“China’s Tencent surpasses Facebook in valuation a day after breaking $500 billion barrier.”

CNBC, 21 November 2017

Over the long run, emerging market equities have delivered a total return of about 11.3% pa in US dollar terms (since the MSCI Emerging Markets Total Return index came into existence in 1988). This compares to an 8.0% annualised total return for developed market equities (based upon the MSCI World Total Return Index over the same time period).

For the year-to-date to 30 November, the MSCI Emerging Markets Total Return Index has returned 36.3%, far outstripping its long-term returns. More significant, though, is the make-up of those returns. The median stock in the index has returned only 21.6%, while 49 index constituents have returned more than 100% year-to-date. Of the 49 stocks to have more than doubled, 22 are in the information technology space, including Chinese internet heavyweights Tencent and Alibaba. Other mega-cap Asian technology names have also performed very strongly: Samsung Electronics +58.0%, Taiwan Semiconductor Manufacturing Company (TSMC) +41.6% and Naspers, a South African holding company with a 33.2% stake in Tencent +76.5%.

Even with strong underlying growth in these companies, we feel it is paramount as investors to maintain valuation discipline at all times. We do not intend to cover all our research on these stocks in this article, but would like to provide an update.

We feel the Tencent business model is one of the strongest in the world. Whilst its total addressable market is smaller than Facebook’s, its core business continues to grow revenues successfully without overly relying on advertising. Cloud and payments have beaten analysts’ expectations, while the cost pressures in the video business seem to be abating. Against this, though, is the degree to which the share price has out-run earnings. Tencent is valued at 37.6x 2018 consensus earnings, which is near the 40x earnings which has historically formed the upper limit to the stock’s valuation range. Even modelling for significant success in cloud, payment and video, we find it difficult to see great upside from here and do not hold Tencent directly. Rather, we hold a significant position in Naspers. Naspers trades at a deep discount to its underlying net asset value (in fact, Naspers trades at a discount to its stake in Tencent alone), and we see Naspers as undervalued, with an exciting portfolio of assets other than Tencent, as well as a cheap and defensive way to have exposure to Tencent. We retain a significant position in Naspers.

We feel it is paramount as investors to maintain valuation discipline at all times

Alibaba is a stock which has delivered very strong results in the last two quarters, both from monetisation of the Chinese user base, and also growth in the international business. Again, this seems to have been significantly valued in by the recent share price rise, and we find limited value above the US$180 per share level (note that we initially bought Alibaba at US$64 about two years ago). We have been reducing the position into strength and are now significantly underweight relative to the index weight.

Similarly, in the semiconductor space, we find TSMC challenging at above 15x forward earnings and have been reducing into strength. There is no denying the company’s edge in its sub-20nm products for high-performance chips, nor the strong return on capital seen in the last four quarters of results, but even pricing this in, we find reduced upside and prefer to allocate capital elsewhere. In contrast, and as previously detailed, we find the low valuation, strong operational performance and improved corporate governance at Samsung Electronics highly attractive and retain a substantial investment in the stock.

Large index constituents delivering strong returns can be challenging for active portfolio managers. We have enjoyed strong returns from mega-cap Asian technology stocks, but our valuation process is now causing us to increasingly differentiate between them.

Fund Manager commentary for the month ended 30 November 2017 covering market reviews, BT Investment Management fund performance and outlook for the period ahead.

Access the commentary here.

In this final newsletter of the year I want to broaden out our analysis of the global reflation theme. While that theme begins and ends in China, I believe this year’s award for ‘Most Improved Economy’ should go to Europe. We take a detailed look at the quality and composition of Europe’s recent growth spurt, assess the sustainability of these growth sources, and break down the ECB’s (and other European central banks’) approach to rate setting, QE and tapering into 2018.

View the newsletter here.

BT Investment Management’s Crispin Murray, Vimal Gor, Peter Davidson and Ashley Pittard provide a summary of the key drivers of investment markets in 2017 and share their thoughts on the prospects for each asset class in 2018.

