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WEEKEND LADDER

A summary of the week’s results

10.07.2015

Week Ending 10.07.2015

Eco Blog

As if Greece was not enough to occupy the attention of financial markets, the Chinese stock market made history in its volatility and the measures brought in to stabilise prices. A systems outage in the US stock market could barely surface through this noise.

By Monday there should be a clearer view on whether the European Union will continue to work with Greece towards some compromise, or whether it will be an exit strategy. At face value the challenge is that Greece will, at least in the medium term, need further funds until its tax collection kicks in. Politicians have the unenviable task of confronting the wrath of their electorates in risking even higher exposure to Greek debt, or alternatively taking it on the chin to write down the value of their debt holdings. Regional considerations of political stability, given Greece’s location, and the possible impact of an implosion of its economy may shift the dial in favour of a deal.

The medium term implications are likely to see stronger language from the ECB on monetary policy and its bond purchase programme to reinforce its support for other peripheral Eurozone countries. There may also be a small shift in tone towards growth rather than fiscal austerity. Both would be welcomed by financial markets.

As most noted, in the longer run China matters much more.  The roller coaster ride and extraordinary measures to stabilise the market has no precedent. Since June 4, the authorities have introduced 35 policies and announcements; below are the ten for 9 June alone. To cite the major restrictions: most large investors will have to hold their stock for 6 months, many securities are not trading at all, short selling is curtailed and margin lending pulled back.

Chinese Sharemarket Announced Policies

Source: Barclays Capital
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The question is, how damaging will this experience will be for China? There is little debate that the authorities actively encouraged equity investment as a way of taking some pressure off property as the predominant source of household assets. The total market value loss since its peak represents the annual GDP of the UK, though investors who bought in March are potentially still breakeven.

On the other hand, only 8% of households have any equity exposure at all, with the bulk of their wealth in housing or savings products. Given the downdraft to property prices in recent years, this would suggest that the reaction to the equity market will not be so substantial to cause economic issues. Falling house values may have tempered consumption spending to a degree, but China’s slowing growth is mostly a function of lower investment spending and exports.

The charts below show the valuation of market components and the correlation since early this year to margin lending. ChiNext is the Chinese version of the NASDAQ, and the valuations of small to medium enterprises (SME) also reached stratospheric levels. However, the big cap or ‘blue chips’ which are valued on global criteria, did not run up that far, and have only retraced on flow rather than a view they are now hugely overvalued. It is more than likely leverage will fall further given the government rules in place; not a bad outcome.

Chinese Sharemarket Indicators

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Comment is made that it would be best to allow some further losses to roll through before any additional attempts are made to stabilise the market, otherwise it is possible another fad market will follow. These events represent one of the few occasions China has mis-managed its financial and economic system and hopefully it can regroup with better oversight.

It is often stated that China has a lot of firepower to stimulate its economy. While that is the case, it will have to take some care on how it goes about this. China does have a relatively high level of debt, particularly in the state sector, and it would be counter-productive to encourage a major credit cycle. It does, however, have very little external debt and therefore could manage the direction of credit growth in some detail. The government has been edging towards easing financial conditions through lowering its interest rates and reducing the reserve requirement for banks. To date, the impact has been modest.

The other is the US$4tr in foreign reserves China has accumulated from its trade surplus over the years. Unlike other countries where the currency should have adjusted more when these surpluses were rising, China has managed its exchange rate and therefore does control this rather large pool of potential income. At this stage there has been no sign that the government would use this surplus as it appears to want to use these resources to fund the Asia Infrastructure Bank and to retain a large amount in anticipation of the eventual liberalisation of the exchange rate.

In summary, growth targets for China are proving much harder to achieve and it looks increasingly likely the rate of growth will reset more rapidly than previously anticipated.

Conspiracy theories ran thick and fast when the US experienced a number of outages on Wednesday, with the obvious question of whether cybercrime was the cause. According to Allianz Insurance, businesses do rate cybercrime and IT failure as a growing problem, though still overshadowed by internal risks and external catastrophes.

Top Business Risks for Worldwide Sample of Companies

Source: Allianz Global Corporate & Specialty
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Outside these top 10, climate change and volatile weather is rising, possibly exacerbated by the drought in the US, while technological innovation is falling, potentially as companies become familiar with these and adopt change. Inflation and deflation rate very low.

For Australia, based on a small sample, the risk ranking is different.

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A much greater anxiety on social media, competition and market fluctuations suggest many companies here are still struggling with the changing external landscape.

