Author: Hugh Dive

The volatility cloud hanging over equity capital markets

And although the number of M&A capital raisings was the lowest in 10 years, the amount of capital raised was the highest since 2011, with investors willing to put more capital into a smaller number of deals.

The “Dogs of the Dow” is an investment strategy that is based on buying the ten worst performing stocks over the past 12 months from the Dow Jones Industrial Average (DJIA) at the beginning of the year but restricting the stocks selected to those that are still paying a dividend. The thought process behind requiring a company to pay a dividend is that if it is still paying a distribution, its business model is unlikely to be permanently broken. The strategy then holds these ten stocks over the calendar year and sells them stocks at the end of December. The process then restarts, buying the ten worst performers from the year that has just finished. In this area, retail investors can have an advantage over institutional investors, many of whom sell the “dogs” in their portfolio towards the end of the year as part of “window dressing” their portfolio. Selling the worst performing companies avoids the manager having to explain to asset consultants why these unloved stocks are still in their portfolios.

In this week’s piece, we are going to look at the “dogs” of the ASX, focusing on large capitalisation Australian companies with falling share prices. Additionally, we are going to sift through the trash of 2018 to try to discern any fallen angels with the potential to outperform in 2019.

Unloved Mutts

The Dogs of the Dow was made famous by O’Higgins in his 1991 book “Beating the Dow” and seeks to invest in the same manner as deep value, and contrarian investors do. Namely, invest in companies that are currently being ignored or even hated by the market; but because they are included in a large capitalisation index like the DJIA or ASX 100, these companies are unlikely to be permanently broken. Inclusion in a large capitalisation index such as the ASX100 indicates that the unloved company may have the financial strength or understanding capital providers (such as existing shareholders and banks) that can provide additional capital to allow the company to recover over time.  Smaller companies tend to face a harder road to recovery with a greater chance on insolvency when they make it onto the “Dogs” list.

Dogs over the Past Five Years

The table below looks at both the top and bottom performers for the past five calendar years and their performance over the subsequent 12 months. As always this is measured on a total return basis, which looks at the capital gain or loss after adding in dividends received.  Whilst sifting through the trash at the end of the year yields the occasional gem – such as Healthscope in 2018 (+9%), Qantas in 2017 (+65%), Fortescue in 2016 (+223%), Qantas again in 2014 – an equal weighted portfolio of the dogs of the ASX 100 has outperformed the index in three of the past five years. In 2018 an equal-weighted portfolio of the “Dogs” effectively matched the ASX200, perhaps a fitting outcome for an unpleasant year for investors.

Themes

Looking at the above table, finding the fallen angel amongst the worst performers seems to work best where the underperformance is due to stock-specific problems, rather than macroeconomic issues beyond a company’s control. For example, Cochlear underperformed in 2013 after weaker sales as the company waited for approval to sell its new Nucleus 6 product in the United States. Subsequently, Cochlear’s share price has gained 202%,  as hearing implant sales bounced back. Similarly, BlueScope steel had a tough 2015, which saw the company seeking government support to help restructure their Port Kemba steelworks. Concurrently, cheap Chinese steel took market share at the same time as key inputs of iron ore, and metallurgical coal was climbing upwards. 2016 saw a significant turnaround for BlueScope’s shares which gained +147% as profits recovered due to cost controls, stronger sales and the benefits of an acquisition in the United States.

Additionally, where the underperformance is due to a company-specific issue, the company in question may receive a takeover offer from a suitor that believes that they can snap up the company cheaply and then fix their problems. The best performing “Dog” from 2017 in 2018 was hospital owner Healthscope (+9%) that is now the subject of a bidding war.

The common factor among the underperformers that have continued their slide in the following year is when the underperformance is tied to factors outside the company’s control, such as a multi-year decline in a commodity. From the list of underperformers in 2014, continuing declines in iron ore delivered further pain to Arrium, Fortescue and BHP’s shareholders. Similarly, a several year slide in oil prices pushed down the share prices of Santos and Worley in the subsequent 12 months.

Unloved Hounds of 2018?

As a fund manager, the key question is whether there are potential show champions in the breed of unloved canines tabled below for the 2018 calendar year. Unlike previous years, the list for 2018 is more concentrated in a few sectors, reflecting industry-specific issues that have caused underperformance, rather than more easily fixed company-specific problems.

Looking at the two vertically integrated financial advisers AMP and IOOF, it is tough to see the near-term catalysts that will transform them into stars in 2019. The final report from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry is due to be delivered in March 2019 and is not likely to be kind to these two companies. Similarly, the three building materials companies in the above table are unlikely to see a reversal of the trend of declining building approvals over the next twelve months. 

