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

Good day, and thank you for standing by. Welcome to the Australian Foundation Investment Company Half Year Financial Results Briefing. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker Mr. Mark Freeman, Managing Director of Australian Foundation Investment Company. Please go ahead.

Okay. Good afternoon. So I'm Mark Freeman, the CEO and Managing Director of the Australian Foundation Investment Company, and welcome to this results briefing. I'd like to begin by acknowledging the traditional owners and custodians from all the lands that we are gathered on today and pay my respects to their elders, both past, present and emerging. I have joining me today on the webinar, David Grace, Portfolio Manager from the investment team; Nga Lucas, also from the investment team; Andrew Porter, our CFO, Matthew Rowe, our Company Secretary; and Geoff Driver, the General Manager of Business Development. Before we start the presentation, a bit of housekeeping on the webinar. 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, a PDF of the slides with page numbers is available on the website. Finally, please note following the presentation, there will be time for questions and answers. You can ask a question either via the webcast or through the operator. I will now start the presentation, and the team will then run through the remainder of the presentation before we turn to the question-and-answer session. So on the slide, Slide 2, there is a disclaimer, just to say we're here to talk about what we're doing in the company. We're not here to give any advice. On to the next slide, the agenda. I'll just give a brief overview of the objectives, and I'll pass over to Andrew Porter, our CFO, to talk about the results. David Grace and Nga Lucas will then talk about the market's portfolio activity and the outlook. So just moving to Slide 5, the investment objectives that the company aims to provide shareholders with attractive investment returns through access to a growing stream of fully franked dividends and growth in capital invested. So overwhelm is to pay dividends, which, over time, grow faster than the rate of inflation and to provide attractive total returns over the medium to long term. Before passing over to Andrew, I just thought I'd touch on ESG. It's clearly a big topic for all investors. At the moment, just a bit on how we think about ESG as the heading of the slides suggests that ESG considerations are integrated into our investment frameworks. The long-term sustainability of the company's business model is a key focus of ours and it's a key input in how we set quality. And so environmental, social and governance issues, lend them sales to an analysis of that. So it's a key part of our investment process. We regularly review companies to ensure ongoing alignment with our investment frameworks. Engagement with companies is also an important part of our process. We conduct our own evaluations on the merits of any shareholding resolutions and also take input from proxy advisers. But at the end of the day, we make our own decisions. We've got on all company resolutions as part of our regular engagement with companies and we actively engage with companies, including when we have concerns that those resolutions are not aligned with shareholder interest. So with that, I'll pass over to Andrew Porter to talk through the results.

Thank you, Mark, and good afternoon, ladies and gentlemen. So slide or Page 8, for those of you who are following the presentation at home. The profit for the half year at $163.7 million, that's up 12.2% from the same time last year. And there will be more details on the components of that and the shareholder review that will be going out of people's dividend statement. But in a nutshell, the contribution of the trading portfolio is up, profit on that was $2.9 million compared to a loss last year. And of course, the major component, the dividends that we received from companies that we invest in, we're up 10%. And major contributors that were companies like Woodside, Transurban, Mainfreight in New Zealand, Santos and the banks. So that increase in profit has led the next figure down to an increase in the interim dividend from $0.10 to $0.11, an increase of 10%. And that's in line with previous statements about trying to align the interim and the final dividends where possible. So if there is the ability to do so over time, 1 would expect to see the interim dividend, hopefully come up closer to the final dividend. The total shareholder return at 1.1%. The shareholder return is below the portfolio return. I'll come on to that in a minute. So that means that the premium of the shares trade at had come back at the end of December. So the figure on the top right hand of the corner, the management expense ratio, this is how much it costs to run AFIC that's equivalent to $0.13 for every $100 that you have invested in the company. The portfolio was actually down from last year, $8.5 billion at the end of December, down $9.6 billion the same time in 2021. So all things being good, you'd expect to see the MER actually increase on that. However, due to changes in remuneration policy, there was a profit from AICS, which is the company's subsidiary, which employs the people who work for AFIC and the other LICs, and that's had a short-term impact in lowering that MER 0.13%. The portfolio return as the 7.1%, including franking. That is below the ASX200 Accumulation Index. And David and Nga will go into some more detail on the causes and the reasons behind that later on. And as I said, last bigger bottom right-hand side, $8.5 billion, down from $9.6 billion on -- at this time last year. And just because I know shareholders are interested with regards to the franking balances that AFIC has. At the end of June, AFIC had effectively just under $0.37 per share after payment of the final dividend. And as you'd expect, if you've seen the financial figures, profit is a little bit higher than that. So actually, the franking credit is a little bit -- you would expect to see the franking credit balance being a little higher than that. So AFIC is still well reserved when it comes to franking credits. Moving on to the next slide on Page 9. That illustrates what I was talking about in terms of the premium that the shares trade at having come down during the year from the previous due to the shareholder return, the share price return being less than the NTA return. And that's what led at the time of the board inside a 2.5% discount to on the DRP or the share plan both DSSP that shareholders can invest in. So with that, I'll pass over to David and to Nga. Thank you.

