Australian Foundation Investment Company Limited (AFI) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by, and welcome to the AFI Shareholder Information Conference Call. [Operator Instructions] And we note that this conference call is being recorded today. I would now like to hand the conference over to your first speaker today, Mr. John Paterson. Please go ahead, sir.

Thank you very much. Good morning -- good afternoon, sorry. I'm John Paterson, Chairman of Australian Foundation Investment Company. I have joining me today on the call Mark Freeman, our Chief Executive and Managing Director; David Grace, a Portfolio Manager from the investment team; Andrew Porter, our Chief Financial Officer; Matthew Rowe, our Company's Secretary; and Geoff Driver, our General Manager, Business Development. AFIC announced its results last Monday morning. Given the present uncertainty in markets, we thought it would be useful to hold this webinar telephone briefing to provide shareholders with an overview of the results and to hear from Mark and David about the portfolio. As you're aware, it's been a very volatile market. The Australian share market was on track for a very strong year until the world was unexpectedly hit with the COVID-19 virus in the early part of the 2020 calendar year. From the market peak in February through to its low point for the year in late March, the S&P/ASX 200 price index is down 36.5%. Surprisingly, despite the significant decline in economic conditions, the S&P/ASX 200 price index then increased 29.7% from this low point until the end of the financial year, being driven primarily by an expansion in market valuations. For some time, we've made a deliberate effort to reduce the number of holdings in the portfolio and to have larger positions in the companies we really like. This year, we've come down from 76 stocks to 61. In these volatile market conditions, the positioning of the portfolio to ensure quality companies with strong industry positions form the core of our portfolio has lessened the impact of negative market. The portfolio return for the year, including franking, was negative 3.1%. Including franking, the S&P/ASX 200 Accumulation Index was down 6.6%. The other key aspect of AFIC's results was the final dividend. AFIC, as a long-standing listed investment company, has reserves, including from realized gains that can be used in more difficult conditions. Understanding dividends are very important to our shareholders, particularly this year. The final dividend was maintained at $0.14 per share fully franked despite falling income in the second half. As we move into the new financial year, the outlook remains unclear as companies face extremely difficult operating divisions. In this environment, the dividend income of AFIC is likely -- the dividend income AFIC is likely to receive over the year is also unclear. As a result, we cannot at this stage make any comment on the expected dividend for AFIC for the year. It'll be addressed as usual by the Board at the time of the half and full year results. Before we start the presentation, a bit of housekeeping on the teleconference. This briefing is based on the material available on the company's website. If you are using your computer to access the presentation via the webcast, the slides will change automatically. If you're accessing by phone only, the PDF of the slides with page numbers is available on the website. [Operator Instructions] I'll now hand over to Mark and the team to run through the presentation.

Okay. Thanks, John. And I'd also like to extend my welcome to everyone on this call. It's a very important part of our process that shareholders get the opportunity to hear from us in terms of how the fund has performed. We've got the slide presentation available, and hopefully, everyone has that in front of them, and we will refer to page numbers as we talk through the presentation. Just starting on then to Page 2. We start with the disclaimer, just to say that we're here to talk about what we're doing in the fund. We don't have a license to give financial advice. We're simply here to talk about what we've been doing in our -- in the portfolio. Turning to Page 3. We've got a result summary. At this point, I'll pass over to Andrew Porter, our CFO, to talk through the results.

