Author: Hugh Dive

During the months of February and August, the majority of Australian listed companies reveal their profit results and most guide as to how they expect their businesses to perform in the upcoming year. Today marks the end of the February 2020 company reporting season and companies have until the end of the day to release their financial results for the past six months, or they will be suspended on Monday from trading on the ASX.

In this piece we are going to run through the key themes that have emerged over February, a volatile month where greed reigned over the first two weeks, to be replaced by fears over the impact of the novel coronavirus COVID-19 in the last two weeks.

Australian consumer doing better than expected

Going into the February reporting season we were concerned that company results would reflect a dramatic pull-back in retail sales due to bushfires, consumer preferences to reduce debt rather than spend, and the emergence of COVID-19.The financial results for large listed property trusts such as Scentre group give a good insight into consumer spending. Scentre’s portfolio of 42 shopping centres accounts for 8% of Australian retail sales and is a good indicator as to the health of the consumer. Sales were up +2% with weakness in department stores being offset by sales growth in food, personal services, supermarket, and even fashion. Elsewhere in retail, JB Hi-Fi saw sales grow +4% as consumers opened their wallets to buy phones, gaming consoles, and Fitbits. Coles and Woolworths both showed approximately 3% sales growth in supermarkets and liquor.

Beating and missing guidance

Going into reporting season, the market develops a sense for the profit that a company is expected to earn, either through explicit guidance by management (generally within a range) or by the average or consensus forecast of the sell side analysts. Beating guidance usually sees a company’s stock rise sharply, whereas missing sees it fall. In February, on UBS’ numbers 1/3 of the companies that have reported beat expectations, 1/3 were in-line, with 1/3 disappointing. This should be considered a good outcome as normally the percentage of companies that beat guidance is much lower than 33%.

Looking at the large cap (ASX 100) companies that beat expectations AGL Energy, Charter Hall Group, Coca-Cola Amatil, Commonwealth Bank of Australia, JB Hi-Fi, Lendlease and Qantas were well received by the market. On the negative side of the ledger, companies that reported a profit number below expectations were Cochlear, Downer EDI, Mirvac, Tabcorp, Treasury Wine Estates and Whitehaven Coal.

Shorts Getting Burned

Traditionally, most of the market attempts to own stocks that will report a good result and increase their dividends. Some fund managers, however, try to capitalise on bad profit results by short selling the shares of companies in the expectation that the company’s share price will fall.

Due to the extreme variance in share price performance over the month, in many cases short-sellers would have gone from tearing their hair out after the short-sold company result mid-month, to toasting their good fortune at the end of the month. Provided the short seller kept their nerve and did not close out the position as the stock rallied on the day of the results.

The two largest short positions – Domino’s Pizza and AMP – would have been painful for those shorting these stocks as their prices have rallied strongly post result, though AMP gave up these gains on general market fears towards the end of February. Domino’s Pizza delivered a result that was around market expectations, with sales in Japan and Germany offsetting weakness in Australia. AMP entered the reporting season with very low expectations to say the least, with questions about the company’s vertically integrated business model being able to survive in a post-Hayne report world. Despite suspending the dividend, losing 440 financial advisers, and taking $2.5 billion of impairments, AMP rallied on the view that after selling some assets such as insurance, the company’s remaining banking and wealth management businesses can absorb further remediation provisions.

Give me my money back!

For the first time in a few years capital management was not the dominant feature of the recent reporting season, with most companies struggling to increase dividends over what was paid in February 2019. Twelve months ago, many companies loosened their purse strings in moves that appear designed both to reward shareholders and to get franking credits into the hands of their shareholders before the expected Labor victory that would have devalued these tax credits. Across the ASX, the dividend payout ratio (dividend per share dividend by earnings per share) decreased. This was due to boards conserving cash for growth, and also to the uncertain impact of COVID-19 over the coming year. While the big miners BHP and RIO paid healthy dividends, many in the market expected large special dividends to be paid based on high iron ore prices over 2019. Given that the iron ore price is likely to be heavily impacted by a slowdown in China, this is a prudent move by the large miners.