Thank you, Andrew, and good afternoon, everybody. So moving on to Slide 11. As we've included in previous presentations, the charts on the slide show long-term valuation metrics for the overall market. The chart showing the price to book and price to sales of the ASX200 over the last 20 years. The help to understand market sentiments, particularly investor risk appetite towards the broader market. Although bounce around a fair bit, both measures indicate that the valuation of the overall market is slightly above long-term averages. And while a helpful starting point, we know the operating environment today for many companies is more challenging with earnings growth as part of combi, as leading economic indicators are slowing while companies are left with stubbornly high cost basis. As a reminder, we invest in quality companies over the long term. We want to benefit from the value of the compounding returns deliver to shareholders over many years. We're not trying to pick the next inflation data nor the timing of interest rate moves, spend our time identifying companies that can deliver meaningful earnings growth over our investment time horizon. Companies that own and operate highly strategic assets that provide a competitive advantage, driving the ability to generate free cash flow in a range of economic environments. Moving on to Slide 12. The operating environment for companies remains uncertain and investor sentiment is focused short term. Investors are weighing up the probability of economic recession, what will China reopening mean for global demand, the rising debt levels of governments globally and the rising operating costs for many companies. As I mentioned earlier, while we remain aware of the external operating environments, our focus remains on the fundamentals of the companies that we invest into, which companies are able to deliver meaningful cash flow growth over the long term companies with the opportunity to invest these cash flows to deliver superior long-term growth while maintaining strong balance sheets and being run by highly capable boards and management teams. Pie chart on the slide shows portfolio diversification as we look to build a portfolio able to perform in a variety of economic environments. So moving on the quadrants, we want a mix of growth companies holding market leadership positions where long-term growth prospects remain strong. For example, Goodman Group, CSL, James Hardy and REA, cyclicals with strong balance sheets, favorably exposed to the long-term economic growth, including resource companies, BHP and Rio Tinto. Officeworks was been companies owning difficult to replicate strategic assets, well positioned to deliver long-term earnings growth. These include the likes of Transurban, Wesfarmers, Auckland Airport and Woolworths. And finally, income stocks, companies with an attractive dividend yield as dividends play an important role in total shareholder returns. These include the banks, Telstra, Mirvac and JB Hi-Fi. As we look to deliver our investment objectives, we want to understand the attributes of each company and what purpose they bring to the portfolio, maintaining appropriate diversification across the 4 factors shown allows the portfolio to perform under various scenarios. So moving on to Slide 13. Chart on the left-hand side shows the relative performance of the portfolio against the ASX200 over various time periods. Including franking over the last 6 months, the market increased 10.8% and while the portfolio delivered a return of 7.1%. As a reminder, the returns for the portfolio is showing after tax and expenses. Tax was a meaningful drag on performance during the year as a results of the takeover or long-haul investment in Sydney Airport. Longer-term performance is slightly below the performance of the market. As we highlighted earlier, the variability of the operating environment over recent years has been as volatile as we've seen for some time. As shown on the slide, portfolio performance over the last 12 months has been disappointing. The 2 largest drags on performance are as follows: firstly, and the most significant has been a sharp pullback in share prices of many quality companies. These include James Hardy, Reece, Mainfreight and ARB Corporation. For context, all these companies delivered exceptionally strong returns in the prior 2 years, with all having delivered positive returns over the last 3 years, inclusive of the recent pullback. These are all high-quality companies well positioned to deliver strong long-term returns to shareholders. As a low turnover tax aware investor, we elected to hold on to the majority of our holdings in these quality businesses. The fundamentals of these companies are unchanged and following a period of overvaluation, we now consider valuations to be reasonable and have recently added to our positions in James Hardy and Reece. Secondly, and as the chart on the right-hand side shows the best performing sectors in 2022 were energy and utilities. Ultimately, the strong performance was reflective of the supply chain challenges for energy following Russia's conflict in the Ukraine. We do have some exposure to these sectors in the portfolio, albeit it's only small. These sectors are notoriously cyclical and as long-term investors, we see better opportunities to capture consistent earnings growth, where we stand to benefit from the value of compounding returns. In a market that was down 1% for the year, the chart on the right-hand side shows a huge dispersion of returns between the best and worst sectors with energy up 49% and information technology down almost 34%. Valuations in the IT sector reached extreme levels last year to a point where risk was being mispriced. While many of these companies have disruptive technology, the market is now starting to appreciate the level of investment required is a attempt to achieve scale. So moving on to Slide 14. Slide 14 shows the long-term performance of an investment in Reece, Australia and New Zealand's leading plumbing distribution business. We're using Reece as an example of the strong returns that can be achieved by maintaining long-term investment in quality companies. Pre dividends over 20 years, Reece's delivered an annualized share price return of 13.7%, materially outperforming the ASX200 return of 4.5% per annum. Despite excellent long-term performance, Reece has been a material drag on portfolio performance over the last 12 months. Share price fell 48% last year. This followed a strong run-up in the prior 2 years. Despite recognizing that Reece was overvalued, we elected to hold on to the majority of our holding as we see the long-term prospects for the company remaining highly attractive. Reece is a dominant market position in Australia and New Zealand, operating now out of more than 600 stores and has the investment attributes we look for. Market leadership in its core market generates strong free cash flow and maintains heavy investment in the business, both in product and technology, improving ease of doing business for their customers. It has a strong balance sheet and has a strong management team and Board with a long history of successful capital allocation. Reece entered the U.S. market in 2018 and has spent the last 4 years defining its competitive advantage. We visited the U.S. operation a few months ago, gaining a deep understanding of the long-term opportunity for the company. Reece's a current network of 200 stores in the U.S. with ambitions to make this far larger over time. Importantly, the company's strategy is aligned with our investment thesis. The growth in the U.S. will be patient and steady. Reece has a long history of excellent financial discipline while taking advantage of value-accretive opportunities as they arise. Moving on to Slide 15. Similar to the Reece example, many companies held within the portfolio have displayed an excellent long-term track record of financial discipline while delivering significant value for long-term shareholders. Slide 15 outlines 10 companies that have delivered strong sales growth over many years. All of these companies hold a market leadership position, all have strong balance sheets and all are run by excellent management teams and boards. The strong sales growth has been delivered over many market cycles, highlighting the well-managed quality companies with market leadership positions to deliver strong shareholder value over the long term. Well, over time, valuations of these companies have swung between fair value, undervalued and overviewed, all will maintain a strong profile of delivering shareholder value. All of these companies own and operate highly strategic assets have a defined competitive advantage, generate meaningful free cash flow and have a long track record of excellent financial discipline, delivering strong shareholder returns. We believe long-term opportunities for all these companies remain strong. So at this point, I'll hand over to Nga just to talk through recent portfolio transactions.

