Week Ending 04.07.2014
We will use this half way mark of the calendar year and end of our financial year to reflect on some of the trends of the past year which have had a meaningful impact on investment markets.
The most significant influence has for some time been central bank monetary policy, in particular that of the US Fed. The chart shows the path of interest rate management and the relative stability since the Fed pulled back on its asset purchases in December 2013. Within the coming 12 months, expectations are that the final phase will commence as the official rate is increased. To date, most have conceded that the process has been handled as well as what one could have hoped for, given the complexities inherent in guiding an economy through monetary policy. This has been key to the benevolent environment for financial asset values.
The relative variability in 10 year yields compared to the remarkable stability in yields on 2 year bonds has allowed fixed interest managers who can assess the likely path of rates to profitably trade the difference between the two. We note this by way on comment on the fixed interest asset class in that there are (albeit higher risk) opportunities to make reasonable returns, even in a low rate environment.
While reflecting the differential longer term inflation rates in higher yields, Australian 10 yr bonds have replicated the pattern of the US market even though economic circumstances have far from mirrored each other. The rise in the Australian bond yields therefore are somewhat disengaged from the relatively weak and uncertain outlook for domestic demand. As we have noted in recent reports, the resource export sector is contributing more than 1% to GDP and this is somewhat abstract from interest rate policy influences.
The easing of long term bond yields in the early part of this year caught most by surprise, pushing out expectations that the inevitable rise in yields will come through in the coming 12 months. This has deferred the evidence in the positioning of fixed interest managers, which have generally taken steps to dampen the impact of rate rises.
The consequences of higher bond rates is a matter of some debate, given the lack of historic precedent with respect to the absolute level of rates and the influence of central banks. The valuation of most components of investment markets is benchmarked off bond rates, and we would struggle to believe they will ignore a change in pattern. Our approach has been to diversify the risk both in the asset allocation and in the components within each asset segment. For example, we have recommended a limit to yield sensitive stocks in Australian equities, including hybrids.
The other major influence on portfolios has been the movement in the A$. Two factors are generally viewed as determining the direction of the currency, namely interest rate differentials and the terms of trade, or price of exports versus price of imports. The chart on the following page shows that interest rate differentials have moved away from the exchange rate in the short term. Either Australian bond yields have to rise relative to US yields, a somewhat unlikely trend, or the A$ is likely to trace downward. Late in the week, Governor Stevens of the RBA gave that impetus by suggesting the A$ was mispriced.
The terms of trade reflect the overall movement in commodity prices rather than just the iron ore price, yet it is the iron ore component that is now become the local bellwether.
The RBA has constructed a weighted index of all commodities (including rural) in both US$ terms (which is the predominant currency in which they are globally priced) and A$, based on our exports. Since peaking at an index level of 127.8 in September 2011 (in both A$ and US$ terms) the index is down 26% in A$ and 30% in US$ whereas the currency is down 15%. While one would not necessarily expect a parallel movement, either commodity prices need to stabilise or the support for the A$ is inevitably undermined.
These issues play directly into the outlook for the Australian economy and investment markets. Weak commodity prices will likely keep a lid on the performance of resource stocks, but in turn may result in a lower A$ and therefore help export profits, reversing the current drag on market: falling commodity prices, yet a strong A$.
The imperative for some kickstart for the Australian economy came from two data releases in the week. Retail spending in May was below par and while weather played a significant role, the pattern of spending is hardly a sign of growing economic contribution from the household sector. That said, households, as many note, are not in a great position to spend given high debt and moderating disposable income. The raw numbers for retail are also perhaps not a bad as the headlines suggest. Supermarket turnover, reportedly now supported by pushing prices up, has been steady. So too the turnover at cafes and restaurants, running at 11.3% growth YTD. It is the discretionary side which is muted, and that is broadly seen as due to consumer reticence as it is due to lack of appeal in the offer.
Housing approvals reported a strong uplift in May compared to last year, but are now trending sideways month on month, indicating the level of activity will peak some time towards the end of the year. With approvals skewed to apartments, the contribution from housing to economic growth will be less than the approvals numbers would indicate.
These data sets once again leave the question open on what can lift the profit growth rate for listed companies. With capital spending and expansionary strategies barely rating a mention (indeed more companies are proclaiming their determination to reduce spending), headline demand weak, it is up to cost reduction to provide the earnings growth. If successfully executed, it would support the potential for the ASX200 to move up, while it does little to lift domestic economic conditions. The singular factor that would be helpful to nearly all is a weaker A$.