Thank you, Mark. For those of you who do have a slide, Page 3. The profit for the year, $240.4 million, was down 40.8% from the prior year. We actually, for those of you who can remember, highlighted these one-offs, about $134 million of them, at the AGM last year, and I'll come on to those on the next slide. John has already alluded to the dividend being maintained at $0.14. Last year, it was $0.32 because we paid an $0.08 special at the interim in 2019. You may remember, there was a bit of an issue with a possibility that franking credits may not be around after the federal election, so that was paid. Obviously, no special dividend was paid this year. So with the exception of that, the dividend was maintained. The shareholder return, so that's the share price plus dividends, including franking credits, was actually positive 2.9% for the year, and that's largely because we moved from a small discount to the MTA to a small premium. Management expense ratio stayed at 0.13%. We consider that to be a good benchmark for investors. We understand that investors want a low-cost investment vehicle. That equates to $0.13 for every $100 that you have invested with AFIC. John has already mentioned the portfolio return, down 3.1%. And the portfolio, $7.2 billion at the end of the year. And just to note, the dividends we paid were just under $300 million during the year, $282 million. So if we go on to Page 4. Page 4 gives, in cents per share, an analysis of how that profit changed from last year. And the big movers from last year to this year, which I've mentioned, are the $134 million, but in cents per share, $0.036 from special dividends that we didn't receive this year that were paid last year. There were some from BHP, from Rio, from Wesfarmers, Qube, et cetera. And then other one-offs, the BHP, we had to do buybacks last year. That was effectively $0.04 per share. And the Coles demerger from Woolworths, which we have to treat as income, was another $0.037 per share. So on an adjusted basis, we would have had $0.227 per share of profit. I call that the adjusted result for 2019. Then what happened this year was a further falloff really in the second half of the year due to the coronavirus of $0.036 per share. And Slide 4, there's a little gray box there, that gives some of the details for it. Obviously, it was the banks having either no interim dividend, deferring it or, in the case of NAV, decreasing it. And some of the other stocks are not paying an interim dividend or distribution, Sydney Airport, Transurban, James Hardie and Alumina reducing it. Those are the major ones that contributed to that decline in the year. We had a small increase in the trading portfolio income. But overall, the profit per share was $0.20. And as John has alluded to, the total dividend for the year of $0.24 was made up for by dipping into reserves, which, as a listed investment company, we are able to do. Hopefully, that gives you some more clarity on to the results. But of course, we'll be happy to take any questions at the end of the presentation. But back to you, Mark.

Okay. Thanks, Andrew. So moving on to Page 5. We start with a couple of charts. The first one on the left is just showing the performance of the index, and John has already outlined the extreme movements we saw throughout the period. As John alluded to, probably the area that did surprise us a bit was the speed of the recovery in the market. Those that who were on the call back in March when we gave an update, there's a slide back in that pack showing that we felt at the low point in the market, we were seeing long-term value in markets generally. The recovery, though, has us back to more fuller valuations. And as I said, the speed of the recovery has been quite extraordinary. It's not unusual to see a bounce of those extreme lows, but it normally takes longer than what we've seen. And on the right-hand side, we've got a chart showing some of the sector movements. The top one, the orange color, is the health care sector. It's actually been quite stable throughout this period. We've got a good exposure to health care stocks in the portfolio. The gray line shows the information technology part of the market, initially, we sold up quite heavily, but there's been a very strong recovery in that part of the market. And then the 2 sectors that are more close to the state of the economy in a more direct way, financials, in particular banks and energy, obviously had a big selloff, and they've continued to languish when compared to the other sectors. Just moving on to our performance. As we pointed out, we had a good year relative to the index. On the long term, we're about in line with the index, but just remembering that the index doesn't have tax or cost taken out of it, so you can never quite get that index return number. We haven't included here. We also know the volatility of our returns is quite strong relative to that index as well. So moving on to the next slide, which is the major changes, just before I pass to David to talk through that. Again, as John pointed out, we've been using this current period to reduce the number of stocks down to 61. Our focus in the downturn was to make sure we came out of this with a portfolio that has a much stronger position in terms of the businesses we're owning. I thought I'd just quickly touch on what we're looking for. We are wanting to hold businesses that have strong, sustainable business model. The world is changing very quickly, and we have to keep rethinking when we look at our companies to make sure we are in the strong businesses. So these are companies that have sustainable, competitive advantage, and we have to keep reassessing that as time goes on. We want businesses that can produce a satisfactory return on capital and return on equity. So that's businesses that we're going to invest that they can make a good return to shareholders. So we want companies that can produce good cash flows. We have a preference for businesses that have more consistent earnings streams, and we want to invest in companies that have strong balance sheets for a strong financial position. We also want to say there is a pathway to earnings growth over the long term. Even though some might be slow growth, we just want to avoid companies where we think there are structural headwinds on those businesses. And we want companies that we feel are run by management teams that have a share of hold of focus and understand the concept of investing for returns. So we want to keep seeking to improve the quality of our portfolio. And we want to keep asking ourselves, are we holding really good companies taking that longer-term view? And we certainly feel at the moment, we've got a very strong portfolio of stocks. It will be a challenging period, but we think we have good businesses in the portfolio, and I think the performance over the last couple of years is a testament to that. So at this point, I'll pass back to David to talk about some of the changes in the portfolio. And I guess one of the changes at this time is we're showing the top 40 stocks to give shareholders a sense of what sits below the top 25 that we publish every month, and David will talk through that as well. So over to you, David.

