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Weekend Ladder
A summary of the week’s results
Week ending: Friday 9th
January, 2015
Giselle Roux Chief Investment Officer David Bruty CFA Investment
Analyst Liz Harrison Fixed Interest Analyst
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Eco Blog As is often the case, the bond market summarises the
evolution of the Australian economy over the past two months. Bond
yields have fallen to all-time lows as the commodity cycle
continues to deteriorate, consumer traction fails to grip and
inflation looks likely to be low for some time.
Source: IRESS, Escala Partners
A thin set of data releases gave few indicators on near term
direction. Trade data for November was better than expected and the
numbers for the prior few months were revised sharply up. Despite
this, a deficit was recorded for most of the year due to falling
iron ore prices and the import of capital equipment for LNG
projects. The ABS appears to be struggling to adjust data for the
variable value and volumes in commodities. In coming months, LNG
exports will start to exponentially accelerate from here on and
should result in a much smaller deficit over the course of 2015.
The question then arises whether export LNG prices hold on to their
current levels. Building approvals followed the pattern of the past
few months with apartment
approvals sharply up, housing flat and non residential still
falling away. This uncomfortable pattern where low interest rates
is fuelling housing investment and little else will continue to
challenge the RBA this year. Many economists, while on aggregate
betting on a rate cut, take the view that the fall in the oil price
and the A$ (in effect a rate cut) may see the RBA sidelined for the
foreseeable future. At a headline level, retail sales for November
were in line with expectations. Within that however, there were
some interesting changes. After a strong period, spending in
restaurants and cafes has pulled back, indicating this renewed lack
of confidence emerging from households surveys. Turnover in food
sales remains higher than one would expect given the low inflation,
suggesting retailers have been slow at passing through lower
prices. In discretionary goods, the iPhone impact lingers in the
data along with decent growth in homewares. However, the previous
uplift in clothing sales faltered, possibly as consumers held
back
2.0
2.2
2.4
2.6
2.8
3.0
3.2
3.4
2.0
2.2
2.4
2.6
2.8
3.0
3.2
3.4
Australian Bond Yields
10 yr bond yield 3 yr bond yield
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spending in anticipation of the year-end sales. Indications are
that after a soft period, consumers have been willing to spend in
the seasonal sales period. What remains to be seen is whether this
is the beginning of a better period of retail spending, the effect
of lower fuel prices or simply the readjustment of sales as
consumers narrow their spending window to the discount periods.
European data shows little signs of life. On one hand, German
employment remains rock solid at a globally comparative
unemployment rate of 5.0%. However, business activity is weak, as
is clear from the composite PMI chart below. Germany and Spain are
positive but easing, while Italy and France are making no
contribution to growth within the Eurozone.
European PMIs
Inflation is low everywhere and edging into negative territory
in Europe due to the impact of oil prices. Ex-fuel, goods prices
are flat while services prices have been moving up at a stable 1.2%
p.a. for some time. Once the oil price cycles through the data,
inflation is likely to be back to a small positive figure, but the
call for action by the ECB from the financial market has gone up a
notch. Cynics may suggest that self-interest from investment
participants is the primary motivation as it is not clear that a
rise in the ECB’s balance sheet will have any direct repercussion
for the economic issues facing Europe. The secondary effect of a
weak Euro is perhaps the more important consequence as it is likely
to stimulate exports and raise import prices.
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Economic releases from China in the coming two weeks are likely
to get close attention. The rate of credit growth will be a key
data point, supported by direct efforts from the central bank.
However, weak trade data may be a precursor to a soft Q4 GDP figure
as it would reflect the likely easing in industrial production and
investment. In contrast to recent years, this year there has been
no early indication from the government that it intends to
undertake a major stimulus and will rather persist with its reform
programme in the interests of longer term outcomes. In the
meantime, some may have noted reports on the performance of Chinese
equities. As with most things associated with this country, it is
not that simple. Chinese stocks are represented in a number of
listed markets under an alphabet soup of designations. The
establishment of the Shanghai-Hong Kong Stock Connect in November
2014 has eased some of the restrictions between A share and H
shares.
