Category: Blog

What is going on in Listed Property

In this note we will look at what is going on in listed property,  the key themes to emerge over the past month from the profit results and how we expect listed property to perform over the next year. Given the name of our firm it would be remiss not to mention that this week marked the 60th anniversary of the publication of the Ayn Rand novel Atlas Shrugged. This novel provides an examination of whether the pursuit of profit is a noble enterprise or the root of all evil and the conflict in society between thinkers relying on facts and those defying reason, supporting their arguments on feelings.

Since 2012, listed property has been one of the top performing sectors on the ASX 200. During this time, other sectors in the equity market have faced concerns about a rising and then falling AUD, volatility in commodity prices that saw BHP abandon their cherished progressive dividend policy, Eurozone issues, near zero interest rates, and bank capital raisings. Listed property meanwhile seemed to be immune to these destabilising forces.
This all changed in the second half of 2016, when “safe” stocks such as Listed Property Trusts and infrastructure stocks, considered to be alternatives to bonds or term deposits, fell heavily on expectations that global interest rates will start to rise in the future. In the February 2017 results reporting season the management teams of the listed property sector addressed investor concerns about the impact of higher interest rates and their ability to grow distributions in a higher inflation environment. This increased investor confidence and accordingly saw the Listed Property sector gain 7% from the lows reached in November 2016.
As real estate is not a homogeneous asset, it is useful to break down the real estate held by the Listed Property Trusts into four distinct groups: shopping centres (retail), office towers (office), housing and apartment developers (residential), and manufacturing or distribution centres (industrial).
Retail
Discretionary retail continues to face the challenges of on-line competition to bricks and mortar, a higher AUD, and slower inbound tourism which has reduced profit margins, particularly in clothing and footwear. Weaker retail sales limit the ability of shopping centre operators such as Scentre and Vicinity to raise rents and typically a rental contract will include a percentage of store sales. New clothing retailers Zara continue to take sales away from department stores like Myer, which is important given department stores are typically the largest rent payer in a shopping centre. Additionally, over the last year shopping centre landlords faced a few tenants closing stores due to insolvency such as Payless Shoes, Howards Storage and Pumpkin Patch.

Whilst the outlook for retail looks difficult, we do not see that shopping centres will become redundant, but they will need to evolve by favouring tenants that offer services that can’t be delivered on-line such as personal grooming and dining.

Office                                     
In contrast to shopping centres, the Australian CBD office market looks pretty healthy for owners of office towers such as Dexus and Investa Office. Vacancy is the best measure of the health of the office sector, as empty floors in an office tower don’t earn rental income for the owners of office property trusts. Overall the market looks stable, but the picture across Australia is quite divergent with vacancy at a 23-year high in Perth being offset by very low vacancies in the Sydney and Melbourne markets.  Sydney and Melbourne have benefited from the conversion of office towers into apartment buildings, which reduces supply, whilst Brisbane and Perth face excess supply from towers built towards the end of the mining boom.

Residential                                     
Unsurprisingly the buoyant residential market in Sydney and Melbourne boosted the results of major residential developers Mirvac, Lend Lease and Stockland. Going into the profit results we were concerned that these developers could face defaults from buyers that have paid deposits for apartments (particularly in Melbourne). A buyer may refuse to complete a sale (thus forfeiting their deposit) if after completion the value of the property has declined or the buyer has had trouble obtaining finance. Our concerns were allayed in February with the developers reporting minimal defaults and healthy forward sales.

Industrial                              
Although the industrial assets continue to be priced higher, the underlying fundamentals have deteriorated with vacancies rising across the sector. Unlike office towers which are relatively homogeneous assets – which means, for example, that an accounting firm can take over space vacated by a financial planner – industrial sites are often configured for a particular tenant. A great example of this is the challenges the BWP face in filling sites vacated by key tenant Bunnings. The industrial trusts have continued to generate profits from re-zoning industrial property to residential. In October Goodman sold an industrial park in Sydney’s north west for $200 million to apartment developer Meriton Group.

One Year Outlook                                   
The total return (capital growth plus distributions) that investors can expect from Listed Property based on four financial components. These are; 1) distributions, 2) movement in asset values as measured by the capitalisation rate which is the rate of return on a real estate investment property based on the income that the property is expected to generate3) expansions or contractions in the market price to earnings ratio and 4) movement in the number of shares on issue (current buy backs or equity issues).

Over the next year, we see a small increase in the average distribution yield and a slight increase in asset values. However, due to concerns about interest rates it is hard to see an expansion in the market price earnings ratio above its current long term average and there are no significant buy backs currently in operation.  Consequently, it is hard to make the case that the bulk of returns that investors can expect from listed property will not come from distributions.