Look beyond the headlines

It is customary to sit back and take stock at this time of year to contemplate what has been, could have been and what is likely to be. Participants in investment markets are accustomed to navigating developments on many fronts and 2017 has offered its fair share of these. Fear factors ranged from North Korea’s nuclear aspirations, Trump’s ambitions to thwart those of Kim Jong Un, Amazon’s desire to scare domestic retailers, Holden marking the end of car manufacturing in Australia and Tesla revealing it fell short of its production targets due to a shortage of batteries to power electric cars. Add to these the constant reminders of escalating household debt, housing affordability, persistently low wages growth and pundits even warning of the next global financial crisis, the average investor has had enough reasons to be fearful.

However, capital markets didn’t quite see it that way. Australian and offshore share markets have delivered healthy gains to investors and other asset classes have achieved positive returns. It shows that market noise can be disparate to reality. Investors who looked beyond the headlines with a degree of perspective and remained invested have done well this year.

Australian shares

Investors in Australian shares oscillated between fear and favour for Resources and bond-sensitive stocks, although Resources may have won the battle this year, with a sector return of 17.5%, compared to 8.4% for Industrials. But look a little deeper within the sectors and there are a plethora of winners and strugglers. Consider the retailing segment, Breville Group (+56.9%) has continued to be a solid performer, although sellers of Breville products like Myer Holdings (-40.0%) and Harvey Norman (-16.9%) languished. Within the travel and leisure segment, Qantas (+78.5%) materially outpaced Virgin Australia (+21.7%). In Media, Ten Network (-82.7%) ran into financial trouble while Nine Entertainment (+61.5%) saw a strong recovery in ratings and earnings.

These varied results provide another timely reminder of the importance of deep and rigorous company research to identify risks and opportunities within the market. Most importantly, the quality of a company’s management team and its strategy in navigating a challenging environment to ultimately drive stock performance should not be underestimated.

“The uncertainty created by disruption is unlikely to abate. This leads to mispricing and therefore great opportunities for active fund managers like us to add value, which is what we saw this year.”
Crispin Murray
Head of Equities

The Australian market does not have the same proportion of high growth stocks as the US so we won’t face the same issue with market valuations in that market. At recent levels the market is considered fair value. In the year ahead, valuations will largely be driven by earnings which are expected to be around mid-single digits. Add a sustainable dividend yield of 3-4% and we should see another healthy total return from Australian shares in 2018.

Australian Listed Property

The listed property sector produced healthy double digit returns over the 12 months to November on the back of solid earnings growth and rising asset values, although some of the gains were surrendered in January. Retail property was an expected focal point for investors, given the economic influences of dwindling retail sales and wages growth together with household indebtedness and the anticipation of Amazon’s arrival in Australia. Hence, retail property was not the place to be for investors, with weak returns from Westfield, Scentre Group, Vicinity Centres and Stockland – which together represent over 40% of the A-REIT index. The Office and Diversified REITs sectors delivered double-digit returns, while Industrial REITs – which are limited in offerings – was the best performing sector.

“US bond yields are an unavoidable headwind for the listed property sector, but the market can really be differentiated by qualitative factors”
Peter Davidson
Head of Listed Property

Filtering the sector for quality provides a fundamentally attractive picture. Despite the interest rate headwinds, key support factors such as the net withdrawal of Sydney office supply, low debt profiles, long term leases with inflation provisions and low vacancy rates make listed property an attractive asset class in 2018. The sector offers fair value and is priced at a discount to the direct property market, based on prices paid in major property transactions this year. We are expecting total returns of 6-8% in 2018.