Thanks, Mark. So on Slide 7, we outlined major portfolio changes over the last 12 months. On the purchases side, we've increased our holdings in a number of high-quality companies: Goodman Group, the largest global developer of distribution centers, benefiting from the increased trend to online shopping; Telstra, offering an attractive dividend yield around 5%, holding a market leadership position in the telecommunications industry; Cochlear, the global market leader in the development and manufacture of cochlear implants; Sydney Airport, a fantastic, long-term asset and an attractive valuation given current market disruption; Cleanaway, holding a portfolio of strategic, post-collection recycling assets as we move to a world of less waste heading to landfill; and Macquarie, a market leader in developing, financing, managing infrastructure projects and sustainable energy projects in wind, solar and hydro. On the sales side, we have done well out of Treasury Wine. However, we feel the challenges in a highly-competitive industry are becoming more pronounced. Dulux was in receipt of a bid and was acquired by Nippon throughout the year. While we consider long-term structural challenges are likely to restrict returns, shareholders can expect from Suncorp, Scentre Group, Adelaide Brighton and Perpetual. Slide 8 to Slide 11 outline the top 40 holdings in the portfolio. Collectively, the top 40 represents around 90% of portfolio value. I'll provide some brief, high-level comments, and we are happy to take any questions later on. While still meaningful, our exposure to banks has declined in recent years as we have allocated capital to other areas. Despite the current challenging environment, we consider our exposure to banks will continue to contribute to portfolio income over the long term. In resources, our largest exposures via holdings in BHP and Rio Tinto, both low-cost producers maintaining strong balance sheets, paying high dividends and benefiting from continued strong customer demand for commodities. We remain happy with CSL as our largest holding in recognition of the long growth runway in front of the business, while Wesfarmers and Woolworths maintain a strong market position in hardware and supermarkets, respectively. Both businesses are performing well in the current environment. Outlined on Slide 10 and Slide 11, there are a number of companies where their weightings in the portfolio have increased significantly over the last few years. We've been able to allocate meaningful capital to high-quality companies where the growth outlook is strong over the long term. Both Fisher & Paykel and ResMed have become larger holdings, following a period of strong performance. Both are favorably exposed to increased demand in the ventilation market. Seek, the leading employment classifieds business in Australia, is an owner-driver business with a large opportunity. There's a population in the markets where they operate that exceeds 3 billion people. Similarly, Carsales holds a strong market position, is a very well-managed company and has a large growth opportunity in both Australian and international markets. Xero is a leading cloud accounting software business, capturing market share in the U.K., while the strong market position of the ASX provides a consistent and stable earnings profile. On Slide 11, NEXTDC operates a nationwide network of data centers, exposes the requirement for more data storage. We continue to consume more through our devices. Both Reece and ARB are owner-driver businesses, where the largest shareholders continue to run the company, both have a strong asset base and are expanding in international markets. And finally, REA Group or realestate.com is the largest online real estate classifieds business in Australia with a market share more than 2x its competitor. REA generates significant free cash flow and is consistently investing in new product development. In summary, while we anticipate earnings volatility to continue, we feel the portfolio is in good shape through the core of the portfolio in quality companies with strong industry positions. I hand back to you, Mark.