Globally, economic releases followed the pattern of recent weeks. US payrolls for May was 288k versus expectations of 215k, taking the unemployment rate to 6.1%. Most expect the Fed to start introducing language on official rate policy by the end of the year in keeping with providing ‘forward guidance’.
European data tracked sideways, implying low but overall positive growth. Draghi continues to refine the support for the banking sector. Credit growth in Europe is still negative – a combination of weak demand for credit and bank constraint. But that has not hampered bigger corporations which have had ready access to capital markets. Nonetheless, Europe is more dependent on bank debt for its mid and small business sector and any way of encouraging them to spend and invest would be very useful.
Trends out of China point to continued efforts to gently warm parts of the economy without imbalanced stimulus. Under the spotlight this week was the regulated deposit to loan ratio, which distorts lending behaviour by the banks. Whether this gradualist approach to deregulation does enough to keep the growth rate ticking over will be tested in the second half of the year.
Investors brushed aside the $680m writedown of Target goodwill, presenting circa 35% of the intangible value for the division in Wesfarmers’ (WES) books, a creation of the acquisition of Coles Group. The group also announced a provision to restructure its liquor business through store closures and inventory realisation. Woolworths has had the upper hand in this product segment for many years and Wesfarmers looks likely to remain a second tier participant. The rebasing of asset values may be a sobering view of the likely profitability of a business and, in this case, Target’s market position is under severe pressure from new entrants as well as changing consumer patterns. It focuses investors on two unrelated factors we consider when assessing any equity investment. Firstly, that return on equity can be ‘managed’ and companies can conveniently ignore this when highlighting their achievements. Secondly, that good business, which Target once was, can fall by the wayside unless they keep changing. Strategic redirection may be painful in the short term and cause stocks to be sold off. We will at times exercise patience with our recommended equities if we are of the view the strategy may be rewarding in the longer term.
This week Carsales.com (CRZ) announced its fourth acquisition since the start of last year. While these other acquisitions have focused on taking stakes in international car advertising websites in developing economies, this time the company has moved into the vehicle financing space, with an agreement to purchase 50.1% of Stratton Finance, an online vehicle financing business, for $60.1m. While some may argue that the purchase appears to be outside of the group’s core competency and perhaps a sign that the domestic market is maturing, the move appears a sensible one in that it will allow CRZ to capture a larger share of the value chain and provide a more complete solution for private sales. Investors will also no doubt be pleased that CRZ expects the deal to be immediately accretive to earnings per share, and this was reflected in the positive market reaction this week following the announcement. We have CRZ in our model portfolios.
Wesfarmers was not the only company announcing writedowns this week, with Computershare (CPU) and Ansell (ANN) also foreshadowing the expected reduction in carrying value of certain assets at their upcoming results in August. In Computershare’s case, the writedowns are the result of a review of its non-core assets, a group which has expanded in recent years as the company has ventured outside of its key share registries business. The total size of the writedowns (US$40m) is not particularly material, however, given the size of its asset base.
Meanwhile, ANN’s writedown of brands that it intends to discontinue was sold in a more positive light, with an associated organisational restructure, which is expected to deliver ongoing operational savings within two years. This outcome looks to be important for ANN to achieve earnings growth given the challenges it has faced in recent times to grow its revenue. While investors will find these writedowns disappointing, management of both companies will be hoping that market’s attention in reporting season will instead focus on their results and outlook, and not dwell on the negative of these announcements.
Fund manager Henderson Group’s (HGG) acquisition of North American-based Geneva Capital Management was well received by investors, with the purchase looking to address its weaker positioning in the US market. HGG expects the transaction to improve earnings per share in the first full year and to give it the platform to grow its business outside of its core European market. Fund managers are expected to post strong profit growth in the upcoming reporting season on the back of favourable investment market conditions over the last 12 months.
Stocks such as HGG are a good play on this longer-term thematic of rising markets. With its dual listed structure (it is also listed on the London Stock Exchange), an unresolved question for analysts is whether it should be compared to its lower-rated peers in the UK, or the premium applied to fund managers in the Australian market. A greater focus for Australian investors should perhaps be a) the outlook for equity returns in the primary market in which it operates (Europe) and b) where exchange rates currently sit and where they are expected to move over time. With regard to the former, valuations look more attractive in Europe, however the economic recovery of the region is expected to be more protracted.