Fund manager Janus Henderson could be poised for a turn-around in 2019, with an improvement in fund performance and further cost outs from the integration of the two funds management companies. As the company is trading on a PE of 7 times with a dividend yield of 7%, investors have a margin of safety. Similarly, a better than expected outcome from Brexit and an improvement in the acquired Virgin Money business could see NAB spin-off CYBG stage a come back in 2019.

Our View

While the Dogs of the Dow might work in a market populated with a diversified range of companies in uncorrelated industries such as McDonalds, 3M, Merck and Microsoft, it does not appear to be a broad strategy that one can use consistently in the ASX. We see that amongst the companies in the ASX 100, the composition of the index is not as broad as the Dow at an industry level. The ASX has a high weighting to resource companies, whose profitability is primarily tied to commodity prices (such as oil and iron ore) that are outside of management’s control and can be subject to multi-year declines. Similarly, the ASX has a high weighting to financials, all of which have suffered throughout 2018 from the Royal Commission.

 Nevertheless, it can pay to sort through the dogs of the ASX. From the table above over the past five years, one of the top performers in the following year can be found by sifting through the dogs of the ASX100.

• November was another volatile month for markets globally, though Listed Property was a steady performer in a month dominated by global macroeconomic concerns and sharp falls in commodity prices, which resulted in the ASX 200 falling -2.2%.
• The Atlas High Income Property Fund declined by -0.5% in November, roughly matching the index. Over the month, several of the Trusts held in the Fund held their Annual General Meetings (AGM) where management teams confirmed that they were on track to achieve the profit guidance for 2019 given to the market in August.
• Whilst Australian housing prices have been falling, residential property represents a very small part of the Listed Property index that is dominated by commercial, industrial and office real estate, sectors that have been performing strongly in 2018.

 

 

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2019.

Over the past six months, there have been numerous headlines around rising energy prices and their impact both on curbing global growth and in cutting domestic consumption as the costs of transporting people and goods around Australia were rising sharply. However, instead of climbing as expected, the oil price has collapsed by 30% over the past few months.

In this week’s piece, we are going to look at the beneficiaries of a decline in oil prices. Conceptually a fall in the price of oil is neither positive nor negative per se, but rather a transfer of wealth from oil producing countries and companies (such as OPEC, Norway, Exxon and Woodside) to energy consumers (OECD, South Korea, China, chemical companies and domestic consumers).

In early October, oil was trading above US$85 per barrel1. The price was forecasted to go above US$100 per barrel as US sanctions on Iran were expected to constrict supply and Saudi Arabia was incentivised to maintain a high oil price to help gain a high price for their upcoming float of Saudi Aramco – see The Biggest IPO of all time.

Over the past two months, the reverse has occurred with oil falling 30% to US$59 a barrel as oil inventories built on higher production out of the USA and Saudi Arabia (due to pressure from Santa Trump), weaker than expected Iranian sanctions and selling from speculators. Saudi Arabia actually lifted oil production in recent months, a move not particularly in their best interests. This has been ascribed both to pressure from President Trump and efforts to mitigate the impact of the journalist Khashoggi’s death in their embassy in Istanbul.

Falling equity markets have also probably played a role in placing downward pressure on the oil price. Macquarie Bank estimated that as a result of the market falls in October and November around $50 billion was withdrawn from commodity funds, which would have resulted in these funds being forced to sell holdings of oil. The chart below shows the price of a barrel of crude oil, for the purposes of analysing its impact on domestic consumers and companies, the price has been converted into Australian dollars.

 

What Happened

In early October, oil was trading above US$85 per barrel. The price was forecasted to go above US$100 per barrel as US sanctions on Iran were expected to constrict supply and Saudi Arabia was incentivised to maintain a high oil price to help gain a high price for their upcoming float of Saudi Aramco – see The Biggest IPO of all time.

Over the past two months, the reverse has occurred with oil falling 30% to US$59 a barrel as oil out of the USA and Saudi Arabia (due to pressure from Santa Trump), weaker than expected Iranian sanctions and selling from speculators. Saudi Arabia actually lifted oil production in recent month, a move not particularly in their best interests. This has been ascribed both to pressure from President Trump and efforts to mitigate the impact of the journalist Khashoggi’s death in their embassy in Istanbul.

Falling equity markets have also played a role in placing downward pressure on the oil price. Macquarie Bank estimates  that as a result of the market falls in October and November around $50 billion was withdrawn from commodity funds. This would have resulted in forced selling of oil held by these funds.