Best and worst results

Over the month the best results were delivered by Charter Hall, JB Hi-Fi, Coca-Cola and QBE Insurance Charter Hall benefited from a large amount of property transactions (some between their own funds – not a good sign) and grew funds under management to $39 billion. Coke beat guidance by improving sales in Australia and Indonesia, which was contrary to the market view that carbonated soft drinks were in a terminal decline. JB Hi-Fi had a solid result with sales growth up +4%, which contrasts sharply with rival Harvey Norman. The latter saw sales increase by just +1.6%, indicating that JB Hi-Fi is winning market share. Additionally, JB’s management gave guidance for 6-8% profit growth for 2020, which was very well received.

On the negative side of the ledger WiseTech, Altium, Treasury Wine and Reliance all reported profit results that were significantly below market expectations. The common themes amongst this group were popular stocks trading on high PE multiples delivering profit results below expectations, combined with bearish management commentary for the coming year. The market is very unforgiving to high PE stocks that don’t deliver. Atlas were concerned about CSL going into reporting season as this was a company with high expectations for profit growth. After growing earnings by 11% and upgrading full year profit guidance, the biotherapy company briefly became Australia’s largest company by market capitalisation in February, before the title was snatched back by Commonwealth Bank.

Looking ahead: guidance surprisingly upbeat

Around 30% of large cap companies upgraded profit guidance for 2020, something that surprised Atlas. Especially noteworthy was the broad range of companies upgrading which included LPTs, cyclicals, defensives and resources. While the novel coronavirus was mentioned often in management outlook commentary, only a few companies such as WiseTech, Crown and Vicinity have downgraded future earnings based on 4 to 8 weeks of travel restrictions. This leads one to suspect that COVID-19 might in some cases be used as a fig leaf to cover other issues in these companies, especially when the management teams from companies operating in the same industry don’t use the virus as a reason for flagging sales and profits.

Managing the portfolio in a “crisis”

The pattern of the COVID-19-induced sell off that we have seen in February 2020 is very broad based and different to selling that I observed in the market falls on the ASX in 2007 and 2008 during the GFC, and on the Toronto Stock Exchange during the tech wreck. The GFC and tech wreck saw selling more heavily weighted towards those companies actually exposed to the negative event. This reflects the greater influence of index funds and ETFs on global markets in 2020.

When an index fund receives a redemption (which dramatically increase during market sell-offs), the manager simply liquidates a portfolio of stocks in proportion to their index weight. This results in the entire market being sold down in a roughly uniform percentage, even companies whose earnings are likely to face a minimal impact from COVID-19. We see that February’s broad-based sell-off in the market reflects the greater influence of index funds and ETFs on global markets in 2020, as index funds comprised a smaller percentage of assets under management 20 and twelve years ago.

Looking through the portfolio, Atlas are adding to positions in companies whose share prices have fallen despite offering investors defensive earnings that are likely to provide consistent dividends through a variety of market conditions. Additionally, the decline in the AUD, which hit an 11-year low overnight to 0.65, will give a boost to offshore earnings from companies with foreign operations.

Our Take

As fund managers are neither virologists nor epidemiologists, I can’t say when the current novel coronavirus will be contained. However as a long term investor who has seen a few unpleasant crises in the market I believe in the words of Abraham Lincoln that “this too will pass” and that consumers are still likely to shop for food, drive on toll roads, consume packaged food and medicine, get medical tests done, as well as bet and play the lotteries. Owning companies that provide goods and services such as these are likely to provide investors with a stream of dividends despite the inevitable times of sturm und drang that occur on the share market.

