333 (property value)
6% (cap rate)

Similarly, if cap rates contract to 4%, the value of that property is now:

$50,000 (income)
———————- = $1,250,000 (property value)
4% (cap rate

So, you can see a 1% movement either way in cap rates can have a significant impact on the value of the property. When you apply this to a pool of assets held in a property trust, there are many more factors to consider (including but not limited to type of sector, leverage, occupancy rates, lease lengths and quality of tenants) but at its core, the primary concept here is that property values can be significantly impacted by cap rate movements.

Further to this point, it is important to understand where the risk-free rate comes into play. As the name suggests, the risk-free rate is the generally accepted rate of return for taking zero risk. This is our north star for traditional valuation metrics. The basic risk/return principles of investing suggest that any “risky” investment such as shares, or property should always have a higher rate of return to compensate for the higher risk. Most investors will refer to the US 10-year government bond as the risk-free rate, however for simplicity in this exercise, let’s use the RBA cash rate as an example.

In 2020-2021 we saw the RBA cash rate fall to 0.1%. Where property investors may have previously transacted on a 5% or 6% cap rate, they were now willing to accept a lower cap rate because the risk-free rate was lower and in some extreme cases, properties transacted with a cap rate in the high 3’s. This meant that property prices rose rapidly. On the flip side, more recently as the RBA cash rate has gone up to 4.1%, cap rates should have risen at the same pace, right? Wrong.

While cap rates have expanded somewhat, they have been slower to react to the rapid increase in the risk-free rate, and we are now in an environment where some property trusts are still valuing their assets on a cap rate below 5%. When the risk-free rate is 0.1%, that may make sense, but when the risk-free rate is 4.1%, a cap rate below 5% simply does not sufficiently compensate the investor for the level of risk they are taking. However, this is where the listed REIT sector gets interesting.

Earlier, we explained the REITs trade on the stock exchange, so they can trade at a premium or discount to their underlying value. While cap rates are arguably still too low, many REITs are trading at large discounts to their net asset value, in some cases 20% or more. This is the market essentially implying what it believes is a more reasonable cap rate, as highlighted in the general example below.

REIT “A” (hypothetical):

Net asset value per unit: $1.00

Book cap rate (used in the trust’s financial statements): 5%

Market price on the ASX: $0.80

“Implied” cap rate based on current market price: 6.25%

Because the REIT is trading at a 20% discount to its net asset value, the market is implying that it doesn’t believe the current 5% cap rate is accurate and is effectively implying that it believes 6.25% is a more appropriate cap rate to value it on. This is not to say that we believe that a 6.25% implied cap rate is a screaming discount for listed property, but it is certainly more reasonable than 5% when the risk-free rate is at 4.1%.

This is just a general example, but it highlights the concept around the current cap rates and discounts in the REIT sector. Heading into an environment where interest rates are peaking for the cycle, we believe there could be potential upside in some high-quality REITs where valuations are sensible, underlying fundamentals including gearing levels are supportive, and where we could get additional valuation upside from possible interest rate cuts in 2024 or beyond.

It is important to highlight that this is just a general concept, and there are many other sectors in which we are also searching for new ideas. Our thinking is constantly evolving and being challenged, but we hope this gives an insight into one of the areas that we are looking at and how we are thinking about markets heading into the coming period.

If you wish to speak with a 360Private Investment Advisor to discuss our services, please feel free to drop us a line at contactus@360private.com.au.