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Half Year Report Card for Australian Equities

The last six months have been stressful for Australian equity investors, despite the calm suggested by the ASX200 delivering a total return of +3.2% (capital appreciation plus dividends). December’s Santa Claus rally/Trump reflation trade went a bit sour in January, similar to the feeling given by excessive consumption of four litre cask white wine from Southern Queensland. The market then staged a recovery from February to April, before grinding down slowly on weaker commodity prices, surprise bank taxes and the potential for higher global interest rates towards the end of 2017.

In this week’s piece, we are going to look at what has happened over the first half of the year, examine some key themes and analyse the catalysts that contributed to the best and worst performers.

 

 

 

 

 

 

 

 

Growth at any price

One of the key themes to emerge in the first half of 2017 has been a willingness among investors to bid up the share prices of companies delivering earnings growth. This activity seemed to ignore the high valuations paid to access these growing profits. This can be seen in the top performing healthcare, utilities and industrial sectors, whose performance was driven by companies such as CSL (Price to earnings ratio or PE 31x), AGL Energy (PE 21x) and Sydney Airport (PE 44x). Whilst these are all very solid companies that I have owned in the past, at current prices they offer little in the way of a valuation “margin of safety” needed when investing in equities.  The wisdom of being circumspect towards fully valued high growth companies can be seen in the performance in 2017 of companies such as Dominos Pizza and TPG Telecom, both of which have fallen heavily when their growth engines began to splutter.

The hunt for yield halts

The two worst performing sectors in 2017 have been the “yield” sectors of telecoms and listed property, though paradoxically the interest rate sensitive utilities sector continued to move higher. The yield sectors have been sold off as the US Federal Reserve increased their interest rate target to 1-1.25% and signalled a further rate rise later on in 2017. For foreign investors, this decreases the relative attractiveness of investing in Australian “yield” stocks such as Telstra (-12%) and Scentre Group (-13%). Domestically the RBA is taking a different stance, holding the cash rate at 1.5% in June and  that a further rate cut could occur later in 2017.

A mixed story for financials

From looking at the above table on the right, financials would appear to have had a reasonable start to 2017, returning a respectable 2% after dividends, however for investors it has been a bumpy ride.  The major banks performed well up until the announcement of a surprise bank levy in the May budget that wiped $14 billion off their collective market capitalisation. Commonwealth Bank (+2%) outperformed ANZ Bank (-4%) and Westpac (-3%), despite the latter two banks reporting in May lower loan losses and profits in line with expectations.

Whilst 2017 has been tough for investors in the banks, the sun shone down on the domestic insurers IAG (+16%) and Suncorp (+12%), as well as the fund managers Challenger (+17%), Magellan (+14%) and Perpetual (+14%) due to a combination of inflows and performance fees. QBE Insurance’s share price (0%) once again went up by the stairs and down by the lift. After reporting a solid result in February that suggested that the company’s turn-around was working, in June QBE unveiled higher than expected claims from its Asian and Latin American businesses, which caused the share price to fall 8%.

Large Outperforms small

Over 2017, the larger companies listed on the ASX (ASX100 +3%) have outperformed the smaller companies (Small Ords +1%). Outside the banks and the energy companies, the larger capitalisation stocks have had a pretty benign 2017, with the average return dragged upwards by the performance of CSL (+29%), Rio Tinto (+12%), Transurban (+11%) and Woolworths (+8%). The key drivers of small capitalisation index underperformance have been the underperformance of mining stocks Oceana (-12%), Independence (-27%) and retailers Premier (-7%) and Super Retail Group (-17%).  Company-specific issues caused falls in vitamin producer Blackmores (-7%) and retirement home provider Aveo (-20%).

Star pupils and the laggards in 2017

Stars and what caused them to shine

In the table above on the left we have listed the top 10 stocks in the ASX 100, and from looking down the list of the stars it is mainly stock specific factors that have driven performance. Qantas benefited from continued falls in the oil price and higher fare prices, whereas BlueScope’s turnaround continues with the steelmaker reporting 200% profit growth in February and announcing a share buy-back. This caps an amazing recovery for a company that was in a very challenging position five years ago, which resulted in a massive equity issue almost 80% below the level at which the company is currently buying back stock.

As mentioned above CSL, Flight Centre, Cochlear and Aristocrat have benefited from the theme of buying earnings growth at any price. Building materials company Boral’s share price has surged based on a recovery in their US business and continued demand for construction materials to fuel the Australian housing boom.

