FY24 was another positive year for domestic equity markets, with the benchmark S&P ASX300 index gliding up to record highs during the fiscal year. Sentiment improved with the interest rate hiking cycle coming to a pause, after a number of rapid interest rate hikes during FY23. The financials sector buoyed returns, while the resource sector languished against a backdrop of weaker commodity prices.

The High Conviction Fund (Wholesale) (the ‘Fund’) increased 4.2% net of fees in the financial year ended 30 June 2024, underperforming the benchmark ASX 300 Accumulation Index’s return of +11.9%.

During the year we were incredibly saddened by the tragic passing of our beloved colleague Michael Murray. Mike was instrumental in developing our equities capability at Australian Ethical and was a wonderful leader within our equities team.

The Fund transitioned to new portfolio management responsibilities and the weighting towards the Healthcare, Information Technology, and Renewables sectors was increased and now represent ~35% of the portfolio.

Despite delivering a positive absolute return for the 12 months to June 30, the Fund’s underperformance versus the benchmark largely reflected a handful of underperforming stocks that outweighed positive momentum in others. The Financials sector was the major contributor to portfolio returns however, with valuations beginning to look stretched, the Fund shifted towards an under-weight position in the sector. This proved to be too early and drove some of the relative underperformance, however, we believe we are well positioned going into FY25.

Information Technology was a positive contributor for the Fund, with the holding in software company, Nuix (NXL), performing very strongly. Over the course of the year, the Fund increased its weighting toward the technology sector, adding to its position in Pexa (PXA), as well as adding SiteMinder to the portfolio late in the year. Including other technology related companies that sit in other GICS sectors, the portfolio now has ~20% exposure to technology companies.

Despite a number of positives, a handful of stocks drove overall portfolio underperformance versus the benchmark. The Healthcare sector was a microcosm of this portfolio effect. While new stocks added to the portfolio performed well over the year – Resmed, Fisher & Paykel Healthcare – their contribution was outweighed by weakness in Ramsay Health Care, Ansell, and Healius. Healius in particular was the single biggest detractor from returns, as the company suffered from earnings downgrades driven by soft volumes and an ineffective acquisition strategy. Healius was divested from the Fund prior to management undertaking an emergency capital raising, and the share price has continued to trade lower since that time. Ansell was also divested during the year.

The Communication Services sector also detracted from performance in FY24. The Fund’s positions in large cap telecommunications companies, Telstra and TPG Telecom, were divested during the year given the ongoing structural challenges in the sector and replaced by fast growing small cap telco, Aussie Broadband. Domain Holdings had a disappointing year, but with property markets in key capital cities performing reasonably well and valuation metrics supportive, we think the outlook is positive for FY25.

Finally, company specific issues at Fletcher Building and Orora drove underperformance in those stocks. Fletcher Building faced a myriad of issues during the year, driving earnings downgrades and the exit of a number of key Board and management personnel. Orora badly timed the acquisition of Saverglass and with cyclical weakness in its key markets, also issued earnings downgrades. While FY24 was a difficult year for both companies, we believe the fundamental issues are cyclical and given that both stocks are trading on low valuation multiples, we continue to see fundamental appeal in both stocks and have therefore retained them in the Fund.

High Conviction (Wholesale) Fund Performance

As at 30 June 2024^*

^Benchmark is the S&P/ASX 300 Accumulation Index. Past performance is not a reliable indicator of future performance.

Inception date: 01/10/2021.

Contributors

• Nuix (NXL) was a key positive contributor to returns in FY24. Under this management team, the business has overseen significant transformation of the business, particularly in evolving the product offering and engaging with their customers, which has yielded positive results. The technology company provided an update that it was likely to exceed its annual contract value (ACV) growth of ~10% in FY24 and upgraded its earnings guidance following a key multi-year deal win in May. Management is expecting to be underlying cashflow positive.

• Westpac's (WBU) Westpac’s strong share price performance reflects the outlook for the sector to have lower bad debts than expected. Westpac has returned excess capital through a special dividend and has increased its share buyback program. Relative to other banks, Westpac has higher costs which it is looking to address through a technology simplification program. With mortgage competition easing and Westpac forecasting a relatively stable margin outlook, we remain positive on the sector to maintain dividends and healthy dividend income yields.

• Suncorp (SUN) is a well-run general insurance company. Near term margin expansion is expected as pricing increases to offset claims inflation and higher reinsurance costs start to earn through. Earnings have recently benefited from high levels of investment income which will moderate with any rate cuts. The sale of the bank to ANZ is expected to complete by the end of July 2024. Capital returns from the sale are expected from 1QFY25.

Detractors

• Healius (HLS) shares fell throughout the period amid diminishing Covid-19 testing revenues combined with solvency concerns around its balance sheet. These factors resulted in an emergency capital raise required by lenders to pay down debt. The equity raise, which was priced at a 30% discount, was accompanied by full-year guidance that implied a material 1H vs 2H skew at the midpoint. We divested our shareholding during the period and did not participate in the capital raise.

• Fletcher Building (FBU) detracted from performance in the period following disappointing earnings updates, legacy issues and concerns around the building company’s balance sheet. In addition, there was significant management and board disruption. We do see long term value in FBU, which has a strong market position in the NZ Building products industry, and expect that there will be progress towards resolution of their legacy issues by the end of the calendar year.

• Orora (ORA) shares declined as the packaging company lowered earnings expectations, primarily due to cyclical headwinds in the recently acquired Saverglass business. Whilst the longer-term business fundamentals are sound, the short-term earnings outlook has softened because of ongoing customer de-stocking and weaker consumer demand. More recently, the North American business outlook has also moderated as a result of softer volumes. Valuation at current levels is compelling, and we anticipate an earnings recovery and re-rate as current cyclical headwinds ameliorate.

Westpac: the bank's strong share price performance reflects the outlook for the sector to have lower bad debts than expected.

Portfolio changes

Additions to the Fund

• CAR Group Limited (CAR) is a global online marketplace and classifieds business which operates in the automotive, motorcycle, caravan, marine and equipment industries across Australia, the US, LatAm and South Korea. CAR has an attractive marketplace business model, dominant market position, strong cash generation and growth optionality in international markets which we view as a potential long-term compounder of earnings.
• IPH Ltd. (IPH) is an international intellectual property services group and is the largest filer of patents and trademarks in Australia and Canada. We believe that IPH is trading on an undemanding valuation and an attractive dividend yield.
• SiteMinder Limited (SDR) is a global hotel commerce platform provider, which offers accommodation providers a range of products to manage the distribution of rooms, take bookings from and communicate with guests. We are attracted to the significant growth potential as it raises its take rate in the large global hotels addressable market, driven by the rollout of its key new products namely Channels Plus (C+) and Dynamic Revenue Plus (DR+) which are on track to accelerate growth from FY25.

Reductions from the Fund

• Bank of Queensland Limited (BOQ) – The High Conviction Fund is concentrating its exposure to major banks with scale advantages. BOQ is embarking on a transformation program to lift return on equity and reduce its cost to income ratio by FY26. Preference has been given to NAB’s business bank differentiation and Westpac’s technology simplification program.

The Financials sector was the major contributor to portfolio returns however, with valuations beginning to look stretched, the Fund shifted towards an under-weight position in the sector.

Sector allocation

Sector overweights
Communication Services, Health Care, Industrials, Information Technology, Utilities (renewables)

Sector underweights
Consumer Discretionary, Consumer Staples, Energy, Financials, Materials, Real Estate

The Financials sector was the major contributor to portfolio returns however, with valuations beginning to look stretched, the Fund shifted towards an under-weight position in the sector.