Thanks, Dave. Just over to Slide 17. Slide 17 shows our recent transactions. The companies listed on the left-hand side show stops we have trimmed or exited during the period. We trimmed our position in Ramsay Health Care after the company received a bid from KKR. The bid subsequently fell away, resulting in share price weakness. However, we remain comfortable with our smaller holdings. We trimmed our position in car sales, Amcor and NEXTDC to manage the size of those positions in the portfolio. In the case of Temple & Webster, with the share prices of many quality companies falling, we saw more attractive opportunities to reallocate that capital. The decision to exit Orica and Reliance reflects our view that the long-term prospects for these companies will be increasingly challenged as competitive intensity increases. On the far right-hand side, we show existing holdings that we have added to in the last 12 months. We used share price weakness to buy quality companies when we see value presenting. Short-term share price weakness gave us the opportunity to add to our holdings in BHP, Mirvac, Goodman Group, Santos, SEEK, Woolworths, ARB, Macquarie Group and Reece. We added to our position in equity trustees by an entitlement offer to fund the acquisition of Australian executive trustees. We consider all these companies to be high-quality companies. They generate significant free cash flow. They are run by strong management teams and have strong balance sheet able to fund future growth. In the new purchases column, we added 1 new stock, Breville. Breville is a well-known small kitchen appliance business. Following a number of years of strong profit and share price performance, recent share price weakness gave us the opportunity to initiate a position in the stock. We have long admired Jim Clayton, Breville's CEO and his strategy to take the brand offshore whilst building a more enduring platform for the brand. The company invests in R&D and in design innovation has an experienced management team and a strong balance sheet. In the following slides, we'll focus on a few portfolio companies in more detail highlighting why we consider them to be good long-term investments for the AFIC portfolio. On Slide 18, start with Wesfarmers. Wesfarmers is a conglomerate that operates a number of large, well-known retail brands, including Bunnings Warehouse, Officeworks, Kmart and Target. Wesfarmers also has a number of other businesses that operate in various industries, including chemicals, energy, industrial, safety and health. I'd like to turn briefly to Bunnings Warehouse, Australia's leading DIY hardware retailer. Bunnings is 1 of the best retailers in the world and is the key driver of earnings growth at Wesfarmers at over 60% of group earnings. It also generates the highest return on capital employed in the company. The business has a long runway of growth through store network expansion. They continue to focus on strengthening the DIY customer offering, expanding data and digital capabilities and targeting the trade customer whilst maintaining cost discipline. At the group level, we like that Wesfarmers looks to establish new businesses and invest in existing operations to provide a good return to shareholders in the long term. Examples of this include the development of the Mount Holland lithium project the establishment of the health division and their investment in the One Digital platform. The company also has a strong balance sheet and a highly regarded management team. Over on to Slide 19. Auckland Airport owns a high-quality dominant airport infrastructure asset in Auckland. The freehold nature of Auckland Airport and its large undeveloped land bank setted apart from other infrastructure assets. We think international passenger numbers will continue to recover post COVID. It is currently at over 75% of 2019 levels, and airport profitability should broadly recover in line with passenger numbers. China announcing the reopening of its borders should also help drive this recovery. The balance sheet is solid with ample capacity for future CapEx needs and the management team is highly experienced. Over on to Slide 20, PEXA. PEXA is a relatively newer company to the portfolio, having listed in 2021. PEXA is Australia's leading digital property settlement platform, allowing Australians to settle property transactions online rather than having to physically exchange paper documents. PEXA handles over 80% of all property transfers and over 90% of all refinancing transactions nationally. Its competitive advantage lies in it being a first mover in building the connections between 6 land titles offices, 5 state revenue offices, the reserve bank, financial institutions and conveyancing and law practitioners in Australia. The U.K. market represents a key growth opportunity for PEXA with an estimated market opportunity 2.5x the size of the Australian market. PEXA again has first-mover advantage in the U.K. and is leveraging their proven track record in Australia in establishing a similar platform. Management are making good progress in the U.K., and we are optimistic about the long-term opportunity ahead, which will take time to execute. At this point, I'd like to hand back to Dave for some outlook comments.