Laggards and their negative catalysts

In every period there are stragglers as well as winners, and on the right side of the above table we have the worst 10 performing stocks. The common theme driving the underperformance of Harvey Norman, Vicinity, and Scentre are concerns that the impending entry of Amazon into the Australian retail market will destroy retailer profitability and result in vacancies in our echoing shopping centres.

Looking through the rest of the list, Santos has followed the oil price downwards, whereas Brambles and Domino’s Pizza have been de-rated on unexpected profit downgrades. The telecommunications sector was a glamour sector in 2016 but has been on the nose with investors in 2017. Increased mobile competition, lower margins, and uncertainty around the NBN have negatively impacted the share prices of Telstra and TPG Telecom.

Our Take

Looking to the second half of 2017 we see that the market has been predominantly negative on the “Amazon effect” and in August many of the affected companies will have the opportunity to reveal how their businesses are performing. Whilst Amazon has had a significant impact on US retailers and thus the owners of many US shopping malls, we see those concerns as being overplayed (though we are underweight retailers in the Atlas High Income Property Fund). Over the last 30 years the US has added a significant amount of retail floorspace such that it is now estimated at 2.2m² of retail floorspace per capita, this compares with around 1m² of retail floorspace per capita in Australia.   

Looking further afield, we expect the banks to show profit growth from the upward repricing of investor and interest-only loans, though it will be a balancing act for bank management teams, as they will find it harder to fight the bank tax with expanding profits.  The resouce companies are likely to report shrinking earnings with commodities drift lower as the effects of Chinese stimulus plans from 2016 continue to fade.   As global rates begin to rise in the back half of 2017, this will put downward pressure on the AUD which will benefit companies with USD earnings such as QBE, Incitect Pivot and Amcor.  In aggregate we expect Australian equities to deliver modest gains in the second half of 2017, mainly as equities continue to present a better investment option to bonds.

Monthly Performance June 2017

  • June was a very volatile month in Listed Property with the index initially gaining 2% before ending the month down -4.8%, mainly driven by a -3% fall on the final day of the month on a bond market mini sell-off.
  • The Fund’s unit price fell -3.1% as declines in share prices were offset to some degree by income received from distributions and calls that the Fund sold that expired worthless. In the broad based sell-off in late June there were few places for investors to hide.
  • The fund generated 1.3% in income over the month of June and we will look to increase the Fund’s ability to generate additional income from the assets held.
  • June was a significant month for the Atlas High Income Property Fund, which is now listed on the ASX’s mFunds platform (AFM01).

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in May and the fund’s strategy

Building Materials Woes: Who pays when things go wrong

The Grenfell tower fire in London in mid-June was very tragic and resulted in 79 deaths. This terrible occurrence has highlighted the extremely negative impact that the choice of building materials can have. There have not been many significant advances in construction materials recently. The Colosseum in Rome was largely built with concrete, terracotta roof tiles were used on the temple of Apollo in Corinth in 700 BC, and plasterboard was invented in 1894.  We see that due to the lack of advances in construction materials, a perception has developed that all building materials and construction techniques are safe and have been tested over centuries.

As a former building products analyst at a large US investment bank I have more than a passing interest in construction materials. In this week’s piece, we are going to look at the impact that plastic-based aluminium composite cladding may have on Australian direct property investors, and who is likely to pay the remediation costs when building materials go wrong. Looking at past examples, the home owner invariably has borne most of the costs for decisions that were not made by them.

 

Aluminium cladding

Cladding is added to a building to prevent rain from entering the building’s structure, to improve sound and thermal insulation, and in many cases to improve the exterior aesthetics of a building. Aluminium cladding consists of two thin aluminium outer layers bonded to a mineral fibre core such as polyethylene or polyurethane. The issue is that not all of the polymers used in the honeycomb core are fire resistant, and indeed some of the cheaper polymers used are actually very flammable.

If the polyethylene core catches alight, the aluminium skin acts as a chimney to accelerate the fire up the outside of the building.  The composite cladding used on the building in London was responsible for the 2014 apartment fire at Melbourne’s Lacrosse building and a number of fires in Dubai. In the Melbourne fire a cigarette left on a balcony table caused a fire to spread up the 13-storey tower in less than 15 minutes.

Australia
In the wake of the Grenfell fire, the Australian Society of Building Consultants estimated last week that there are 2700 buildings in Sydney utilising aluminium composite cladding, and 50% of the high-rise buildings built in Melbourne over the past decade also use it. The aluminium cladding commonly used in Australia and installed in Melbourne’s Lacrosse building is Alucobest which is imported from China and is cheaper than fire-resistant aluminium cladding such as Alucobond.