Thanks, David. So it's very interesting to see when you step back and look at the portfolio, those sort of groupings around the key store type businesses, as David touched on, like the Woolworths and Wesfarmers. Yield companies like Amcor and Telstra, which we think have very strong businesses into the future. David touched on those owner-driver stocks, which includes Mainfreight, which is in the top holdings as well that's run by the management. We have a significant shareholding in their businesses. The health care grouping with CSL, Sonic, Ramsey; and the growth stocks in that area like Fisher & Paykel or ResMed and Cochlear, where we've built up our technology exposures. As David touched on with the Seek, Carsales, REA, Xero, NEXTDC and IRESS; and some niche industrial businesses, such as Qube, Cleanaway and also James Hardie, which is a fantastic business in the U.S. that has a market-leading position. So we think the portfolio is -- has a mix of strength and growth and a real focus on businesses that make great returns. So just moving on to Slide 12. Just some closing remarks before we go to questions. Just looking at the PE of the market, our view is that valuations are now pretty full at the moment. Money has come back into the equity part of the market. We view that is a lot of cash out there. There's been a lot of liquidity thrown at economies. And essentially, people need somewhere to invest, and so the weakness really saw our retail investors pull back into the market as there are really no alternatives to get yield. Low interest rates is also something that is driving up valuations. We've seen particular strength in certain sectors, and I touched on earlier, technology and health care. We are a little bit concerned that the multiples on those areas of the market are becoming quite extreme. We will continue to hold the great companies we own, but we're wary about chasing those sectors at this point. The full impact of the virus on earnings is still yet to be played out. Certainly, the next 12 months are going to be very challenging for certain aspects of the market. Recovery out of this phase is going to be very unclear as well. Clearly, there's a sense of economies trying to come out of lockdown, but that's been -- there's been a number of issues with that as we've seen economies struggle with rising infection rates, so it's going to be a very challenging outlook. Despite that, we think our portfolio is very well positioned. We do take a longer-term view. We do believe that we have strong businesses that can endure tough times, and we're comfortable with the businesses we own. And with that, just one final point. Any sort of future buying would really have to rely on further weaknesses. We felt like we made some good adjustments. As I said, we wanted to make sure we came through the downturn with a stronger portfolio. We think that we've achieved that. And in terms of -- I'll probably get a question on this, as I do, where do I think market is going. I'll say that upfront. I have no idea. We don't try and predict markets. We never do. Trying to do that is a very tough game. All we can do is try and make sure that we are in good, quality businesses taking a longer-term view. We do have to keep reassessing that, as I said, and we'll just wait for further weakness to look to accumulate the company. So with that, I think it's really time for questions.

Yes. So we'll throw open to questions. We might take a few from the webinar first, and then we'll go back to the telephone to see what questions may be coming through there. So one of the question we have got through the webinar is in terms of bank dividends. Do you think any of the banks will pay the deferred dividend that they paid for the deferred dividends from last financial year?

Yes. Well, it's not just dividends. There are some other companies that announced deferred dividends. The answer to that is we don't know at this point. I think it's going to be a challenge to do that given the current conditions we're going into, and I think a lot of Boards are under pressure to make sure they maintain a strong balance sheet in this period we're in. We also understand banks. Obviously, they take guidance for APRA, and that can change as well based on how the economy is performing. So look, it's hard to give an answer on that. I guess we're really hopeful. But at the end of the day, we certainly want the banks to stay in a strong position. And that's the #1 thing we tell our businesses. We obviously want to get dividends from the companies we hold, but #1 is to make sure you do that from a position of strength.

Just a reminder, it's only 2 of the big 4 banks because NAV reduced that and TBA or announcing. So it's only ANZ and Westpac that, that would apply to.

So I guess one of the other themes that's coming through on the -- through the questions is the dynamic of retained earnings within AFIC, I guess, how do we generate those? And the other question out of that cause is, how long do we foresee that we actually use those retained earnings to support the dividend?

Well, retained earnings generally at the moment are coming through either prior year profits when we haven't paid them out. But over the last couple of years, it tends to be from the realized gains that we make. So that's when we sell a stock or more than we bought it for. It sounds very obvious, and we haven't pay tax on that. So that has built up over the years because we haven't paid it all out to shareholders because, otherwise, you'd reduce the size of the portfolio. And the simple answer is it will be up to the Board each year to have a look at what we have and what we can afford to pay out, bearing in mind what the economic conditions look like. So I can't really put a figure on the number of years. It will be -- continue to be done. We'll just have to wait and see, as John said, at the half year and the full year, what the outlook is like, what we've actually received. But there are certainly are reserves that we can continue to use. Mark, any comments?

No. Again, it's a Board decision each year. But there are more reserves, and we did it during the GFC.

We did.

And we've done it through previous economic downturns or market downturns in history, and we feel our shareholders benefit from that. But as I said, each downturn, we have to really assess as we go along. But there are -- as I said, there are more reserves there, and we'll just have to see how the year pans out.

So one of the other questions is about Sydney Airport and the impact of a second airport potentially on its business.