Locally, APRA has forced down the growth in housing, with May finance approvals falling sharply for both new and established homes as banks added to the required deposit for investor lending.  Housing’s contribution to GDP may fall below expectations in 2016.

On the other hand, employment is proving a lot more resilient than most economists had expected. June data has unemployment sitting at 6%, with decent growth in full time jobs in recent months. Other indicators, such as hours worked, were stable, giving no indication that labour utilisation was diminishing. Even the most mining of states, WA, sported solid numbers. Unsurprisingly, therefore the RBA has left rates on hold.

The US FOMC minutes were a touch more dovish and forecasters are dancing around the September versus December rate hike. The committee did note the issues in Greece and China as well as the modest rate of consumer spending, while also commenting on the steady improvement in the labour market.

Weak spots in global economic data has been a feature of Q2. The export engines of Germany and Japan have been notably soft in recent months. While some investors will turn this into a positive of even more financial accommodation, many more would wish for better growth trends and accept that it would then limit easing.

The UK budget made interesting reading. Measures introduced included:

-      Working age benefits frozen for 4 years

-      Child tax credits limited to 2 children from 2017

-      Personal tax threshold to rise to £11,000

-      Minimum wage to rise progressively from £7.20 to £9.00 by 2020

-      Mortgage tax relief reduced for investors

-      The corporate tax rate to be cut to 18% by 2019

-      Student grants for low income replaced by student loans

-      Threshold for inheritance tax raised to £1m in 2017

-      Abolition of non- domicile tax status by 2017

A feature is the low wage growth offset by limiting benefits and the Chancellor noted that the taxpayer has been subsidising costs that should be incurred by the employer. While only some 5% of workers are on the minimum wage, it is likely a larger group of lower paid will benefit as this trickles up the chain. Wage growth is already averaging over 3%, with legislation on minimum wages only likely to limit a growing wage inequality that would otherwise arise.

Company Comments

While equity markets have experienced a spike in volatility this week as a result of events in Greece and China, corporate news has been relatively quiet in the weeks leading up to August’s reporting season.

Caltex (CTX) reported its unaudited results for the six months to 30 June, which showed a 45% improvement in underlying profit. The company has made progress on its strategy to move towards a focus on its sales and marketing division, yet the volatility in its remaining refining business continues to drive the group’s overall performance. CTX’s Lytton refinery in Brisbane showed a marked improvement in earnings for the six months as a result of favourable refining margins, despite going through a period of scheduled maintenance. For the first four months of 2015, the average refining margin was US$15.71 per barrel, in comparison with the 2014 first half average of US$9.20. The chart below illustrates the level of volaility in refining margins over the past 2 ½ years, with the large gap on a rolling year basis the key reason for CTX’s higher profits.

Caltex: Refining Margin ($US)

Source: Caltex, Escala Partners
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The future success of CTX will be more dependent on growth in its sales and marketing division, which it noted was operating in challenging conditions with sales volumes of transport fuels lower in the half. Caltex has been one of the better performing Australian large cap stocks over the last 18 months, partly as a result of the increase in profits from its refining business (where it has converted its Kurnell refinery to an import terminal) but partly due to a re-rating of its earnings as this exposure has reduced. The stock currently trades on a forward P/E of 15.5X, which adequently reflects its outlook.

Following on from its recent strategic update, AGL Energy (AGL) updated the market on a review of its upstream gas business, which has resulted in $435m in asset impairments. As the company now has secured a contracted gas supply through the next decade, AGL will be spending less capital on further projects in this area, as well as divesting several non-core assets. The decision appears to be consistent with its revised strategy to deliver improved shareholder returns through capital allocation decisions that have more certain investment outcomes.

Separately, AGL also reaffirmed that its FY15 will be in the top half of its guidance range. AGL noted that a cool start to winter on the east coast of Australia had been beneficial to its retail business, something that should also give a boost to our preferred exposure in the sector, Origin Energy (ORG).

Webjet (WEB), which predominantly remains a domestic-focused online airfares portal despite diversifying somewhat in recent years, reported better than expected transaction volumes for the six months to 30 June. While Flight Centre (FLT) has had its troubles of late, we believe that it is better placed to deal with the structural shift of consumers looking to book holidays online given its market share in the more high touch packaged holiday deal segment.

ABS travel data out this week showed a more promising trend on trends in outbound international Australian travel, with annual growth at a respectable 4% p.a. While the growth rate has unsurpsingly fallen over the last few years on weakness in the $A and soft consumer sentiment, we believe that this long term positive thematic for the industry remains intact. A rebound in Qantas’ (QAN) share price over the last year does not reflect a booming domestic market, with domestic passenger growth negative year-on-year, but rather a more rational market in which capacity growth has fallen.