Source: Deutsche Bank
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The A share market, with participation mostly from locals, has a
reputation for a high level of trading and volatility. While this
is likely to change as the Stock Connect programme matures,
historically individuals, who own 26% of the shares, account for
some 78% of trading activity. Another large component is held by
‘insiders’, that is, executives and directors of the companies.
Little attention is paid to fundamental valuation criteria. Global
investors, with limited access to date, have been cautious on their
participation and generally stayed with the H shares. Of the CSI300
(the Shanghai and Shenzen stock index of the largest 300
companies), 43% is represented by financials, which reinforces the
caution that investors should apply to using ETFs in these markets
as the sector and stock concentration tends to be high. Many global
funds prefer to access China through Hong Kong’s Hang Seng index.
Companies with their geographic base in China make up 54% of this
index, global companies 23% and Hong Kong-resident companies the
remaining 23%. Based on consensus data (Bloomberg) the forward P/E
for the MSCI Asia Pac ex Japan is 12.3X. The highest valuations are
in India and Philippines while Hong Kong and Korea screen with the
lowest weighted average P/E’s. The Shanghai Index sits almost
exactly in line with the regional average. The Renminbi (RMB) cross
rate with the US$ has been remarkably stable in light of the
vigorous moves elsewhere. With the currency increasingly being used
in trade, some believe it is only a matter of time before the RMB
is considered a reserve currency and will form part of global
central bank holdings. As that comes about, monetary policy in
China will become part and parcel of global financial markets.
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Company Comments Reports this week suggested that Rio Tinto
(RIO) is on the verge of announcing a share buyback when it reports
its 2014 results next month. As we highlighted late last year,
chances of any significant increases in capital returns were coming
under pressure due to the continued decline in commodity prices.
Accounting for the bulk of its earnings, the iron ore price is
particularly significant for RIO and thus the 47% drop in 2014
changed the assumptions on the timing and extent of capital
management. This more recent speculation has come from a more
stable iron ore price environment since mid-November and a
declining $A (which is expected to remain low). Despite this higher
reliance on iron ore compared to its other large diversified peer,
BHP Billiton (BHP), RIO looks to be the more likely to commence a
share buyback in the near term. There are several reasons that
support this view. Firstly, relative to its level of profitability,
its capital expenditure commitments over the next few years are
lower than that of BHP. Secondly, the company has already achieved
its net debt target of “mid-teens” and its gearing is at the low
end of its 20-30% target range. As a result of the resetting of its
dividend throughout the financial crisis, RIO’s current payout
ratio is also lower, providing it with more flexibility. Finally,
despite the aforementioned drop in commodity prices, a key message
from RIO management at their investor seminar held in late November
was to “materially increase returns to shareholders”. Based on
current consensus forecasts, RIO should have generated
approximately US$2.0-2.5bn in free cash flow after dividends in
2014. In the absence of a recovery in commodity prices in 2015,
this figure could well be lower in 2015. A modest increase in the
company’s gearing levels may be required to help fund the proposed
buyback. A buyback of any size should be well received by investors
who in recent years have called for a greater level of capital
discipline by the diversified miners. Providing further share price
support in the short term (and also possibly influencing RIO’s
decision to accelerate its capital management plans) will also be
Glencore’s interest in acquiring the company. RIO rejected an
initial approach from its rival in July of last year, however
Glencore cannot make another approach until April. Perhaps lost
through the holiday season was the news that Skilled Group (SKE)
had received a takeover approach from Programmed Maintenance
Services (PRG). Both companies provide contract labour services to
primarily blue-collar employment industries and the share prices of
both had been under some pressure in recent times as a result of
the subdued domestic labour market and lack of any meaningful wage
growth. Comparatively, SKE had been impacted to a greater degree
due to its larger exposure to the offshore oil and gas and mining
industries (see chart on following page). With a share price
decline of over 50% between September to just prior to the
announcement of the takeover approach, it is hard to disagree with
SKE’s assessment that the bid is timed rather opportunistically.
Adding to this proposition is the fact that SKE is in a period of
management transition, with a new CEO starting the role this week.