Thanks, Nga. So moving on to Slide 22. We've highlighted in the presentation today that economic conditions and the operating environment the company remains uncertain, effects of inflation and high living costs are placing pressure on parts of the economy. In this environment, investor sentiment is short term, waiting to determine the impact of company earnings from the challenging operating environment. And actively managing the portfolio, we look to identify quality companies, hold them in a meaningful way and look to own over the long term to benefit from the power that compounding returns can deliver to shareholders. Portfolio remains invested in well-managed, high-quality companies that own and operate highly strategic assets while maintaining strong balance sheets. . At this point, I will now hand back to Geoff to coordinate Q&A.

Thanks, David. [Operator Instructions] So the first question, which I'll pass to Mark perhaps. AFIC seems to be underperforming the ASX in the short and long term. Why shouldn't I just invest in an ASX200, ETF instead?

Thanks, Geoff. Well, as you can see on the previous chart, we're just a little bit behind the index. And clearly, our intent is to beat the index, and we're certainly working hard and focused on doing that and we'd like to see our performance improve going forward. I guess, having said that, just a couple of factors I would say is that we are comparing ourselves with the index. The index is pretax, pre cost. So I guess as an investor, you can't actually get to the index, we have certainly costs being taken out of it, but it's also pretax. We are post tax. We've actually developed quite a bit of capital gains at the moment. So we've got quite a lot of franking credit seeing on the balance sheet that we haven't paid out and until we do...