Global shares

Global equities did a reasonably good job of delivering the growth our super funds aspire to achieve, with more than half of the companies within the MSCI World Index rising by at least 10% (in Australian dollar terms). Most regions registered double-digit gains, led by the US (+19.9%) with two thirds of US stocks achieving a positive return. Investing in the mega-techs – Facebook (+46.9%), Netflix (+44.5%) and Alphabet (ie. Google, +24.7%) – delivered exceptional returns. The S&P500 Index closed at record highs 59 times this year. In contrast, the UK (+6.4%) was a distant laggard while the euro zone (+12.0%) was backed for early signs of economic recovery.

We continue to believe that the tailwinds over the last five years which have rewarded indiscriminate broad market exposure are becoming headwinds. This approach is unlikely to yield as market valuations become less compelling and monetary support is ratcheted back. Moving into 2018, the market environment will be best suited to selective ownership of quality companies that are well positioned to withstand a higher interest rate environment and an uncertain geopolitical landscape.

“Share prices are unlikely to continue moving ahead in unison. The changing market environment means investors need to be conscious of valuation, conscious of franchise strength and cautious on cash flow”
Ashley Pittard
Head of Global Equities

Fixed Interest

Australian fixed income posted reasonable returns in 2017, with little differentiation between the Government and credit sectors. Markets began pricing in expectations of rate hikes early in the year before pushing out the theoretical tightening timeline. Returns across the major overseas bond markets ranged from -0.9% to +2.0%, with the global fixed income asset class as a whole returning -2.7% . The Australian dollar appreciated 4.8% against the US dollar but weakened against the euro and British pound over the year. Although returns were muted across the government sector, credit investments performed well as they benefitted from strong share market performance. Strong appetite for risk also transferred to the high yield market, where the yield premium over investment grade credit tightened to levels not seen since 2014 when the market began to correct.

“Looking to the year ahead, we are wary that the goldilocks environment that kept yields range-bound and risk assets supported in 2017 will not be sustainable. We believe a defensive fixed interest allocation remains a critical component of an investor’s portfolio.”
Vimal Gor
Head of Income & Fixed Interest

Factors like an unprecedented unwind of accommodative central bank policy and a leadership-directed shift in the composition of Chinese growth highlight the risks facing credit and government bond markets. This in turn threatens to spark the return of volatility, as well as imbalances like the strong run from high yield credit to correct in 2018.

Investment implications

Investors need to be resilient to market gyrations and ensure risks are appropriate within their overall investment portfolio which is less likely to replicate the path set in 2017. Asset allocations need to be balanced to reflect the inherent shifts in market leadership on many levels. Interest rates are more likely to increase than decrease, albeit in a trajectory that follows evidence of sustainable economy recovery. Investors should also maintain an allocation within a multi-asset portfolio to the Alternatives sector through a selection of strategies that have a low correlation to equity and bond markets and therefore offer additional diversification with the potential for enhancing returns.

Thankfully, I do not have to make predictions on markets. Looking back to January 2017, who would have guessed the direction and particularly the trajectory of markets in Asia? With that said, we are to some extent in the business of estimating future outcomes. By buying or holding certain stocks, I do make implicit assumptions of what I hope or anticipate might occur over time.

Questions, questions, questions

There are several big issues for markets to grapple with. We are in a synchronised global economic recovery. Commencing around mid-2016, growth has accelerated globally in 2017. How strong and how long it will last is the big question. Central banks, especially the Federal Reserve, seem to indicate a determination to ‘normalise’ monetary policy. Will the Fed raise rates four times in 2018? Will the unwinding of its balance sheet be smooth, or will it disrupt asset prices across the world? Geopolitics, both in the Middle East and around North Korea, keeps hitting the headlines. With President Trump seemingly embroiled in several unfavourable domestic issues, will the US resort to distracting domestic attention towards foreign entanglement? In my naïve analysis, signs of inflation seem to be sprouting everywhere – whether it’s commodity prices or wage inflation or in the general cost of doing business. Will inflation reflect in the numbers in the US and drive long bond yields higher? And, finally, a benign liquidity environment has powered a rally in momentum growth stocks. Does that pause or continue? Will out-of favour sectors and countries be the beneficiaries if that happens?

