Monthly Investment Review August 2013
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1 Monthly Investment Review August 2013 Presented by:
2 MARKET WRAP AS AT 31-AUGUST MONTH 3 MONTHS 6 MONTHS 1 YEAR 3 YEARS 5 YEARS INTERNATIONAL EQUITIES Dow Jones Industrial -4.45% -2.02% 5.38% 13.13% 13.93% 5.11% MSCI World Index -2.33% -1.28% 4.81% 15.13% 10.87% 1.83% AUSTRALIAN EQUITIES S&P/ASX 200 Accumulation 2.50% 5.33% 2.83% 24.28% 10.14% 4.65% FIXED INTEREST UBS Comp Bnd (0+yr) -0.32% -0.52% 0.73% 2.30% 6.25% 7.10% UBS Corp Bd (0+yr) 0.00% 0.43% 2.06% 5.68% 7.42% 8.00% PROPERTY S&P/ASX 200 A-REIT Accumulation -0.16% -1.78% -0.38% 16.58% 11.33% -0.83% Source: IRESS EQUITY MARKETS Equities managed to edge higher through reporting season, despite company outlook comments remaining very cautious. Dividends beat expectations, with Boards continuing to show a preference for returning capital to shareholders. Corporate activity remains depressed, but during the month Amcor and UGL (following Brambles last month) announced demergers. In small caps, Domino s Pizza and Iress made material acquisitions. Global macro data continues to be mixed, but was broadly positive during the month. US 2Q GDP came in at +1.7% qoq annualized (Bloomberg +1.0%) and the ISM beat expectations (55.4 vs. Bloomberg 52.0). Europe returned to growth after 6 quarters of contraction printing 2Q GDP at +0.3% qoq. Escalating tensions in the Middle East late in the month spilled over to spike the oil price (Brent +6%). The ASX200 (inc dividends) closed up +2.5% in August. The High Conviction and Socially Responsible portfolios performed in line with the market while the Income portfolio outperformed. Lend Lease, Seek and Southern Cross were top contributors to performance as their profit results and outlook were well received by the market. Trade Me and QBE Insurance detracted from performance as their results missed market expectations. FIXED INTEREST Domestic macro news flow remained weak, with nominal retail sales for June disappointing consensus for the fourth consecutive month (+0.0% mom vs Bloomberg +0.4%) while the July unemployment rate was 5.7% (Bloomberg 5.8%) but driven by a -0.2% decline in the participation rate. The looming Federal election (7 Sept) dominated news flow, with the Government pushing out expectations of the Budget returning to surplus to FY17 from FY16. The RBA cut the cash rate -25bp to 2.50%, and the AUD/USD was marginally lower ending at US$0.895 (-0.3c). The Fixed Interest portfolio outperformed the benchmark for the month. PROPERTY REITs closed out August by lagging behind the broader XJO, despite what would be characterised as an inline or above set of reporting season results. The Property portfolio outperformed the benchmark for the month. Page 2 of 14
3 MARKET REVIEW This month we will review the potential impact of the election, provide an overview of reporting season, discuss the recent improvement in European economic data and briefly discuss key risks. Election The polls are predicting a Coalition win and the bookies have paid out. As a consequence the market is likely to have already factored in this result. Nonetheless a change in Government and the end of this extraordinarily long election cycle will boost sentiment. A look back at the last 30 years and 11 elections, has seen the Australian stockmarket increase by 1.31% each month on average in the three months following an election. That equates to an almost 4% gain for the quarter immediately following an election. The key for markets will be a sustainable move in the economic data, particularly business and consumer confidence. Early in the year, low interest rates looked as if they were going to drive improved economic activity until dampened by the early election announcement. However more recently we have begun to see some signs of improvement, especially in the housing sector. We have summarised the potential impact of a change of Government on the prospects for various sectors. Sector Impact Reason Mining Positive Removal of mining and carbon tax to have a positive impact. Reduced red tape to be supportive of new projects. Large energy users Positive Removal of carbon tax. (airlines, steel) Telco Negative Fibre to the node to be accelerated under coalition means Telstra loses its monopoly position quicker. Large employers Positive Reduced union influence over time. Infrastructure Positive Reduced red tape to accelerate projects. Expect State governments and other projects on hold to accelerate post election Healthcare Marginal positive A little more sympathy towards profit motive of healthcare providers although budget squeeze will limit the opportunity. Retailers Marginal positive Potential pick up in sentiment post election. Page 3 of 14