Australian consumers

Australian Bureau of Statistics (ABS) survey reveals that households spend an average of $230 each month on fuel for vehicles. As a result of a falling oil price, motorists in Sydney have seen a litre of petrol fall from $1.65 to around $1.15, which was estimated by Commsec to result in a saving of around $70 per month or equivalent to a 0.25% interest rate cut on an average mortgage. Further falls in the oil price will only increase the impact of this de facto stimulus plan. For example, the sustained lower energy prices consumers saw over the period 2014 to 2016 resulted in an additional $1,100 per annum being added to the average household’s finances when compared to the period 2010 to 2013, with the greatest benefit being felt by those living on the periphery of the country’s major cities. Higher disposable income will also help Australia’s embattled trading banks, as consumers will have a greater capacity to service existing mortgages, keeping bad debts in check.

Higher consumer spending

On the ASX, the largest beneficiaries of the stimulus package of falling petrol prices will be the consumer staples and consumer discretionary retailers, as historically savings at the petrol bowser have been spent on food and liquor, as well as consumer goods such as electronics and clothes. As such, we would expect to see stronger sales figures in 2019 from Wesfarmers, Coles and JB-Hi-FI.

Higher retail sales will also benefit retail listed property trusts such as Vicinity and Scentre as a large proportion of retail spending is still done in bricks and mortar stores. The last twelve months have proven to be very volatile for Australia’s retailers and shopping centre owners. In late 2017, virtually all companies connected to retail saw their share prices fall significantly on news that Amazon was entering the Australian marketplace. The impact of the US e-commerce giant has been fairly muted so far, with Australian retail sales in shopping centres up between 2 and 4% in 2018. Undoubtedly Australian retail sales have been assisted by the government legislating that from the 1^st July 2018 online retail sales below $1,000 would be subject to GST, a move that helps level the playing field between foreign websites and Australian retailers .

 Large energy users

Among the companies that consume large amounts of hydrocarbons, Qantas is the most obvious beneficiary of a falling oil price. In 2018 Qantas spent $3.2 billion on jet fuel and Australia’s carrier has seen a 25% decline in the price of jet fuel over the past few months. Due to hedging, Qantas will not see the full benefit of this fall in 2019, though the carrier will see a nice boost to profits especially as travellers are still paying over $400 for a one-way flight from Sydney to Melbourne and the flights are all pretty full.

Miners such as Rio Tinto and BHP are both significant consumers of petrol and diesel and sell commodities such as iron ore that is priced independently of the oil price. Moving dirt consumes a large amount of energy in cracking the rocks, removing overburden through explosives, and moving iron ore and coal to the ports on the coasts off Western Australia and Queensland. In the first six months of 2018 higher oil prices reduced Rio Tinto’s profit by $200 million, though the miner should see some relief in the second half of 2018. Previously BHP saw a limited benefit from falling oil prices by virtue of its US onshore oil and gas assets, though these were sold in June 2018 for US$10.8 billion.

Oil importing nations

Whilst falling energy prices will be causing much angst in the oil exporting nations, these declines should provide a boost to the major oil importing economies of China, Europe and Japan. Improving sentiment in the US and Asia will have a bigger impact on the prospects for global growth and Australian exports than oil-induced recessions in Russia, Saudi Arabia, Venezuela or Iran.

The nation that is likely to see the biggest benefit from falling oil prices is China, which in 2017 imported $162 billion worth of crude oil and is the top oil importer globally. Interestingly in 2015, the USA was the largest global importer of crude oil. However, the development of the shale oil industry has reshaped the oil industry, as it has shifted the USA from being an importer to an exporter of oil. Clearly, a factor such as falling oil prices that stimulates the economy of Australia’s largest export partner will have a positive impact on a number of Australian listed companies from miners and tourism operators, to exporters of wine and food.

Our Take

The positive impact of the 30% fall in the oil price over the past two months has not received much attention by the market. There has been a greater focus on what has happened to FANG’s (Facebook, Amazon, Netflix and Google) share price in overnight trading in New York, selling Australian stocks when these are weak.

We see that falling oil prices will provide a nice boost to Australian corporate earnings if maintained for a period. The additional cash from falling oil prices improves the balance sheet of the nation’s consumers, causing either spending on consumption or on paying down debt, and at no cost to taxpayers! By contrast, Kevin Rudd’s “GFC economic security package” from October 2008 delivered a one-off $1,400 to pensioners and $1,000 per child to families and was credited as boosting GDP by 1%, but cost taxpayers $10.4 billion.