This week we increased the weighting of CSL in our model Core portfolio. The stock has been a market darling for an extended period of time now, as it has consistently delivered high earnings growth over the long term. This week the stock received an upgrade from a broker, highlighting the expected benefit that it should receive from issues with the flu vaccine of a key competitor, and thus the incremental sales that should result on higher market share for this season.
While this is a positive at the margin, the longer term success of the company is down to several factors – strong underlying demand growth for its product, a fairly concentrated supply side and a willingness to focus on driving long-term sustainable earnings growth through substantial R&D investment. Also underpinning its share price has been of series of buybacks – over the last four years these buybacks have totalled approximately $3bn, or close to 10% of the company’s current market capitalisation, further enhancing the group’s EPS growth. With a sound balance sheet, further capital management is likely to continue in the medium term.
FY14 Market Summary
FY14 proved to be another solid year of returns for the Australian sharemarket, with the key ASX 200 index rising 12.4% over the 12 months, or 17.4% on a an accumulation basis. The key index has now recorded four positive years out of the last five since the depths of the bottom in 2009, about the normal extent of this pattern.
A key difference in the market’s recent performance was that it was driven more by earnings. Coming out of the GFC, equity returns had, to a large degree, been driven by price/earnings multiple expansion, however earnings have picked up in the last 18 months. The market again, however, has run a little further ahead of this growth in earnings, indicating that the P/E multiple has again expanded to a degree.
The year was characterised by differing performance over the two halves. In the first half, it was the more cyclical sectors that led the way, including mining and energy stocks, cyclical industrials and diversified financials. This trend reversed in the second half, with higher-yielding defensive companies doing particularly well, particularly REITs, utilities and the major banks. The exception to this was perhaps the performance of consumer staples, with major retailers Wesfarmers and Woolworths struggling, along with Coca-Cola Amatil.
These trends can largely be traced to changes in both the economic environment (both domestic and international) along with fixed interest markets. In the second half of 2013, bond yields rose, global growth expectations were high, and commodity prices were generally accommodative for the mining sector.
A speed hump was hit at the start of 2014 as the US entered a ‘deep freeze’, triggering a pause in the country’s economic recovery and delaying the expectations of interest rate settings. Bonds have since rallied again, and local investors have switched back to higher-yielding stocks in the market. The low relative growth expectations and high valuations for many of these companies has led us to reduce their weightings in our model portfolios, although a catalyst is yet to emerge that will influence the broader investment community.
While markets have been trading at a slight premium to historic valuation levels, volatility has been particularly low, not only in Australia, but in global markets as well. This perhaps reflects a relative calmness amongst investors and a more relaxed attitude to risk, discounting the possibility of a sharp correction in the short term.
The table on the following page details the performance of the various sectors for the financial year, listed by total returns (inclusive of dividends) and earnings growth, the expected earnings growth for the next 12 months and the forward P/E.
Most notable from the table above was the performance of the materials sector, with the major mining companies benefiting from a much more refined focus on reducing their cost bases – these respective programs were put into place a little while after most commodity prices peaked in early 2011. FY14 earnings growth expectations for the sector has been pared back in recent months, particularly as the iron ore price suffered a substantial drop in the first half of this calendar year, although this was a supply-driven reaction. This has also translated into a much more subdued outlook for FY15, as the sector again faces the twin headwinds of a strong $A and a lower price environment – cutting costs further and/or increasing production levels could well be required to hit expectations.
Of the other sectors to do well, financials (excluding REITs) benefited from rising asset values, the banks were again assisted by cyclically low levels of bad debts, while the energy sector rose amid steady progress (and no major hiccups) at the various LNG projects currently under construction.
Looking ahead to FY15, the PEG ratio, or price to earnings growth ratio, gives us an indication of how current stocks are priced relative to their expected earnings growth. While our table lists figures that are relatively short-term in nature (a 1 year basis), the energy sector screens amongst the better sectors on this basis, with Santos, Origin and Oil Search all expanding their production as their LNG projects enter the production phase. Health care and consumer discretionary also look fairly good on this measure assuming earnings growth forecasts are achieved.