4 Reporting Season Overview The reporting season started well but finished with a whimper. Overall there were around 43 positive surprises and 69 negative ones, with the key highlight being a 10% increase in dividends. Earnings forecasts largely met 2013 expectations for Industrial companies, with Resources a little weaker than expected. Overall the market has downgraded FY14 by 1.7%. A number of trends have emerged this reporting season: 1. Without a doubt the 10% increase in dividends was the highlight. However with payout ratios at the upper band of acceptable levels it will take earnings growth to drive dividends higher. 2. Sales growth was generally disappointing, reflecting the soft demand environment for most segments in the market. 3. Cost cutting was strong across a range of sectors, and the benefits of this cost cutting will continue to be seen in Interest costs surprised on the low side for a range of companies, reflecting the falling cost of funding. 5. Based more on discussions with management than actually seen in results, companies exposed to housing seem to be making a recovery in light of lower interest rates. 6. Outstanding results were noted from Internet companies such as Carsales.com, Realestate.com, and Seek. 7. Companies which have performed well over the past year have struggled to push on this reporting season. (Share prices are starting to reflect more optimistic outcomes for small cap high growth companies and large cap defensive companies). 8. Interest was starting to emerge in domestic cyclical companies thanks to better than feared results. Page 4 of 14
5 The market is forecasting 8% growth in FY14. The key drivers of growth next year will include: 1. Improved resource earnings as cost cutting delivers better outcomes and Chinese demand remains solid. 2. A modest improvement in demand for domestic companies as the A$ and lower interest rates improves the outlook. 3. Lower interest costs and cost cutting will continue to have an impact. 4. Lower A$ will have a strong impact on earnings growth given the number of companies operating offshore. Page 5 of 14
6 So given these drivers, it would appear as though we will see decent earnings growth for the first time in three years which is not inconsistent with past trends. A fall in interest rates should drive an improvement in the outlook for earnings eventually, which we tend to think has been delayed by the election this cycle. In terms of our portfolios as always, we had a number of outstanding results and some companies which disappointed. We would highlight Seek, Sonic Healthcare, Crown, Hendersons, Ansell, Southern Cross Media and Lend Lease as producing excellent results. The disappointments included QBE, Brambles and TradeMe. Below we highlight Seek and Trade Me: Page 6 of 14
7 Seek Source: IRESS Profit after tax was up 8%, while cash flow and dividends were up 27%. This was despite a very difficult year for their core domestic employment business which was down 7%. The International business was up 32% with Brazil benefiting from investment in recent years (up 46%) and China continuing to grow (up 20%). The education business (up 75%) also benefited from recent investment and the counter cyclical nature of the business (if people cannot find a job they opt for education). The outlook for Seek appears promising. We would expect earnings for the domestic employment business to bottom this year and that they will continue to enjoy strong growth internationally given their strong position in a number of markets (Mexico, Brazil, China, Malaysia, Singapore and Hong Kong). In addition the foreign student market is improving thanks to the falling A$, so we would expect Seek s international student business to demonstrate growth next year. Page 7 of 14
8 Trade Me Source: IRESS Trade Me delivered a result in line with expectations with revenue growth of 15% and earnings before interest and tax up 12%. The disappointing aspect of the result is that they flagged growth in FY14 will be a little below that in FY13 as they invest in staff and projects to ensure the long term success of their ebay like General Items business. General Items saw a modest 5% revenue growth in FY13 as they attempt to migrate the business from a focus on used goods, to one that targets new and used goods. This is taking a little longer than anticipated and hence the need to invest to ensure future success. Their classifieds business (selling cars, real estate and jobs) is performing well (up 29%) and the prospects remain very strong for this business. While we understand the market s reaction to this result we are quite relaxed regarding the long term outlook. Management are doing a sound job and we support their moves to continue to invest in their business. The long term growth outlook remains very strong and accordingly we have used the weakness to top up our investment. Page 8 of 14