Liking North Asia, tech and financials

By looking at the allocations in the portfolio, the tilts you can observe are towards North Asia for countries and technology and financials for sectors. Technology stocks have delivered high growth but valuations have expanded as well. With that combination comes susceptibility to a pause in momentum investing as well as a rise in bond yields which can impact valuations for these names. I am reviewing some of my technology holdings in the hardware manufacturing area with a high possibility that I could trim some of them. A large allocation to China indicates my assumption of a benign outlook in China. GDP growth might not be stellar, but growth in cash profits and earnings for corporate China could be surprisingly robust. Internet-related companies are likely to sustain growth over time. 

The tilts you can observe are towards North Asia for countries and technology and financials for sectors. 

In the ‘old’ economy, a couple of developments are worth noting. The resolve demonstrated by the government in removing capacity in the steel, cement, coal and aluminium industries has been, in my view, a significant event. Take steel as an example. By shutting approximately 7% of capacity in the past 15 months, the surviving companies are generating solid cash profits.

After sustaining cash losses in 2015 and early 2016, the steel industry in China is now earning substantially higher cash margins per tonne of steel. Once considered a big negative in China – diktat by the government – now looks like the saviour. Whether it is due to environmental pressures or the threat of trade sanctions, these capacity restraints have helped the steel industry recover smartly. Cynics will ask how long can this last. Can the government remain committed to these shutdowns? Will such high profits not tempt the industry to reopen those plants that were shut down? Of course there are valid questions and there is a risk of re-openings. However, in my view, apart from the survivors which benefit from capacity shutdowns, there is an unintended positive impact on China’s banking sector. In the past, banks were directed to lend to companies that created jobs and resulted in GDP growth. Never mind that the rising capacities imperilled the profitability of borrowers and in turn hurt the banks due to rising non-performing loans. With several ‘old’ industries generating better growth in profit and cash flow, the banking sector in China is starting to see a positive change in the health of their leveraged borrowers. GDP growth might not be stellar, but, for a change, cash flows and profits for industrial China are growing. If this lasts, it will be positive for macroeconomic stability and for the banking system as a whole.

Rising Chinese bond yields

For banks and financials in China, another development worth noting is the rise in 10-year government bond yields. A rise in the cost of money is exactly what China needs. In the past, I’ve commented on the fact that money was too cheap and abundant in China, which in turn allowed growth in leverage and misallocation of capital.

The clampdown by authorities on capital outflows is likely one reason for this increase in the cost of money. The shutdown of irrational borrowers, like the Anbang Insurance group or the HNA group, and the recent crackdown on P2P lenders and micro-lenders are signs of a return to some rationality in China. As these irrational borrowers disappear from the scene, the genuinely good financial institutions (yes, there are some in China too!) are starting to assert their competitiveness. We own two of them: Ping An Insurance and China Merchants Bank. If my analysis is right, not only will they benefit from higher margins but also from a large increase in market share at a time when economic growth is stabilising and profits for China corporates in general are better. In sum, I am a bit more sanguine on profit growth in China, wary of momentum and aware that the biggest risk we face is a dislocation of bond yields if inflation reflects in numbers in the US. I do think we have a balance in the portfolio to mitigate some of that inflation risk, but, as always, time will tell.

I wish you a Merry Christmas and a prosperous 2018.

Tax reform legislation finally seems to be moving along in the US. While the equity markets cheer, the consequences for junk-rated issuers can be very unpleasant. As much as 4/5 of the high yield issuers could be worse off as a result of the proposed changes, which may in turn exacerbate and accelerate the current default cycle.