• The Atlas High Income Property Fund gained by 3.6% during January. While this was an above-average return, a portion of these gains was a recovery after some curious price activity on the last day of 2019. Here the entire market was sold down by close to -2% in a thinly traded four-hour session. In hindsight, this appears to have been an offshore index fund reducing its weight to Australian securities, with these losses recovered in the first week of January.
• The key news over the month was a large fall in the Commonwealth Government 10-year bond yield that fell to 1%, as the negative impacts of both bushfires and the Coronavirus on the Australian economy have raised the probability of further rates cuts by the RBA.
• The falling official cash rate has seen the major banks cut their benchmark 180-day term deposit rates fall to 1.25%. While this looks grim for savers, the situation is likely to get worse with six-month interest rate futures at 0.65% which points towards further cuts.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.

The greatest returns on the stock market rarely come from buying the well-loved stocks whose share prices have performed strongly, but rather from unloved companies that outperform low expectations.

As a fund manager I like to sift through the market’s trash to find some investment treasure.

A systematic investment strategy of investing in underperforming companies, named “Dogs of the Dow”, was popularised by Michael O’Higgins in his 1991 book Beating the Dow. This approach seeks to invest in the same manner as deep value and contrarian investors do.

O’Higgins advocates buying the ten worst-performing stocks over the past 12 months from the Dow Jones Industrial Average at the beginning of the year, but restricting the stocks selected to those that are still paying a dividend.

Limiting the investment universe to a large capitalisation index like the Dow or ASX 100 improves the chance that the unloved company has the financial strength and understanding capital providers (existing shareholders and banks) to support a recovery over time.

Smaller companies tend to face a harder road to recovery, with a greater chance of insolvency when they make it onto the “Dogs” list.

The strategy then holds these ten stocks over the calendar year and sells them. The process then restarts.

While buying the worst-performing companies each year involves owning some with issues that may worsen, this strategy has outperformed the Dow in seven of the past ten years, and the ASX in six of the past ten years with a tie in 2018.

One of the reasons why this persists is that institutional investors report the contents of their portfolios to asset consultants for annual review. This process incentivises fund managers to sell their “Dogs” towards the end of the year, a process known as window dressing the portfolio before being evaluated.

IOOF, for example, lost 52 per cent in 2018. In early 2019, fund managers with IOOF in their portfolios would have been facing some pretty stern questioning about why they owned the troubled wealth group. IOOF’s share price recovered by 54 per cent throughout 2019 to be one of the top-performing stocks on the ASX last year.

Here, retail investors can wield an advantage over institutional investors, picking up companies whose share prices are under pressure late in the year ahead of any possible rebound when the selling pressure stops in January and February. Retail investors can afford to take a longer-term view.

The better strategy

Over the past year, the “Dogs” from 2018 returned 27 per cent, significantly outperforming the ASX 200 index’s return of 23 per cent. Underperformance from AMP, Challenger and Boral was outweighed by recoveries in the share prices of James Hardie, Lendlease, IOOF and BlueScope Steel.

The common theme in the reversal of performance of 2018’s “Dogs” is an improvement in the company-specific issue that had been weighing on the share price. James Hardie benefited from both a recovery in the US housing market and falling raw material costs; IOOF rebounded as it stabilised the ship; and Lendlease progressed its troubled engineering business towards a sale, demonstrating the underlying strength of its global residential developments.

When we went through this exercise in January 2019 looking at which of the “Dogs” would shine, Atlas saw that the pain would likely continue for both AMP and IOOF, a view that was only partially correct.

Atlas considered that the share prices of Janus Henderson, Lendlease and Virgin Money UK (the former CYBG) were the most likely to rebound over 2019, as these businesses either solved issues or recovered on the prospect of a workable path to Brexit, with investments made in Lendlease and Janus Henderson.

Looking at the ASX 100 underperformers for 2019, the key themes impacting their market valuations are falling coal prices, interest rates, and a slowing domestic housing market.