Australia: Short Term Residents Departing (Year-on-Year Trend Growth)

Source: ABS, Escala Partners
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Sector Focus: Health Care

While accounting for well under 10% of the Australian equity market, the health care sector has been an important source of returns for the long-term domestic investor. This week we look at the features of the companies within the index, the outlook and valuations across the sector.

Composition

Similar to many other sectors of the Australian market, the index is quite highly concentrated. CSL, at a market capitalisation of $41bn, is the largest company and accounts for more than 40% of the overall index. Ramsay Health Care (RHC) and Resmed (RMD) are the second and third largest companies, with both stocks just over 10% of the healthcare index.

ASX 200 Health Care: Sector Weights

Source: Iress, Escala Partners
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Characteristics

There are a number of broad characteristics of the health care sector that separate it from the rest of the broader market:

- the companies typically provide essential products or services and thus are less reliant on the economic cycle;

- as a general rule, the underlying growth of the industry is higher and relatively predictable compared to most other sectors of the market. Underpinning this growth is the long term structural trend of an ageing population and the rising complexity of treatments available.

- across the market, the sector has amongst the highest exposure to international earnings and thus will benefit from a weaker Australian dollar. While many Australian companies that have outgrown the domestic market have struggled when attempting to expand into international markets, the experience of our health care stocks has been much more successful. CSL, Resmed, Cochlear, Ramsay Healthcare, Sonic Health Care and Ansell can all point towards either strong or market leadership positions in their respective global fields.

- a select number of companies within the sector are dependent on the success of a single product or a small number of products (e.g. Cochlear, Resmed). This can result in a very high rate of profit growth when these are successful (particularly as a company leverages off a reasonably high fixed cost base), although the counter risk is a high level of earnings risk when specific issues arise with these products.

- the level of government funding is an important consideration with many of these companies as this will typically allow the products and services to be accessible to a broader population. The stretched nature of many government budgets could lead to either margin or top line pressure in the medium term.

- ongoing research and development investment is required by many companies in order to retain their respective market positions. Assessing this pipeline is the core of market rating of these companies.

- fundamental data points towards the strength of the sector; profit margins are, on average, higher than the rest of the market; return on equity is higher; cash flow generation is good and balance sheet leverage is lower. The downside is lower dividend yields as a result of reduced payout ratios and high R&D investment.

Performance

The healthcare sector has been one of the more consistent performers over the last decade. Over this time, the sector has generated a total return in excess of 300% (or 16% p.a.), compared with the broader market, which has doubled over this time (or a 7% p.a. return). The sector has also outperformed its global peers, as illustrated in the chart below.

Performance of Market and Health Care Sectors

Source: Bloomberg, Escala Partners
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This performance has been driven by robust earnings growth by the major stocks. The table below highlights the 10 year compound earnings growth of the key stocks in the sector:

Compound EPS Growth of Selected Stocks

Source: Bloomberg, Escala Partners
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While this performance has no doubt been impressive, the relatively high concentration of the index has led to a narrow set of companies that have comprised this performance – unsurprisingly, CSL has accounted for over half of the overall returns. Ramsay has driven just over 15% of the index’s return, with Resmed just under 10%.

Valuations

The price to earnings ratio of the health care sector (21x forward earnings) is at a significant premium to that of the broader market (15x), reflecting the characteristics, track record and outlook described above. Compared to how it has traded historically, however, the sector does not necessarily look expensive. The charts below show that health care is currently in line with its average premium over the last decade.

Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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Conclusion

The larger, established companies in the index typically have had excellent track records of long term value creation. While the size of several of these companies now will make it somewhat difficult to replicate this high historic growth rate, we believe that the outlook for many companies in the sector remains bright. The quality of the companies is also higher compared to the broader market; the competitive advantages of companies within the sector are stronger and more sustainable than most; the profitability and cash flow conversion across the sector is high, and the underlying growth environment is favourable. We believe that a well balanced Australian equity portfolio should have exposure to a number of these stocks as long-term holdings.

Within our model portfolios, CSL has been a core holding and has more appeal following a recent pullback. We have also added Regis Health Care (REG) as a smaller position in the last couple of months. We would be opportunistic buyers of Ramsay (RHC), Healthscope (HSO) and Resmed (RMD). Sirtex (SRX) has captured the attention of many fund managers and may be one to place on the radar. Some may feel they will miss out on the upside unless they invest early in a story, however we would note that a feature of the sector is the longevity of performance once established.

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