Under the current tax “reform” bills that have been passed by the US Senate and House, legislators have imposed a cap on interest deductibility at 30% of EBIT and EBITDA, respectively. On the flipside, issuers will also receive a lower rate of tax at 20% and have the ability to fully expense capital items in the year purchased rather than depreciate over a number of years. It has been argued that allowing immediate expensing of capital expenditure will promote more spending and economic growth. 

Our concerns with these likely tax changes are both the intended as well as unintended consequences to credit markets. Various estimates suggest that under the House version of interest deductibility (maximum 30% of EBITDA) approximately 40% of non-financial issuers will be unable to fully deduct their interest expense. However, that is the more generous of the two proposals. Under the Senate version that has interest deductibility maximum of 30% EBIT, approximately 83% of non-financial issuers will be worse off than present. Prima Facie, with no change other than the interest cap, investors can determine that high yield companies that do not have greater than 3x interest coverage (‘low end’) will be worse off. The negative impact of the proposed legislation largely affects B and CCC rated issuers, and will lead to increased spread dispersion among high yield issuers – a trend that has been developing over much of this year even in the absence of the latest set of tax proposals.

Our concerns with these likely tax changes are both the intended as well as unintended consequences to credit markets. 

The proposals not only put further pressure on the already strained cash flows of many high yield issuers, but also amplify the downside of credit cycles. Since the deductibility of interest is a function of earnings, as earnings wane so will the issuers’ ability to claim a deduction for interest, creating a double-whammy effect on corporate earnings and liquidity in late economic cycles. Consequently, such a tax law will only increase the volatility of cashflows experienced by high yield issuers. This increases the jump-to-default risk of levered issuers that have low levels of interest coverage. 

As such, we believe a cautious stance towards high yield credit remains warranted. This is alongside a number of other concerns for the area including a wave of industry disruption, which poses a particular threat to the Consumer Discretionary and Telco sectors. Considered within the context that spreads are near their pre-GFC lows, the potential limited rewards do not justify the increasing risks.

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1 Peer rankings are determined by Pendal using Morningstar’s universe of Equity Australia Large Blend, Equity Australia Large Growth, Equity Australia Large Value, Equity Australia Mid/Small Blend, Equity Australia Mid/Small Growth and Equity Australia Mid/Small Value funds. See here for more details.

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This year I’ve made significant changes in the portfolio. In our monthly updates and calls, I’ve mentioned the challenges I’ve had with performance over the past 12 months. The reasons can be summed up in three buckets:

1.  A couple of stock-specific mistakes (Giant Manufacturing and PChome Online, both listed in Taiwan) where disruption of their businesses by internet-enabled competition affected them in a sudden and unexpected manner. 

Giant’s bicycle manufacturing business, which I thought was relatively immune from the challenge of online retail, was upended by the proliferation of app-based bicycle sharing business models in China. The novelty and ease of renting bicycles has dramatically cut back the desire to own them, especially the high end ones. Giant’s sales growth in China and margins overall suffered as a result. 

PChome Online had a reasonably dominant hold on online shopping in Taiwan until a private/venture capital-funded company (which only recently listed) came up with a much better user interface and offered free delivery for goods, forcing PCHome Online to respond and sacrifice margins and profits. I have since sold out of those names.

2.  Post the US elections, interest rates rose a trifle, coinciding with a global cyclical recovery. China Mobile and KT&G in Korea, (both are cash-generating business with low to slow growth) suffered a de-rating on their multiples. I sold out of both.

3.  Indian Prime Minister Modi’s decision to demonetise high value currency notes in November 2016 caught me off guard – some of our holdings were rural consumer focused; the impact of the withdrawal of notes was felt mostly in rural India where cash still remains the primary medium of exchange. Small businesses across the country and the agricultural sector were hurt badly and many people employed in these areas witnessed a tough economic situation. Many consumer-oriented businesses reach rural India through the ‘wholesale’ trade. The wholesalers – middlemen – in turn reached far corners of the country dealing with ‘mom and pop’ stores in rural areas. This part of the chain deals in physical cash. This link of the distribution chain was severely affected. Some of our holdings had an adverse adjustment to their business models and they are still recovering from that blow. 