So okay. We always felt that, that was going to be sort of -- it was going to introduce a certain level of competition. I guess the plans on that airport is going to be very challenging to see how the government approaches this given its current economic conditions. And obviously, it's a project that creates jobs. But the economics of it, we always felt were questionable. Sydney Airport has the ability to dissipate, they didn't. And that probably, again, it's a sign of the narrow returns that project will generate. So there is a question mark in my own mind personally about whether that project gets pushed back at some point in time. It's a project that will take many years to evolve, eventually it will, but I think one of the points that Sydney have been talking about is that they are hopeful that any movement of traffic to the new airport is going to be more domestic. Sydney's most possible -- profitable customers are the international travelers, and they feel that most of the traffic on international will still go through Sydney, and that will open up some, effectively, more slots for the domestic with international. So a longer-term view. Hopefully, not too much disruption. But competition is always something that will take a little bit away from that core business, but it's many years out.

All right. Thanks, Mark. A couple of other questions are really about the structure. This one's about how or what the sort of portfolio turnover typically? And also the other question is about structures, how do we keep our MER so low?

Okay. So the turnover over the last year has actually been 7%. So compared to pretty much every other fund manager in the market, that is extremely low. We understand that tax is a considerable drain on returns. We know that retail investors understand tax when they buy and sell shares. So our objective is to make sure that good companies we can hold for the long term. And we're not seeking to trade, we are seeking to be a part owner in the business and receive the profits through dividends and hopefully see that compounding growth over time. So we think the portfolio is in good shape. It's hard to forecast what's going to happen, but our expectation at this point, the portfolio might actually -- the turnover might be lower looking forward given the shape we're in. So that's one thing we want to make shareholders aware of. The MER is about 0.14% -- 0.13%. We don't pay performance fees. Shareholders own the company. There's no management group hanging off. And that keeps the costs very, very low, and it also gives shareholders the chance to benefit from a growth in market value.

Mark, we'll throw open to the telephone questions. Operator, if we can, please?

[Operator Instructions] We have a question coming from the line of [ Paul Butestand ].

I've been a shareholder in AFIC for almost 30 years. At one stage, it's National Australia Bank, which your largest shareholding. Why do you have such faith in National Australia Bank when, for the last 20 years, in my opinion, they've been a relatively poor performer? And that was confirmed by a number of issues associated with the Hayne Royal Commission.

Okay. Thanks. So it's a very valid question. And our exposure to the banks, as we touched on earlier, has been reducing steadily every year. We still have a lot of shareholders that appreciate frank dividends. However, I think the biggest structural change that's occurring at the moment is the return on equity the banks produce and the growth in earnings. And we had quite big holdings for many years in the banks because they were achieving return on equity anywhere from sort of 13% to 16%, which is a good result, and they're reducing pretty good earnings growth. NAV was probably the most pointing out of those. We felt they had a strong position in the small business part of the market that they never really capitalized on and they should have. We kept holding it. But I guess the big change now that's occurring, as I said, is the erosion of return on equity, which at the moment is sub-10%. And we would need to see the returns at least get over double digit, otherwise, we'll have to keep seeking other areas of the market to allocate capital.

The next one comes from [ Ken Perry ].

Keep up the good work. I've been saying that for same as the previous year for about 30 years. Well done. Congratulations. I've noticed in the holdings, certainly in the top 40, that there's -- doesn't appear to be any insurance like QBE and Suncorp. So what's your feeling in that area?

Okay. So the question was on insurers, QBE and Suncorp. We don't own QBE. We've exited Suncorp over the year, and we do have a smaller holding in IAG. But as you said, it falls outside the top 40. Again, when we look back at history, both QBE and Suncorp, the return on equity they make, and as I said, the returns that shareholders receive at our business is very important. It's actually been pretty disappointing. There have been businesses that have always had to come back to the market to raise capital when times are tough. That dilutes earnings. And we felt that those industries were -- I guess, structurally, were going to have challenges to improve those returns over the long term, and we have just found better alternatives. And it's, again, alluding back to the previous question, a similar story with the banks. We're finding better places to put our money over the long term given the risks involved. We do have a smaller position in IAG. The last result was quite disappointing. Their history on returns has been better than the other 2. They have been turning about 13%, which we felt was satisfactory, and you're getting a lot of that back through franked dividends. But once again, we're going to go back and reconsider that one after their recent result. There are some longer-term structural issues, too, particularly on the general insurance around vehicle, car insurance. Once we go to driverless cars, there is a view in some circles, certainly that the cars are not going to have as many accidents. So insurance won't be needed as much, and therefore, it's going to reduce the size of the industry, that industry. So there are some potential headwinds there that keep us away from those sectors so we can get better returns in other parts of the market.