28 September 2023
Australian Financial Review
Todd Barlow, chief executive of the $11 billion investment house Washington H Soul Pattinson, isn’t surprised by the storm clouds gathering over global markets. The big shock is that they’ve taken so long to arrive.
Barlow delivered yet another set of strong full-year results on Thursday, with the net asset value of the group’s portfolio – which spans listed equities, private equity, private credit, property and also includes large, long-term holdings in a series of big listed companies such as coal giant New Hope Corporation and building materials and property group Brickworks – rising 8.8 per cent, or 12.3 per cent if dividends were reinvested. That was 1.2 per cent better than the return from the All Ordinaries accumulation index over the same period.
Washington H. Soul Pattinson CEO Todd Barlow has been bearish for a year. David Rowe
But the strength of that return belies both the drama unfolding on global markets, and the way Barlow and Soul Patts’ chief investment officer, Brendan O’Dea, have repositioned their portfolio for what is increasingly looking like a dangerous period.
As Barlow took investors through the Soul Patts results, the price of Brent crude oil rose to $US95 a barrel in Asia, the highest point for 12 months and a 32 per cent increase since late June.
As oil rose, so too did inflation concerns and bond yields, with the benchmark 10-year US Treasury rate holding its 16-year highs of 4.6 per cent. Just two months ago, the 10-year yield was sitting at 3.7 per cent.
This extraordinary move in bonds is finally pressuring share prices. The ASX 200 dipped again on Thursday, with the index now down 5.5 per cent since the start of August, and struggling to hold its year-to-date gains.
The lesson here is simple, O’Dea says.
“There’s no doubt that rates matter, and they matter across all investment classes, frankly. It’s our expectation that economies will slow and earnings are likely to be challenged going forward.”
Soul Patts’ portfolio is not immune from this, of course. Brickworks, in which it owns a 43.1 per cent stake, reported a 13 per cent fall in earnings from its building materials division, which Barlow says reflects both weaker consumer sentiment and rising costs – electricity costs were up 28 per cent, labour was up 13 per cent, maintenance up 12 per cent and some raw materials up 20 per cent.
But Barlow and O’Dea have prepared for the pressure higher rates will put on economic growth and earnings by dramatically restructuring the Soul Patts portfolio over the past 12 months.
First, the group’s large-cap equities exposure shrank by $1.2 billion during the 2023 financial year, as it focused on a smaller group of higher-conviction bets. Second, its net cash position has increased a stunning 87 per cent, to $911 million. And third, it has increased its exposure to private markets – private equity and private credit – by $1 billion to $1.9 billion.
“We’ve been a little bearish for the last 12 months and we’ve been caught a little bit by surprise at the strength of the equity markets in the last 12 months,” Barlow says. “We might be a little bit early on our call, or we might be wrong, but we’re lucky in the sense that we’re getting paid a reasonable clip to sit on cash.
“But I would say that you were starting to definitely see some early signs of the market coming to us. The price for risk and the price for liquidity is going up, whether that’s debt or equity.”
Private markets are hardly immune from slowing growth and weaker earnings, of course. But O’Dea says valuations in these markets have been much faster to readjust to higher rates than equity markets, which could have further to fall as a result.
In private credit, for example, base rates and credit spreads have moved quickly to reprice the new environment, which is why Soul Patts (and seemingly every other institution in the world) is rushing to lock in low double-digit returns by lending to the growing number of businesses who are being forced out of the traditional banking sector.
“You’re getting paid more than you would in the equity, but you also have your downside protected. It just makes a lot more sense for us,” Barlow says, while stressing that Soul Patts does not feel it is being forced to take out-sized risks to find these returns.
“We wouldn’t lend to somebody that we weren’t happy to own their equity.”
Similarly in private equity, Soul Patts is focusing on smaller businesses that don’t need large amounts of debt. Its largest exposures in this asset class include agriculture and water holdings, financial asset management and, of all things, swimming schools.
“We’re lucky that we can still get that bit of value from businesses that are not quite at scale or have fewer potential buyers for them. And therefore it makes them more attractive.”
Watching for signs of stress
Soul Patts’ recent shift to private markets has been spurred in no small part by its acquisition of Milton Corporation in 2021. Given this move, Soul Patts’ recent decision to increase its stake in struggling listed fund manager Perpetual, which is down 17 per cent since late August, attracted plenty of interest around the market.
O’Dea insists there’s nothing to see here – this is a value play, not a precursor to a bigger deal.
“We’ve been on that register for decades. We know that business really well – it’s a high-quality business with three very good embedded businesses there and good people running them. And simply we saw an opportunity to add to a position when the stock was under pressure post earnings [results].”
Soul Patts has also been playing close attention to the situation at beleaguered casino operator The Star Entertainment Group, which this week stunned the market by launching its second major equity recapitalisation in just seven months.
Barlow says Soul Patts had been talking to Star as part of the group’s debt renegotiations, but eventually the group decided on a larger equity raising and small debt package.
“Because of the small amount of debt they raised, the pricing on that is a little tighter than what we would typically look for, so we didn’t participate in the debt. Frankly, I think that the business could have supported more debt.”
Soul Patts took only a small slice of the equity raising, which received lukewarm support from institutional investors.
The eclectic collection of businesses inside Soul Patts, its long history (it celebrates its 120th anniversary as a listed company this year) and its sustained returns mean the group has occasionally drawn comparisons to Warren Buffett’s conglomerate Berkshire Hathaway; Bloomberg data puts Soul Patts’ total return over the past 20 years at 1368 per cent, compared with 643 per cent for Berkshire, which famously does not pay dividends.
The All Ords accumulation index has delivered a return of 460 per cent over the same period.
While Barlow and O’Dea believe Soul Patts’ shift towards private markets should insulate the portfolio from a potentially rocky year ahead, they are watching closely for signs of stress, particularly in consumer-facing sectors – where the latest retail sales data on Thursday showed softer than expected activity – and in housing.
But it’s interest rates that will continue to set the tone for markets, O’Dea says.
“There’s going to be pressure out there until markets decide where rates are going to settle.”
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