In seeking to identify which among these “Dogs” will shine in 2020, history suggests that it will be those companies whose falling share price were due to company-specific problems, rather than industry-wide issues such as a falling commodity price.

We see that construction company CIMIC and financial services group Link Administration are the most likely to stage a recovery, either due to a takeover bid in the case of CIMIC, or a Brexit-led recovery in Link’s financial administration business.

This piece originally appeared in the Australian Financial Review

Sifting through the trash for stockpicking treasure

Smaller companies tend to face a harder road to recovery, with a greater chance of insolvency when they make it onto the “Dogs” list. The strategy then holds these ten stocks over the calendar year and sells them. The process then restarts.

Investing in equities is a long game, with share prices in the short-term influenced by market emotions, forced selling, and Trump tweets – factors that often have very little to do with a company’s profits and growth prospects. However, over the longer term, companies that generally reward their patient shareholders with a higher share price are those that grow earnings and navigate their way through the issues that markets, regulators and their customers throw at them.

Next week the 2010s will come to a close, a decade that has generally been very kind to investors in Australian equities with the ASX 200 up by 130%. In this week’s piece, we are going to look at how Australian equities have fared over the past ten years, along with the key themes that have influenced the share market during this period.

Setting the Scene

December 2009 was a pretty bleak period for investors. While the ASX 200 had recovered from its low in February 2009, investor confidence remained very fragile. The Babcock and Brown group of companies had just gone into administration and Centro was looking very shaky. Over the course of 2009, ASX listed companies had raised a record $70 billion in hurried rights issues and placements to shore up company balance sheets, placating the banking wolves howling at their doors. The 2009 financial reporting year was one to forget with companies delivering weaker profits and writing down the value of assets acquired in the heady days before the GFC.

Key Factors

While management teams can grow earnings via expanding into new markets, taking market share from competitors, and making acquisitions (or selling unprofitable businesses), external factors over which a company’s management has no control such as exchange rates, commodity prices and interest rates often have the biggest impact on a company’s profits and thus share prices. Over the past decade, the Australian Dollar vs the US Dollar has declined from US$0.90 to US$0.68 after peaking at $1.10 in 2011. The 25% decline in the Australian dollar in the 2010s has steadily boosted the earnings of companies such as CSL (+885%), Amcor (+266%) and Sonic Healthcare (+154%), all of which derive most of their profits from operations outside Australia.

Similarly, the steady decline in interest rates over the past decade has reduced interest costs for all Australian companies, increasing profits after tax. In January 2010 the benchmark Australian Government ten-year bond rate was 5.7%, but it finished the decade at a low of 1.29%. For households over this period borrowers have seen the standard variable rate decline from 6.9% to 3.3%. On a $700,000 loan, this would cause monthly payments to decline from $4,900 to $3,430 per month. While falling interest rates saw Australian credit growth increase from 0% to 12% in 2016, over the past four years credit growth has fallen to 3-4%. High levels of household debt and tighter bank lending standards discourage additional borrowing, despite further rate cuts.

NAB’s Chairman Phil Chronican made an interesting point in November 2019, noting that the RBA’s rate cuts were not achieving their goal of stimulating the Australian economy. He saw that when interest rates were cut, NAB’s borrowers were not reducing their monthly payments to spend on consumer goods, but were maintaining their monthly repayment to pay down their loan faster. Conversely, savers such as retirees living off term deposits – who are likely to spend all of their interest income – now face reduced cash flows. Thus, the fall in interest rates over the past decade appears to have resulted in a wealth transfer between savers who would otherwise be spending their interest income, to reduce the debts outstanding for borrowers. This transfer has affected a minimal positive impact on the economy.

The falling oil price over the past decade has provided a consistent headwind for Woodside (+11%), Origin Energy (-12%) and Santos (-13%). However, decisions by Santos and Origin to spend tens of billions on competing LNG export plants at Gladstone in Queensland when the oil price was over US$100/bl (now US$60) has weighed on their share prices. The development of US shale gas in the early part of the decade changed the USA – one of the largest oil importers – to a nation that is now exporting energy globally. Arguably this is one of the major changes over the past decade, as it has damaged OPEC’s capacity to manipulate the global oil price and has revitalised US manufacturing, now powered by cheap US energy.