Nonetheless, the synergies on offer look to be substantial and thus
resulted in the rare occurrence of an increase in the share prices
of both the bidding company and the target. Although SKE is yet to
formally respond to the proposal, the company’s stock is currently
trading at a slight premium to the valuation, suggesting some level
of investor confidence in a transaction taking place. Further
consolidation in the mining services sector is a distinct
possibility over the next couple of years as companies adjust to a
weaker revenue outlook and pressure on margins, although picking
potential investment targets is an exercise fraught with
danger.
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Skilled Group and Programmed Maintenance Services: Revenue by
Sector
Source: Company reports
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Stock Focus: AMP AMP is the largest listed wealth management
company in Australia. The company is vertically integrated through
its funds management, financial advice and funds administration
platforms. While the company generates the bulk of its earnings
from its wealth management division, it also has a retail bank and
an insurance arm giving it a higher level of diversification
compared to the listed pure fund managers. The key structural
driver underpinning the long term growth in AMP is the expansion of
the Australian superannuation industry. The ideal of self-funding
of retirement for Australia’s aging population has long been a goal
of successive Australian federal governments over the last two
decades. System growth is thus mandated by the regulatory framework
that sees compulsory superannuation contributions of 9.5% of
employees’ salaries. Recent changes to this will see this rate rise
again early next decade until reaching a 12.0% rate by 2025.
Investment market growth is the other key variable on a
year-to-year basis. Short term fluctuations can obviously be quite
material, however the longer term trend of rising equity markets
(the primary asset class) is a further positive. With this
background, the key for those in the fund management industry is
capturing their share of this FUM growth. Pleasingly, recent FUM
flows for AMP have been positive. In Australia’s wealth management
industry, AMP is a large-scale and low-cost operator, giving it an
advantage compared with its smaller competitors. The company’s
brand name is particularly strong which was enhanced through the
downturn as it avoided any specific events that caused reputational
damage to many of its peers. AMP was further transformed by its
acquisition of AXA in 2011. It has been successful in delivering
substantial synergies which gave it a more vertically integrated
business covering the entire financial services’ value chain
through AXA’s retail platforms. AMP is currently 18 months into a
business efficiency program with a target of $200m in recurring
run-rate savings by the end of 2016. The majority of these savings
are expected to be delivered in 2015 and 2016, helping to underpin
the group’s earnings growth over this time. AMP is targeting
savings from the rationalisation of product duplication and
construction, automation of operational areas and improving
efficiency in back office operations. The company’s investment
management business, AMP Capital, has the largest scope to record
growth outside of the domestic market (in particular through Asia),
which is one of the core planks of its strategy. Over the past
couple of years, FUM growth and investment performance have both
been strong. AMP recently strengthened its Asian commitment through
a 20% investment in China Life Pension Company. AMP’s wealth
protection division provides a range of individual and group term,
disability and income protection insurance production. The division
has been a disappointing performer for the company in recent years.
The business has been impacted by a number of cyclical and
structural issues which have resulted in a poor claims experience
and lapse outcome for the group. Importantly, AMP have looked to
address these issues and the division reported a much improved
result in the first half of 2014. While AMP’s assumptions in this
unit have been rebased lower, the stabilisation of these problem
areas provide a greater level of confidence in the outlook for the
overall group in the medium term.
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Outlook AMP has sound underlying long term structural growth
drivers and is a relatively defensive investment option among funds
management stocks due to the size and diversity of its operations.
While regulatory change remains an ongoing risk for the company,
AMP has to date successfully managed the changing domestic
landscape, including the transition of some clients onto its
lower-margin MySuper offering. On a forward earnings multiple of
15X and a yield of 5.1%, the company’s valuation is undemanding. We
have recently added the stock to our model portfolios.
Source for all tables/charts: Bloomberg, Escala Partners
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Corporate Authorised Representative of Escala Wealth Management Pty
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owned by EPL. The content of this document is general in nature
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prepared without taking into account your objectives, financial
situation or needs. Thus, before any investment decision is made
based on this document, an EPL investment advisor should be
consulted or you need to consider the appropriateness of the advice
having regard to your objectives, financial situation and needs.
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