Whilst not all of the aluminium cladding used in these buildings is of the flammable variety, investors owning apartments with non-compliant cladding may face significant remediation costs, dramatically reducing returns.  In February 2016 the Victorian Building Authority (VBA) found that 51% of the 170 high rise residential and public buildings around the Melbourne CBD had non-compliant external aluminium cladding. Paradoxically the VBA audit concluded that this did not pose a safety risk.

We would suggest that owners of apartments constructed over the past decade investigate whether the cladding used in the construction of their asset is of the fire-resistant variety. In the case of Melbourne’s Lacrosse building, owners of the apartments are still battling through the courts over who is responsible for the $15 million repair bill.  Based on our crude calculations, this represents a bill of $100,00 per apartment, a significant sum for investors in an apartment building where two-bedroom apartments are being sold for between $400k and $500k. Research indicates that apartments were sold off the plan for ~ $300k in 2010, so the remediation costs may eat up most of the capital gains.

Chinese drywall (plasterboard)
Similar to the abovementioned Chinese made aluminium cladding was the contaminated plasterboard used in residential construction in 100,000 homes in the US between 2001 and 2009.  During the homebuilding boom in the US last decade, there was insufficient local production of plasterboard which caused builders to source Chinese-made plasterboard that also happened to be cheaper. The high levels of pyrite in the cheaper Chinese-made plasterboard resulted in the release of sulphur gas into the home, which is bad for respiration of residents and also causes corrosion of copper pipes in the walls. The remediation costs are quite significant with costs being around US$200,000 to remove and replace the plasterboard on an on a four-bedroom home.

Despite major importers of the plasterboard being companies the giant German building materials company Knauf, affected homeowners were eventually limited to claiming only a tax deduction after replacing the plasterboard.

Who pays? Leaky homes in rainy places
In New Zealand and British Columbia, changes to the building codes in the 1990s resulted in the uptake of building materials and construction methods more suited to the sunny Mediterranean, rather than the rainy South Island of New Zealand or Vancouver where it rains on average 160 days per year. The change resulted in buildings with minimal eves to disperse rain and wrapped in a fashionable textured cladding such as stucco or fibre cement. As water gained entry into cracks in the building structure, the timber frames began to rot and mould developed.

 

Despite the cause of these building calamities being changes to government construction policies, the owners of the buildings ended up bearing most of the costs of remediation. In New Zealand after many years of litigation and builders going into administration, a bailout package was put together. This the split the costs with 64% covered by the property owner, 26% local council and 10% Federal Government.  In Canada, the situation was even grimmer for property owners, with the best offer being an interest free loan and tax relief.

Our Take

Whilst many would assume that builders or developers would be responsible for replacing aluminium panels that are susceptible to fire, the above examples strongly suggest that owners of property with this material installed are likely to bear the costs of replacing the problem building materials.

Not all Great Ideas turn into Great Companies

In my experience, most professional fund managers and equity analysts are frequently given unsolicited stock ideas from clients and friends. Generally, these are small companies, with a great idea that is either going to turn them into the next Amazon or revolutionise a particular industry.  Frequently these companies are difficult for investment professionals to value as they are often at a very early stage. They tend to be long on promise, but short on profits and assets that provide the basis of most valuation methodologies. Inevitably the person presenting the idea knows much more about the exciting technology behind the company and is very enthusiastic about its prospects.

In this week’s piece, we are going to look at the processes and questions that investors should ask when looking at early-stage listed companies.  Atlas is not endorsing any of the companies mentioned in this piece, they are only mentioned in the context of the process that we use in evaluating early-stage companies.

1. How much runway do management have?

The first thing that I look at when reviewing one of these speculative companies is how much time or financial runway management has in which to commercialise their idea before running out of cash. Whilst companies can look to raise additional equity to extend this runway, this is almost always done at a discount to the prevailing share price and relies on supportive investors. Few early-stage companies are financed by debt, as the interest rates charged are likely to be high to compensate for the risk of lending to an unprofitable company.

Investors should look at the company’s cash flow statement to gauge how much cash the company has been burning for the past six months. Compare this against how much cash is on hand on the balance sheet. The reason for using the cash flow statement is that this represents actual cash flows and is harder to manipulate than the profit and loss statement. For example, when I looked at cloud call recording software company Dubber in February, the company reported a cash burn of $4M in the previous six months, yet had $5.2M cash on hand. Here unless there is a dramatic change in the company’s fortunes, one could expect another equity raising within the next 9 months.