9 European Data and risks to economic growth The surprise over the past month has been the improvement in manufacturing data in Europe as demonstrated in the chart below. The surprise packet is the UK which is now growing its manufacturing at the fastest rate in decades. While the growth is off a low base, expectations have also been very low. Europe continues to present significant challenges, however some growth offers hope that they can meet their challenges. The improved data is coming at the same time as solid results continue in the US and a slight improvement in Chinese data. The growth outlook for 2014 looks significantly improved as a result and we are seeing some tentative support emerge for resources. There are however three key risks at present. Risk 1: The US is trying to unravel their quantitative easing. There is potential for an increase in bond rates to undermine the growth rates. Risk 2: As discussed in recent months, China faces some structural issues around the level of debt and a housing bubble. Their ability to manage this will have consequences for their growth rate. Risk 3: Geopolitical tensions are rising over the Middle East. Global appetite for conflict appears low at present so we tend to think that any market instability associated with this risk will be short lived. Page 9 of 14
10 Top Down Our current positioning is as follows: 1. Offshore plays (AMC, BXB, ANN, QBE). There was some profit taking emerging in this segment at the results. Upside risk will arise from the currency shifting lower and by a global economic recovery. The downside risk will arise from any support emerging for the currency and the fact the segment is now well owned. 2. Rotation out of bonds into equities (HGG, MQG, QBE). This trend continues to emerge with recent fund flows supportive. Upside risk from earnings leverage as trend continues to deliver. Downside risk in the short term if markets sell off due to concerns re Syria. 3. Underweight defensive companies (WOW, TLS, Utilities). Stocks struggled to kick on during reporting season and earnings and valuation appear full. Nonetheless they can bounce on a relative basis if markets sell off. 4. Domestic housing related stocks (LLC, SGP, DLX). We have added to this segment given the improving sentiment and lead data on housing. 5. Sustainable growth stocks (TME, SEK, CWN, SHL, AZJ, AIO). Segment generally performed well for us during the reporting season. Strong performance should mean they are well supported by the market. 6. Resources (RIO, BHP). Chinese data has been more supportive, PMI was strong and Iron Ore prices suggest upgrades. However sentiment towards China remains weak and results suggests it is still some way off before shareholders enjoy capital returns. Page 10 of 14
11 PORTFOLIO MOVES High Conviction and Income Portfolios Purchase of Origin Energy Limited (ASX:ORG) Company Description Origin Energy has operations and projects spanning the energy supply chain; from gas exploration and production to power generation and energy retailing. Origin Energy is currently embarking on a company transforming development, called Australia Pacific Liquefied Natural Gas (APLNG), as it aims to monetise its large domestic gas reserves via LNG. Investment Thesis Origin Energy has lagged the market during the last few years as the market has been concerned around capital expenditure blowouts on its APLNG project and potential equity raising. The underlying utilities business has been impacted by steep competition and large discounts which is weighing on earnings. We have become more comfortable with these issues as we discuss below. Origin has a 37.5% interest in the APLNG project with a total cost for the project expected to be A$24.7bn. We note a number of analysts have factored in more cost overruns and we believe a lot of the negativity surrounding costs are well reflected in the current share price. Costs pressures have actually started to ease given the slowing mining sector is freeing up labour and this is giving Origin confidence on its ability to deliver the project within budget and schedule. The project is 50% complete and will start delivering cash flows in FY16. Competition in the retail electricity market has been fierce and Origin has been offering steep discounts to retain customers. This has resulted in a drag on earnings and while there is early signs of competitive stability this earnings pressure is expected to flow through in FY14. Price deregulation in Queensland and NSW will improve wholesale market dynamics and move to more sustainable long term retail margins. Page 11 of 14
