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WEEKEND LADDER

A summary of the week’s results

18.05.2018

Week Ending 18.05.2018

Eco Blog

- Workers around the world have not enjoyed any meaningful improvement in wages in this economic upturn. Australian employment growth is matched with an effective flat real wage growth rate.

- Similarly, historically low unemployment in Japan has had almost no decipherable impact on salaries.

- Consumer spending, by default, is restricting economic growth from accelerating in much of the developed world. In contrast, Chinese household consumption is robust. The adaption to new brands and trends could prove a hurdle for developed market companies that aim to take their formula into China.

Job growth in Australia remains sound if somewhat slow. Unemployment is stalled in the mid 5% range as new roles are met with a modest rise in the participation rate. The bulk of the jobs are unsurprisingly in construction, the public service and hospitality. The latter two are dampening the average wage growth to an annual 2.1%, which seems to have had a greater impact on consumer sentiment than any upside from the budget. The long-standing Westpac Melbourne Institute implies that most household are sitting at about average in terms of their financial circumstances, which aligns with other indicators such as spending growth and debt servicing.

Consumers Sentiment - April 2018

Source: Westpac-Melbourne Institute
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The household sector is likely to prove the key to any decision on rates by the RBA. A flow through of wage growth via the public sector is the most probable trigger.

  • Benign but soft economic conditions in Australia may be paralleled in both equity and fixed income indices this year. Nonetheless, security selection is as challenging and with as much potential for relative performance as before.

After a notably weaker tone in Europe, Japan joined that trend, printing a small contraction in GDP in the first quarter of the year. The consensus is that the conditions are not that bad and that the frequent revisions to GDP could well turn the quarter to a positive. Private spending was flat along with a moderation in exports, likely due to Yen strength. Matching trends elsewhere, wages have resisted the fall in unemployment, now at 2.5% growth.

Japan unemployment rate and wage growth (latest: March 2018)

Source: MIAC, MHLW
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  • Japan has been a productive equity regional allocation, particularly given the AUD weakness against the Yen. The longer-term story of better corporate governance, balance sheet management and global flavour of many Japanese companies still allows for stock selection.
  • In fixed income, for a Canadian investor for example, the returns from Japanese bonds allowing for currency hedging benefits, is higher than buying US treasuries yielding over 3%.

China has shifted strategy since Xi Jinping has cemented his position. Quality of growth is the mantra and an emphasis on self-sufficiency as it becomes confident in its status within the world. The more the US castigates China on trade, the more the government will want to develop its own expertise and extend its influence on global affairs.

Further, the constant adjustments to both fiscal and monetary policy are another potentially stabilising factor. Just as the tensions with the US increase again, land sales have taken an upturn, particularly outside the top cities. This plays to the inequality theme, a big focus in recent times.

Residential land sales by city category

Source:Deutsche Bank, CREIS
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This micro-management comes with an increasingly subdued infrastructure spending programme and the persistence of supply side reform that is expected to hold back addition to manufacturing capacity in basic industries.  This is in on top of the controls imposed on unregulated lending which will invariably reduce credit growth in the short term.

On the other side is high consumer confidence and buoyant services consumption. Homegrown development of brands and products are increasingly pronounced and in tune with the rapid turnover of the product lifecycle. A recent high-profile example has been the growth in a coffee company akin to the likes of Costa or Starbucks. Luckin Coffee has exploded from a start-up this year to delivering more than 5 million cups of coffee using well honed social media, free giveaways and narrowing the customer base to young office workers that are in very close proximity to an outlet.  The price point of coffee is also a telling sign on income and expenditure, averaging around US$4 per serve (in line with western world), with Luckin pitching in just below the other brands.

It reinforces that consumers in these countries are a complex mix of patterns observed in developed regions, but often with a unique twist that may not suit many corporations imbedded with an approach that seeks to replicate their formula across the globe. Copying the theme (coffee, loss leading to gain share), adjusting the offer on price (appealing to younger consumers), marketing (social media and app based) and convenience (400 stores in five months compared to the same number for Costa in 12 years) may erode the growth and margin of the global players. Progressing to employment via services is expected to be a key feature of coming years.

  • ‘Doing it my way’ is increasingly obvious across China policy and consumer trends. Along with the inclusion into the MSCI noted last week, the attention to investment options within China can only increase. We are therefore less enamoured by fund managers that want to point to the share of revenue from emerging economies as opposed to stocks domiciled in those regions.

Investment Market Comment

- Over the past year domestic small cap companies have provided strong returns while larger stocks lag. The allocation to small cap can be via our preferred managers or ETFs. In general, we prefer active management given the changing styles in the category whereas the ETFs will stay with their formulaic screens.

For the past twelve months we have seen Australian small cap stocks significantly outperform their large caps counterparts with the S&P/ASX Small Ords returning nearly 20% compared with the S&P/ASX 200 Accumulation return of 5.5%. Given this, we have highlighted the five small-cap ETFs available to Australian investors.