On the also on the balance sheet that's under the issue.

Yes. So we've got quite a lot about franking credits. And to the point we pay those out it's a drag on our performance. So I guess a couple of other factors is AFIC has had a much more stable dividend profile than being in the index, and we know our shareholders appreciate that steadiness to the fully franked dividends we pay out over the long term and the volatility of our returns, tends to be lower than the index. And obviously, through the LIC structure, it's a transparency it gives 2 investors as well. But yes, I reiterate intent still to meet the index over the long term.

Thanks, Mark. The question here about what investments AFIC has in lithium production. David?

Thanks, Geoff. So look, we do like the lithium thematic, but at the moment, there are no pure-play lithium producers in the portfolio. And thinking of the logic behind that is really just our caution around current valuation levels. So the lithium price is now trading significantly above cost of production. In fact, many multiples of the cost of production and with lithium as a mineral being widely available, we see that as a large incentive for new supply to come to the market. So -- it's a sector that we continue to watch, but our interest levels really would be at lower prices where we feel that the risk reward is more balanced than what it is currently.

Question about our holdings in Woodside and Santos. The questions -- I'll read the question directly. How can we be sure that you won't get the green bug and start off loading Woodside. Nothing -- noting that you increased your Santos position, which is good and also referencing the fact that we're under BHP was that a large contributor to the underperformance of the portfolio.

Sure. Yes. First of all, just touch on I guess, our view around the LNG or the energy market. So our exposures are through Santos and Woodside and quite rightly, we did add to our Santos position, having seen the share price fall quite materially during the period. Look, we view both of those companies is largely to be producers of LNG. And in our mind, that's a critical transition fuel as we do move towards energy coming from more renewable sources. But -- in that regard, we see demand remaining high for some period of time while that transition takes place. And we remain pretty comfortable to hold both of those companies believe that they'll both generate quite material cash flows as that transition occurs. In regards to BHP, so we were around index we initially and with an up wagon in the index having seen the collapse of the DLC structure out of the U.K. The index weight increased quite materially in that period. So that was about a 4% to 5% increase in the index weight. And while we did buy quite a substantial amount of BHP during the period. It wasn't enough to get us back to an overweight position. So while it was a drag on performance in the context of the things that I mentioned during the presentation, it wasn't material.

Another thing to add just on the Woodside in Santos. That transition fuel piece is obviously really important. But we want these companies to improve on their ESG capabilities. And certainly, they put out a ton of information on how they are looking to do that. So that's what we're looking for is our companies to continuously improve their ESG positioned and that helps us sort of sustain any investment in them.

Just on, this is a related question, I guess, in some ways. Given our portfolio focus regarding climate change. Do you think the portfolio reflects the ESG in this -- in the structure of the portfolio in terms of climate change.

Yes. So I guess just ESG more broadly as opposed to any particular element of that. We're certainly very focused on ESG, and it's 1 of the considerations that we take into mind with any investment we make or to hold on 20 investment. And just reiterating that our process is very much looking at the long-term performance of the investments that we make and ESG factors are critical in terms of the company being able to deliver consistent earnings growth over the long term. So it's certainly 1 of the key criteria that we look for as is many other things that really just affects the company's ability to be able to deliver strong share price performance over a long-term horizon.

Just a follow-up, Geoff, we have looked at the portfolio in terms of how it compares to the index in terms of carbon intensity, and it's well below the index. So it is something we will continue to track going forward. But as of everyone, all our companies to continuously improve on ESG factors.

Thanks, Mark, David. Has there been increase in international exposure in the portfolio and is still a plan to spin off the international LIC.

We've added a bit more to the portfolio. We do have the capability to add a bit more. But just to remind investors, we said we're going to keep it between 1% to 1.5% of the overall portfolio. So a very small overall position. Obviously, we want to develop a longer-term track record, which is consistent to our approach. The portfolio performance, we've been over the 6 months or a very pleasing 6 months. And so the pathway we see on a net gives us a lot of comfort. But it's just that longer-term track record we want to see first before we think about bringing it to the market as a product.