The Leaders of Today aren’t always the Leaders of the Future

The below table looks at how the ASX Top 50 stocks in December 2009 have performed over the past decade. Particularly striking is the distribution of the table, with only 17 of the Top 50 stocks outperforming the ASX 200, and the bulk of the Top 50 underperforming. This is because the performance of the index has been driven by companies that were either quite small in 2010 such as Magellan (+884%) or were still a twinkle in their founder’s eyes, such as Afterpay.

Ten per cent of the ASX Top 50 from December 2009, did not get a chance to shine over the full ten years as they were taken over by mostly foreign buyers. Generally, this was good news for Australian shareholders as Japan Post and SAB Miller clearly overpaid for their acquisitions of Toll and Fosters respectively, with both companies subsequently writing down the value of the transport and beer assets by billions. Though overpaying for ASX listed companies is not solely the province of foreigners, AMP’s $4.15 billion bid for AXA Asia Pacific in 2011 has proven to be a poor move.

Top Performers on the ASX

The key themes among the leaders are companies that have grown earnings (CSL, Fortescue, Sonic Healthcare), benefited from falling interest rates (Transurban, GPT), and have enjoyed a tailwind from a falling Australian dollar (Amcor, Macquarie). The fall in the oil price has dramatically improved Qantas’ business model, transforming the company from one needing to raise capital to stay afloat to one that consistently conducts share buy-backs.

Bringing up the rear

Steelmaker Onesteel/Arrium is the worst-performing stock in the Top 50 over the past decade with the company going into administration in 2016 causing equity investors to lose their entire investment. The steel company’s long steel manufacturing operations and significant investment in some small high-cost iron ore mines in South Australia resulted in climbing debts and mounting losses.

However, several household names have also had a decade to forget. AMP (-29%) suffered due to a poor acquisition in AXA, along with rough treatment in the 2018 Royal Commission into Financial Services that exposed flaws in the 170-year-old company’s business model and has raised questions about its long-term viability. While QBE Insurance (-16%) has been a better performer over the past few years, for most of the 2010s management has been dealing with the hangover of an acquisition spree that saw QBE grow via acquisition into one of the Top 10 global insurers. Unfamiliar areas of business such as Argentinian workers compensation and Ecuadorian crop insurance resulted in large profit downgrades before these business units were sold.

Among the top 4 major banks, Commonwealth Bank (+130%) is the pick of the litter, though this result matches the ASX 200. Commonwealth Bank’s outperformance is likely due to its higher return on equity and lower loan losses compared with the other banks, as well as avoiding offshore adventures that have caused pain for NAB and ANZ’s shareholders. Against a background of falling credit growth, rising compliance costs and newly aggressive regulators levying heavy fines, ANZ (+91%) NAB (+62%) and Westpac (+79%) have all returned less than the ASX 200 over the past decade.

Our take

Overall the past decade has been better for equity investors than most fund managers would have predicted in December 2009, when large companies were still going under as a result of the GFC. The 130% return over the 2010s equates to a compound growth rate of 8.7% per annum, around the average for Australian equities since 1900. One of the biggest issues that all investors face is the relentless noise and news flow that often obscures the long-term trends for company earnings. What is clear from reflecting on the past decade is that companies that have successfully grown their share price over the long term require both astute management teams, but also some help from underlying economic trends outside of the company’s control. While top-performing companies such as CSL, Macquarie Bank and Amcor have all made successful acquisitions and grown their existing operations, they have also all enjoyed support from the tailwinds of decade long decline in the Australian dollar and falling interest rates.

This article also appears in Firstlinks Headwinds and tailwinds, a decade in review