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Insights

Bespoke market insights from our CIO

01.06.2014

Australian Equity Insights - June 2014

May was a month of consolidation for the Australian equity market, with the S&P/ASX 200 Accumulation Index inching higher over the course of the month.


There were a few key thematics that drove the market’s direction:

- In the materials sector, the iron ore price fell 13% to its lowest level since the sharp fall in the third quarter of 2012. The issue affecting the market this year has largely been supply-related, with Australia’s Pilbara producers adding significant tonnes to the global market, pushing prices down. Despite Chinese economic data and indicators being weaker in the early part of this year, demand has been quite strong, with record iron ore imports and steel production levels. The iron ore price has, in the past, bounced back from such falls rather quickly, although any recovery this time around is likely to be more subdued given the current supply/demand balance in the market.

- The budget caused some direct impact to a few select sectors, such as healthcare through the proposed introduction of GP co-payments and, on the other hand, contractors through increased infrastructure spend. The overall cuts in budget spending, however, are likely to have a broader impact on the market, with consumer confidence taking a hit and weaker retail spending figures.

- Globally, bond yields again defied the expectations of many to drop further, in many cases to the lowest levels in the past 12 months. Short covering and the speculation over the European Central Bank cutting rates further were behind the moves for the month. 

Source: Bloomberg, Escala Partners
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M&A activity appears to be returning around the globe, and the Australian market has been no different. SAI Global became the fifth ASX 200 company within the last two months to receive an indicative takeover offer, following on from Treasury Wine, PanAust, Goodman Fielder and David Jones. While recent targets have been characterised by underperforming companies, picking the next target is a game fraught with danger for investors.


Of note in May was a lack of downgrades in the market, with the month typically a danger period as we approach the end of the financial year. Trading updates were generally fairly positive, and companies that reported half yearly or annual results throughout the month were largely in line with expectations. 

Market Valuation (As at 31/5/14):

Source: Bloomberg, Escala Partners
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Australian equities were slightly higher in May, which has historically been a poor month for sharemarket returns. The energy sector was the best performer, which was driven in particular by further positive news on the PNG LNG project, in which both Oil Search and Santos have an interest. The materials sector struggled on the back of the fall in the iron ore price, with the major stocks in the index having significant exposure to the commodity. 


As we approach the end of the financial year, attention should turn to the expected earnings growth in the market expected in FY15. At this stage it appears that growth is expected to moderate compared to FY14. A large driver for this forecast is the lower growth profile expected in the key materials and financials sectors. In materials, cost reductions are expected to play less of a role in profit growth in FY15, hence production growth will become more important. For the banking sector, a low credit growth expectation, along with less scope for improvement in bad debts, points toward an expectation of mid single-digit earnings growth.

Portfolio Changes

This month we have made minor changes to both the core and extended portfolios.


In both portfolios we have downweighted the holding in Telstra (TLS) by 1%, and added to the existing holding in Transurban Group (TCL).


Telstra and Transurbarn are in the portfolios primarily for their income-generating ability and the yield they provide investors. We favour an investment in Transurban over Telstra at this point in time for several reasons:

Revenue Growth

Telstra’s revenue growth is expected to be more difficult over the next few years. The company has done an excellent job in offsetting the continued decline in its fixed line network with strong growth in its mobiles business. However, with overall market growth much lower than that experienced by Telstra - a large part of this has come through market share gains – this cannot be relied upon as a consistent source of profit growth. The ability of the telecommunications industry to turn mobile data growth into profit is also clouded at present, particularly as wi-fi hotspots grow in number and popularity.

Transurban’s revenue, meanwhile, has good growth characteristics, driven by increased traffic growth over time, CPI+ linked price increases and the operational synergies that are realised by owning a network of toll road assets.

Dividend

Investors have been expecting dividend growth from Telstra for some time now, and although the company slightly lifted its interim dividend in February, the ability to increase this in a material way over the next few years is limited given that it has a low earnings growth profile and it is already paying out the majority of its earnings in dividends. 

On the other hand, Transurban recently reaffirmed its full year distribution guidance. The company also is guiding towards an 11% increase in its distribution in FY15, despite recently undertaking a capital raising.

Acquisitions

Transurban has recently completed an acquisition of Queensland Motorways and a capital raising that was well received by investors. 

Telstra, meanwhile, could potentially make an acquisition in the near future, as the company now has a strengthened balance sheet following a number of asset sales over the last 12 months. With Telstra receiving payments from the federal government as consumers switch to the NBN, these are likely to be used to invest in new businesses to offset the earnings lost from its fixed line copper network. Telstra’s management acknowledge that there are few growth options left in the domestic market, and therefore the possibility of an overseas transaction would likely raise the prospects of achieving success.

Monopoly Assets

Transurban is the owner and operator of largely monopoly toll road assets, while one could argue that Telstra is moving in the other direction as it loses control over its fixed line copper network and essentially competes on a more level playing field through its retail business.

Performance and Attribution

In May, the Core portfolio outperformed the S&P/ASX 200 Accumulation Index, while the Extended portfolio’s performance was similar to that of the market.


The extended portfolio underperformed the core portfolio largely due to its holding in Super Retail Group. Super Retail provided a trading update early in the month, with mixed performance continuing across its various divisions.


Stocks to do well included Downer (a possible beneficiary of the Federal Government’s budget) and Macquarie (building on its full year result). Oil Search and Santos recorded good gains over the month as PNG LNG shipped its first cargo.


FlexiGroup lost the strong gains it had made in April despite a fairly positive strategy day mid-month, while Rio Tinto dropped on the back of a fall in the iron ore price.


We have detailed the top 5 and bottom 5 stocks from the Extended Portfolio, both from a performance perspective, and from an attribution (i.e. relative to its market weighting) perspective:

Source: Bloomberg, IRESS, Escala Partners
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Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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