12 Sale of AGL Energy Limited (ASX:AGK) We funded the purchase of Origin Energy with the sale of AGL Energy. AGL has also been impacted from competition in the retail market and we expect them to benefit from a rebound in the retail market, similar to Origin. The key difference between the stocks is their gas reserves. While we believe AGL will be able to monetise their gas reserves we feel Origin offers greater valuation upside through their APLNG project. Socially Responsible Portfolio Purchase of Slater & Gordon Limited (ASX:SGH) Company Description Slater & Gordon Limited is an Australian law firm focusing on Personal Injuries law comprising workers compensation, motor vehicle accidents and civil liabilities. Slater & Gordon also provide advice to organisations involved in commercial or business disputes. Slater & Gordon operates core businesses with 69 offices throughout Australia and across 10 locations in the UK. Slater & Gordon now includes five brands in total: Slater & Gordon (national), Trilby Misso Lawyers and Conveyancing Works (Queensland), Russell Jones & Walker and Claims Direct (UK). Investment Thesis Defensive company with growth characteristics non-dependent on macro-economic cycle. Unlike other areas such as commercial and property law, it is largely held that the Personal Injuries space, is relatively defensive and insensitive to economic factors. Personal Injury cases operate on a No win, no fee structure, but stringent case selection process enables some 90%+ success rate. This business model requires a solid balance sheet to be able to support the working capital that gets built up during the case with revenue only realised at the end of case (duration of 1-2 years). This puts the bigger players in a better position and bodes well for Slater & Gordon s acquisition strategy. Slater & Gordon s strategy is to consolidate the fragmented Personal Injuries industry through acquisitions in addition to organic growth. Slater & Gordon entered the UK market (4-5 times the size of Australian market) last year and have acquired 4 more targets. Management commentary suggests trying to lead the consolidation of UK personal legal services market as no dominant law firm brand exists. Expected to execute a number of further transactions over next 6 to 18 months. Page 12 of 14
13 From a socially responsible point of view, Slater & Gordon provides social justice. The No win, no fee structure also gives people with limited finances access to justice as they only pay law fees after the case is won and settled. Sale of InvoCare (ASX:IVC) InvoCare has been a long term solid performer for the portfolio but the position was sold after reviewing InvoCare s earnings outlook and price target. InvoCare provided a disappointing update at their full year 2013 result with lower funeral case volumes particularly in May and June impacting earnings. We continue to believe InvoCare has attractive investment qualities but believe this is adequately captured in the valuation. Page 13 of 14
14 SOURCES: Iress Deutsche Bank Citi DISCLAIMER In this disclaimer: "we", "us" and "our" includes the Company, its related corporations and their respective officers, employees and authorised representatives; a reference to this document includes all attachments. The information contained in this document is confidential and is intended solely for the addressee. If you are not the named addressee, you must not disclose or use in any way the information in the document. If you have received this document by mistake, please notify the sender immediately by reply document and delete this document and destroy any printed copy. There is no warranty that this document is error or virus free. This document may be a private communication, and if so, the views expressed are the views of the sender only and not those of the rest of us. We believe that the information in this document is accurate and reliable, but no warranties of accuracy, reliability or completeness are given (except insofar as liability under any statute cannot be excluded). We do not accept responsibility for any errors, omissions or negligence. This document may contain general financial product advice which has been prepared without taking into account your objectives, financial situation or needs. You should, before acting on the advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. This document must not to be distributed to retail investors outside of Australia. Page 14 of 14
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