India in focus 

A year since demonetisation, I thought it would be apt to take stock of its impact, the performance of stocks as well as the exposure of our portfolio to India, which has come down over the past year. It’s not just my reduced holdings but also the composition of those holdings which has changed.  From 2015 when almost one third of the portfolio was invested in quality Indian stocks, our exposure to India stands at around 12%, of which half is in cyclicals.

Many commentators rightly point to the long-term attractive nature of the Indian market. I have never disagreed with that premise. I won’t bore you with the details but favourable demographics, rising income, aspirational middle class, well-managed businesses and, of course, a change in government in 2014 were just some of the arguments in favour of India. Yet, in my opinion, the Indian stock market does not seem to be as attractive relative to the other Asian markets.  

For any asset to deliver positive investment returns, we need a combination of three factors: the asset has to be cheap on an absolute or at least on a relative basis; the asset should display either rising earnings or improving cash flow profile; and we must encounter a benign and improving liquidity environment.

A benign liquidity environment, thanks to a depreciation of the US dollar has been a common factor for all of Asia. However, only in North Asia have all three factors come together in my view. India, on the other hand, remains a haven for liquidity. The external benign liquidity remains turbocharged by the super abundant domestic liquidity. This was a direct result of demonetisation, when all of the cash in circulation was forced into the banking system. Deposit growth surged at a time when loan growth moderated due to a much weaker economy. 

While the liquidity situation in India remains very conducive, in a regional context, the stock market is not cheap. 

Two traditional stores of value, gold and property, were adversely affected by demonetisation. These asset classes were typically the repositories of unaccounted cash and, after 8th November 2016, it was not easy to transact in those assets. In effect, savers in India had very little choice. By default, equities became the preferred asset. Inflows into the domestic mutual funds have sky-rocketed in the past year.  

This mismatch between deposit growth and the need for loans/funding by the economy was so wide that interest rates started to come off sharply. Since that initial shock to demand, especially in the rural and agricultural parts of the economy, demand conditions have remained subdued. Reported GDP numbers for India have shown the nature of the slowdown in India. Witness the credit growth conditions in India broken down by regions and scale of industries below.

But in this subdued environment, there is just one area which has witnessed an exceptional boom: personal lending – some for mortgages but mostly for unsecured loans – soared. 

There are several explanations for this. As the shock of demonetisation affected smaller industries, many smaller businesses and individuals were forced to borrow money to stay afloat. State-owned (SOE) banks are in dire condition due to non-performing loans (NPLs) and are in no position to lend. As interest rates fell, non-banking financial companies (NBFCs) benefited the most from a reduction in their cost of borrowing; they have more than adequate capital. Along with better technology to assess borrowing needs, wider reach through branches and agents in urban areas and credit bureau infrastructure to assess risks, almost all NBFCs have powered ahead in their lending spree.

There is no doubt that a good credit bureau system and use of technology to assess risks are big positives. As I mentioned, SOE banks are on the floor and in no position to compete. With unsecured loans still a very small percentage of GDP, there is genuine room for growth. 

All these are very valid and sane arguments. Yet there is always an element of unbridled optimism when it comes to unsecured lending. Currently in India, there is a surge in new finance companies (not just fintech) starting up to take advantage of this big opportunity. With the government about to recapitalise the SOE banks, they, too, might be in a somewhat better position to compete in this space. I do not mean better from a risk assessment or technology standpoint, just better on interest rates. Ultimately, similar to any banking system in the world, the price of loans will be the key area of competition, thus in a way undermining the risk characteristics of this lending opportunity.