Both iShares and SSGA SPDR aim to track the performance of the underlying index. However, the SSGA SPDR the investment approach is 'sampling' rather than 'full replication' representing 70-90% of the stocks in the index. Current FUM is less than $20m and once it increases the manager states that it will adopt the ‘full replication’ approach. The purpose is to provide a portfolio with lower turnover, relatively accurate tracking, low costs, and sufficient primary market liquidity. Vanguard follows the MSCI Australian Small Cap Index, which represents the smallest 14% of Australian all company index. Vanguard is approximately 50% underweight to the top 20 performing stocks in the S&P/ASX Small Ords over the past year, implying illiquid, low turnover stocks have been stars. As a result, it has lagged the two ETFs.

Betashares Small Companies Select Fund aims to outperform the ASX Small Ords index through a rules-based and systematic screen that avoids poor quality companies. VanEck tracks the performance of the most liquid, dividend-paying companies. As with other market cap segments of the index both high-dividend and value funds have underperformed.

Small Cap ETFs, Small Ords and ASX200 Performance as at 30/04/2018

Source: Morningstar, Escala Partners
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The major driver in small cap outperformance has come from the miners, with the Small Resources sector producing a total return of 56% over the past 12 months. Naturally, fund managers who have been overweight materials have benefited from this.

Total Returns of Small Ords, Small Resources and Small Industrials

Source: IRESS, Morningstar
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However, with approximately 40% of the stocks in the Small Ords having fallen in value in the past 12 months, it is as equally important for managers to avoid these bottom dwelling stocks or the the corporate collapses. Pleasingly, the returns of most of our recommended funds have outperformed the Small Ords index.

Preferred Small Cap Mangers Performance as at 30/04/2018

Source: Morningstar, Escala Partners
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  • Given the overall track record of alpha generation of our recommended funds, we believe that investors should consider the benefits of active over passive investment options in Australian small cap investment management.

Fixed Income Update

- The US implied future rate of inflation, known as the break-even rate, hits a 4-year peak as we examine inflation linked bonds.

- Global bonds sell off as a rise in yields in both Italy and the US affect sentiment.

The absence of inflationary pressures over the last few years had inflation linked bonds offering little value to investors. As the name suggests, these bonds are designed to help protect investors from the negative impact of inflation by linking the bonds’ principal and interest payments to a recognised measure such as the Consumer Price Index (CPI). These instruments are commonly known as ‘linkers’ or ‘TIPS’ in the US. The structure of these securities is such that they pay a pre-determined regular coupon (for example, 1%) with the remainder of the return being linked to the inflation rate and capitalised daily into the principal value.

With inflation levels at particularly low levels these instruments have offered a cheap form of funding for issuers. This has led to market growth in recent years with global volumes said to have increased ten-fold since 2008. The government and corporates in United States, United Kingdom and France are the biggest issuers of these bonds.  As inflationary overtones build, these instruments have become more popular for investors seeking to hedge that risk. For asset allocators they increase diversification given the low correlation to other asset classes, and while similar to bonds in terms of credit security, should fair better in an inflation driven bond market sell off. 

This week the break-even rate, which is the future rate of inflation implied by the gap between yields on 10-year Treasuries and US TIPS, climbed to a four-year high of 2.19%.

10-year breakeven inflation rate

Source: Federal Reserve Bank of St.Louis
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  • Late last year many of our recommended global bond funds added to their allocation of inflation linked notes. Prior to this year’s spike, the break-even rate was low, making these instruments a cheap hedge to rising inflation.

Higher yields in the US and Italy have instigated the downward move in global bond prices this week, albeit the causes have are quite different.

Political jitters have emanated out of Italy on the back of talks that the ‘Five Star Movement’ and ‘The League’, are negotiating to form a government. Rather than bonds benefitting from a flight to safety, Italian government debt has been viewed like a credit selling into a ‘risk off’ move. The yield on the 10-year Italian bond hit 2.12%, up 0.17% and the biggest one day moves in 2 years. The gap between the German and Italian 10 year bond yield rose to its widest level this year. This is a broadly used indicator of political stress in the Eurozone area.

In contrast, a positive growth story in the US pushed bond yields higher following the release of solid economic data, including strong retail sales figures, and a rise in oil prices. The benchmark 10 year broke through 3% again, testing levels above 3.10%.  This marks a 7 year peak and is significant given the number of assets such as US mortgages that are priced off this yield.

Yield on the benchmark US 10-year government bond

Source: IRESS, Escala Partners
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  • Duration bond funds will invariable struggle though many believe the current bond yield is close to its likely upside unless there is a larger unexpected spike in inflation.

Corporate Comments

- Telstra (TLS) has guided towards the lower end of its forecast earnings range, however its core underlying profit is falling at a faster rate. The company’s dividend beyond this year is expected to be in focus given the lack of short term solutions to its problems.

- Growth has been priced an increased premium in the Australian market over the last 18 months. Three ‘market darlings’ provided updates this week reflecting this development, with CSL faring the best after an upgrade to its FY18 guidance.