Conversely, technology company Fastbrick Robotics had no debt and $10M of cash on hand. This is sufficient to fund the company’s development of a bricklaying robot beyond 2019. Without making any judgement as to the relative investment merits of the two companies, the second company has more flexibility to weather delays, without coming to the market to raise more equity to keep afloat. Obviously, the spectre of near-term equity raisings provides a cap on a company’s share price, as outside investors know there will be discounted share issues in the future.

In more extreme circumstances, the lack of a financial runway has seen companies with solid ideas or assets going into administration, with these assets later picked up by competitors.

2. Management’s record and shareholding

The next step is to look at the experience of management and board of the company in question.  Here what I am looking for is not so much experience at large and well-known corporations such as General Electric or Westpac, but rather experiences in guiding small and more financially unstable companies through to an IPO or trade sale. Large companies have little difficulty in getting attention from potential investors or banks and managing cash flows. Additionally, executives from large organisations are unlikely to have had experience of running a number of business areas while also having a laser-like control of costs.  Looking at job management software GeoOp, it was apparent that the chairman and CEO have solid experience in the digital space and in running start-up ventures.

Additionally, investors should look at the percentage of the company owned by management, as a management team with a significant portion of their personal wealth invested in the company are more likely to act as good agents on behalf of the other shareholders. Here investors should look at existing holdings, as well as the share options granted when management hit certain targets such as profitability and specific share prices.

3. Who else is on the share register?

The presence of larger corporations or well-regarded fund managers on a fledgling company’s share register should be viewed as a good sign. This can indicate that others have done the due diligence on the company, and it is often helpful that they have the voting firepower to stand up to management and scrutinise decisions. The presence of competitors or corporations in similar industries could indicate the possibility of a takeover at a later stage. In the Dubber example mentioned above, the presence of small capitalisation manager Thorney on the share register at 6.4% is a positive sign.

However, the presence of well-known fund managers on the register should not by itself be viewed as sufficient grounds for investment.  Most if not all small capitalisation fund managers have positions in their fund that they now regret and may be quite illiquid at the size of their investment. What may seem to be a significant investment for an individual investor may only represent 0.25% of a large fund.

4. Who are the Company’s competition and what is the size of its addressable market?

All successful small companies face the spectre of competition from large industry players. In some cases, large competitors may be watching the target company closely, learning from their mistakes, before launching a competing product or technology drawing on the larger company’s scale and market access.  Whilst “disruptive” financial technology companies or fintechs are very much flavour of the month at the moment, I find it hard to believe that the big banks and insurance companies are not keeping a close watch their activities. A great example of this is mobile payments company Mint Payments which in 2013 went from 2c to 40c per share on expectations that the company’s wireless point of sale would enjoy spectacular growth. The share price has slid back to 6c as the banks and technology companies such Apple launched competing payment products.

When looking at the prospects for a company and its potential growth, it is important to look at the size of the market to which its products can be sold. A small niche market might not attract competition from larger players, but significant share price growth is unlikely to come from dominating a very small market. Additionally, investors should be wary when a company suggests that it has no competitors, often this is a case of no competitors yet.

5. What barriers to entry are there?

A small company’s prospects of enjoying significant share price gains are significantly decreased if there is little in the way of barriers to stop other firms from entering into their industry. The technology sector in particular has been an elephant’s graveyard of large companies laid low by smaller, more nimble competitors that jumped over the low barriers to entry.  Examples of once exciting companies that only had low barriers to entry include AltaVista, Netscape and Myspace.

Recently we looked at social media marketing company VAMP that was planning on listing on the ASX and was backed by high profile Nova Scotian Qantas and Fairfax Media director Todd Sampson. The social media marketing firm had an exciting buzz as it was designed to capitalise on growing demand from advertising agencies and high-profile consumer brands to connect with Instagram ‘influencers’. However, on reflection, this particular antediluvian fund manager thought that the barriers to entry into social media marketing are quite low.

Our Take

Whilst most small companies have an exciting good, technology or concept that is inevitably presented in a form that will result in large gains in the share price, we see that it is helpful for investors to have a five-point checklist to look at when evaluating a small, exciting, yet unprofitable company. Atlas would like to thank our supporters whose ideas helped in writing this article.