India’s near-term blues 

The bigger question that plagues my mind is the effect of a slowing economy on disposable income. So far, almost every company we meet remains very optimistic for the long term, but over the next 12-18 months suggest a very uncertain and muted demand environment. The effect of the Goods and Services Tax (GST) in consolidating industry structures in favour of the bigger listed firms is self-evident. Yet there are teething troubles in implementation of GST. That is a minor impediment. The bigger one is the disruption to small-scale businesses which leads to a fall in employment. Similar to the rest of the world, technology disruption will also have a dampening effect on employment generation in India. Data is hard to come by, but anecdotal evidence suggests that job creation still remains the single biggest challenge for the country. Demonetisation and introduction of GST in quick succession has dealt a significant blow to small enterprises. 

While the liquidity situation in India remains very conducive, in a regional context, the stock market is not cheap. Indian stocks have always enjoyed a premium over the region, but that was at a time when the rest of the region had little to no earnings growth. As we look into March 2018 and March 2019 growth estimates, what strikes me is the very narrow group of stocks particularly in materials and banks that will contribute to the earnings growth expectations. 

While private sector banks and NBFCs will deliver 15-25% earnings growth, they trade on P/E multiples of over 20x while their price-to-book ratios average 4x for 20-22% ROEs. That is not cheap in my view, by any means. These premium multiples I cite for banks are what I also observe for comparable Indian businesses in the quality space. As the saying goes, that the grass is always greener on the other side. But my question is: is this grass or AstroTurf?

Edwina Matthew, Head of Responsible Investments at Pendal, talks about our approach to responsible investing and current issues we have been working through with investors.

BTIM’s Davidson and Forrest on how Amazon is reshaping malls

When Myer declined to renew its lease at Westfield Hurstville, a Scentre Group shopping centre in NSW, a chill went through the property trust sector.

“They needn’t have worried,” says Julia Forrest, one of the portfolio managers behind BT Investment Management’s listed property strategy. “That space that was doing $30 million is now doing $100 million,” she estimates. “It’s a buzzing centre, it was an amazing opportunity to transform what was an old, tired centre into a food hub with lots of services, some mini-majors, that has just driven traffic through the roof.

“If Myer wants to close some boxes there’s certainly opportunities across the portfolios to really invigorate that space.” As many as 19 of Myer’s 63 stores could close or shrink, the department store has flagged. “I’m sure they’re looking at other spots where maybe Myer won’t renew and are thinking the same thoughts.”

Forrest and Pete Davidson, who is BTIM’s head of listed property, heard the drums beating about Amazon’s arrival in Australia many years ago. And while they do not take the seriousness of this threat lightly, they argue the property sector has not got enough credit for how it is responding.

“This is the long game, it’s probably going to be a 30-year game.”

“What people probably underestimate is the response from the shopping centre industry. The ability to use technology to improve the shopping experience be it parking or be it what’s offered to customers, that’s something that isn’t in the equation at the moment,” says Davidson. “This is the long game, it’s probably going to be a 30-year game.”

Westfield Group, which the fund is overweight, surged last week as global interest in top mall operators returns. New York-listed General Growth Properties was linked to buyout talks with its major investor, Brookfield, but Davidson says sentiment towards Westfield had already been turning.

“There’s been a lot of circling interest in the stock, which needed a catalyst. Most people accept that there’s a great NAV or asset value uplift that’s coming there through the developments such as Croydon, Milan and most recently Century City,” he says. “Also US retail is recovering. Really the market’s just looking for some guidance for next year, which we’ll probably get at the AGM in February.”

However, they do not share the same confidence for “B-grade” office and “B-grade” malls.

‘Shrink more to greatness’

The US mall experience is useful in approximating Amazon’s impact but it is flawed too. American malls do not have supermarkets as anchor tennants because grocers, as they are known, are located on “strip” shops.

“There are some areas of weakness, obviously discount stores and department stores, which are probably going to shrink more to greatness,” says Forrest. “But the generation of foot traffic going to supermarkets – if you’re doing two visits a week, you’re generating a massive amount of foot traffic that you don’t see in the US.”