Telstra’s (TLS) downgraded earnings guidance this week didn’t raise any new issues for the company, but rather confirmed an acceleration of the headwinds for its medium term earnings profile. While the downgrade was relatively minor in nature (EBITDA is now forecast to be at the low end of its stated range), this notably includes its one-off nbn connection receipts from the government, which will now be higher than previously expected. Consequently, on an underlying basis, the downgrade was worse than the headline level.

Presently, the core problem that TLS faces is one of competition. With the broadband and mobile markets now relatively mature in nature, prices have been falling in the ongoing battle for subscriber or market share growth. This is particularly evident in the mobile market which, until recently, was the primary driver of earnings for TLS. Previously, average revenue per user (or ARPU) was rising at a low or mid single-digit rate; now it is declining at almost the same pace. Combined with slowing subscriber growth, revenues and margins have come under pressure. Likewise, margins in broadband are being competed away given the increasingly commoditised service from the nbn.

Telstra: Mobiles Revenue and ARPU Growth

Source: Company reports, Escala Partners
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The prospect of increased revenues from higher mobile data usage over time has clearly not materialised, with consumers the winners from rising data limits at a lower cost. The short term outlook for the mobile market continues to be challenging. TPG’s imminent entry could potentially lead to a further step up in ARPU deflation given the company’s strategy of being the price leader while the introduction of unlimited data plans is an unwelcome development for the industry’s profitability.

TLS has been classed as a value stock for some time now and a more positive view on the stock would incorporate upside from a significant cost out opportunity than currently targeted and a re-emergence of its mobile network superiority with the rollout of its 5G network. The latter is longer dated and will require significant capital investment by the company and there is the unknown factor of possible cannibalisation of fixed broadband revenues if households switch to mobile-only.

The question of TLS’s dividend sustainability has inevitability been raised again this week following the downgrade. As a reminder, the company’s 22c forecast dividend for FY18 is a combination of that relating to underlying earnings (15c) and a special dividend component from its one-off nbn receipts (7c). The first part of the equation is under pressure given the earnings decline in its underlying business (>10%), while the latter will gradually roll off over the coming three years. Some analysts are already predicting reduced dividend payments over the next few years, thus reducing the attractiveness of the stock as a yield play for investors.

  • This represents a tough decision for fund managers. The headline yield including franking is circa 10% and the P/E is under 10 times. Assessing the potential outcome may take time and we will follow up with recommended managers on their views.

A number of companies more at the ‘growth’ end of the Australian equity market also provided updates this week. The share price reaction was reflective of the rising premium that has been incorporated into these companies. CSL, Treasury Wine Estates (TWE) and A2 Milk (A2M) have all been among the key individual stock drivers behind the ASX 200’s returns over the last 18 months amid a strong earnings environment that has led to positive EPS revisions for each stock.

Growth Stocks: Forward P/E Premium to ASX 200

Source: Bloomberg, Escala Partners
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CSL upgraded its FY18 guidance by 7.6% at the midpoint (and against the fairly recent hurdle of an appreciating USD), although a more modest 4% share price gain was indicative of a high degree of anticipation in the announcement. The company’s guidance was already considered to be conservative after a solid first half, with consensus forecasting an earnings beat.

CSL pointed towards positive product and geographic sales mix shift, although a severe northern hemisphere flu season (a positive for CSL’s acquired flu vaccine business) is unlikely to be capitalised. Nonetheless, the update was a further tick for the company’s management, with positive outcomes from its high R&D investment spend and robust underlying demand for its products. The stock has been an important contributor to the performance of the Investors Mutual SMAs over time and we have also held a position in our model equity portfolio.

China is the key theme behind food and beverage companies A2 Milk and Treasury Wine Estates (TWE) and both disappointed with updates this week. The China opportunity is no doubt significant for both companies, which has been reflected in sharp share price appreciation over the last few years, although it is rare that the growth pattern will be as smooth as hoped.

A2M issued FY18 sales guidance for the first time, which was slightly below that forecast by the market which resulted in a sharp sell off. The guidance still represents a substantial rise on FY17, although its growth trajectory appears to have been disrupted by a transition to a new label. A2M has been a favoured holding among small cap funds over the last couple of years (and the company has now graduated to the ASX 100), however, more recent commentary from several managers suggests that its valuation has become stretched.

Meanwhile, TWE disputed a report that claimed that inventory levels of its wine labels in China had reached worrying levels resulting in widespread discounting. While the company’s Asian strategy has proven to be a success in the last few years, issues have been raised around the limited appeal of brands outside of its Penfolds label, which are often bundled together in supply deals. Across the group, the mix shift to luxury higher-end brands has been an important driver of the company’s margin and earnings growth over the last few years.

While A2M is somewhat more reliant on its growth in China, the investment thesis for TWE is broader, with a balanced geographic mix across Australia, the US and Asia. For example, in the US, TWE is looking to shake up the legacy distribution model in the US with a direct to store solution that would capture a larger slice of the margin in the supply chain. Having only been announced fairly recently it remains to be seen whether the strategy will be successful. While management does have the runs on the board (and was validated after rejecting a takeover offer in 2014), TWE’s current share price and P/E of 28X arguably does not reflect the degree of cyclicality (admittedly which are often long in nature) that has historically plagued the wine industry.

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