Davidson thinks the Amazon factor peaked when it acquired Wholefoods. “But if you follow it at the moment, Amazon are actually withdrawing some of their fresh offer across nine states in the US because it’s quite hard to make it work,” he says. “Yes it’s a concern but I don’t think it’s terminal. If you assume that Amazon got 3 per cent share of Australian retail sales in the next few years that’s roughly equivalent to $9 billion, which equates to the sales of Big W.”

Before funds management, Davidson started out as a treasury dealer with Midland Montagu. Forrest was investigating organised crime. They have been at BTIM 23 and 15 years respectively.

The strategy is reducing office exposures, but they note the incredible levels that assets are changing hands at because of the influx of offshore money.

“B-grade office is selling 19, 20 thousand [dollars] a square metre, which is above replacement cost,” Forrest says. Even so, “the [listed] sector’s actually cheaper than buying direct, you can access better quality assets in the sector cheaper than if you were to go to the direct market and you obviously don’t have any transaction costs.

“If you were to go buy an office building on this street [in Sydney’s financial district] you might be paying 4, 4.5 per cent and you can buy a vehicle that may be yielding 5, 5.5 per cent with growth and obviously you don’t have to manage it yourself.”

In New Zealand, they own Precinct Properties and Vital Healthcare, and in childcare, another sector they like, the fund owns Arena and Folkstone. “The working for families initiative means there will be a big release of government payment next year to boost the sector and it’s also defensive and reliable,” Davidson says.

Strong assets

Mirvac is the fund’s largest stock overweight at the moment. It “has got some of the best earnings growth in the sector, very good management team, great ESG, good office portfolio,” Davidson says. Its retail assets are in “really strong urban locations” that are not experiencing as sharp wage pressures as elsewhere in the economy, according to Forrest.

Beyond Westfield and Mirvac, the third main overweight position is Charter Hall, which is exposed to rising asset values in office and industrial.

“Like most property tragics, we end up with phones full of photos of shopping centres,” says Davidson, who scrolls through hundreds of images of shop fitouts and al fresco dining areas.

The discussion has turned to Stockland Wetherill Park in Western Sydney, a property where Stockland has also utilised rooftop solar targeting 1,200,000 kWh annually.

“They’re recreating a little bit of a Melbourne vibe, it’s like a Melbourne laneway in Wetherill Park. And you can do that, it’s got a nice inner-urban feel about it,” says Davidson.

“It’s worth noting they focus a lot on walkability within their new subdivisions so that’s great, you can only admire that. They’re looking at the whole issue of a better sense of community, a better sense of belonging, more exercise and better health outcomes.”

In terms of assets, he also rates highly Scentre Group’s Chermside – “Brisbane’s Chadstone” – and North Lakes, another Queensland attraction. Mirvac’s 200 George Street gets the tick as an innovative office property, and Goodman’s logistics joint venture out at Oakdale is “in some ways the mall of the future”. He has also been to an Amazon distribution centre in Shanghai, which spanned 400,000 square meters or two-thirds of the size of the Pentagon.

“It could be New York, London or it might be Maitland. We’re there.” 

Forrest nominates Westfield London as the best shopping centre in the world, “in terms of curation, presentation, market presence, domination, transport and keeping it relevant and dynamic”. She also recommends the Tramsheds foodhall at Harold Park in Sydney, a Mirvac project linked to its residential development.

“You know you’re passionate about a job when you do it for free, it’s so interesting,” says Forrest. At Westfield Stratford City, another Westfield property in the UK, shoppers can only walk in one direction on the busiest trading days because the mall is so congested, she says.

“We’d categorise the market into fortress malls, and alternatively, safe neighbourhood. It’s the piece in the middle which is a little bit riskier,” says Davidson. “There’s risks there, but I think largely in the price.”

In the next couple of weeks he is going to Maitland to look at a new Stockland shopping centre. “It could be New York, London or it might be Maitland. We’re there.”