Our Take

The Property Trust sector as a whole appears to be trading at a premium to fair value. We see that catalysts which propelled the sector up over the last three years have largely been played out and the majority of returns over the next 12 months will come from distributions and income from writing call options over existing holdings. The sector currently trades at a +26% premium to net tangible assets (14.2x forward PE and 5.2% yield).  The portfolio strategy of the Atlas High Income Fund of populating the portfolio with higher quality domestic rent collectors combined with a derivative overlay strategy to enhance income should outperform in this market. Further, the focus on trusts that are delivering recurring yield should result in a higher distribution yield and lower earnings volatility for our investors.

Hugh Dive CFA
Chief Investment Officer

Themes emerging from reporting season

This week saw the end of reporting season for 180 of the S&P/ASX200 companies and around 2,000 of the companies listed on the ASX. Over the past month these companies revealed their profit results for the last six months and provided guidance as to how they expect their businesses to perform in the upcoming year. Whilst we regularly meet with companies between reporting periods to gauge how their businesses are performing, during semi-annual reporting season companies fully open up their car bonnets to let investors have a detailed look at the their financials. Until this happens, investors don’t know for certain whether they are going to find burning oil and hissing pythons or see that the company’s growth engine is running to expectations.

We previously looked at what happens behind the scenes in reporting season and in this week’s piece we are going to run through the key themes that have emerged over the last four weeks.

Surprising strength

The February 2017 reporting season was on average benign for investors was generally better than expected due to strong earnings growth from the miners (BHP and Rio Tinto), banks (Commonwealth and ANZ) and healthcare (CSL). Earnings growth in these sectors offset weakness in profit in the industrial sector.  Overall we have seen approximately 18% growth in earnings over the 2016 financial year, though the bulk of this is due to the resource companies enjoying the benefit of resurgent commodity prices. Excluding the resources companies, earnings per share from Australian companies in aggregate climbed by +6% over the past year.

Rock diggers looking good
The market was expecting the miners to do well as commodity prices – namely coal and iron ore –  had received a boost. This was largely due to a Chinese stimulus plan in 2016 based on rapid rise in fixed asset investment in infrastructure, reducing real estate taxes and loosening lending standards. What surprised us was the commitment among the miners to controlling production costs, reducing debt and keeping a lid on capital expenditure. This allowed BHP to report a 65% increase in profits and a 150% increase in the dividend (that had been savagely cut in February 2016).  Rio Tinto paid off US$4.2 billion of debt and announced a share buy-back.

On the conference calls to investors, management teams promised to maintain capital discipline and not waste the windfall of temporarily higher commodity prices. I am hopeful that before I retire from the funds management industry sometime around 2050, I will have seen a commodities boom where shareholders capital in mining companies was not frittered away on questionable acquisitions and marginal projects at the top of the market!

Banks squeezing their pound of flesh

Whilst the banks and financials stocks performed well in the last quarter of 2016, January saw a significant sell off in their share prices of around -5% as investors became concerned about the impact of rising interest rates.  Commonwealth Bank reported cash profits of $4.9 billion, which was higher than expected due to cost controls and keeping loan impairment expense flat at 0.17%. Similarly ANZ reported that revenues were up +7% and there were minimal loan losses.  NAB reported a 1% fall in quarterly profits but echoed the other banks’ views on low loan losses.  We see that the banks are well placed to have a good 2017 as the repricing of their loan books will drive revenue growth.

Give me my money back!

Capital management was a feature of the recent reporting season and was understandably popular with investors. Rio Tinto, CSL, Coca-Cola and even QBE Insurance announced share buy-back plans. In the case of QBE Insurance we found it hard to get excited about their A$500 million buy-back given that they conducted a A$780 million capital raising 2.5 years ago at a price that was a 15% discount to the current share price.

At a dividend level AGL Energy, Transurban, Rio Tinto, GPT and Bluescope Steel all increased dividends to shareholders that were above market expectations. Across the market the dividend pay-out ratio remains high and is now approaching 80%. Increasing dividends and buying back stock boosts share prices in the short term  and plays to the current “search for yield” investment theme. However, in the longer term companies do need to retain cash to reinvest in their operations in order to grow.

Best and worst results

Over the month, the best results were delivered by Transurban, Rio Tinto, QBE Insurance, CSL, Boral, ANZ Bank, Invocare, Treasury Wine Estates and AGL Energy. The common theme amongst these companies was a solid control of costs and a profit result that did not rely on an improvement in the domestic Australian economy. Woolworths’ share price performed well after they announced sales growth that was ahead of Coles for the first time since 2009. However, shareholders paid for this market-share gain in the form of lower prices, which caused profits in food business to fall by $131 million to $811 million.

On the negative side of the ledger Blackmores, Genworth, James Hardie, Brambles, Domino’s Pizza and Primary Healthcare all reported disappointing results compared with other companies. The common themes among this group was high price-to-earnings rated companies not delivering on high expectations, or companies that had downgraded expectations and hence delivered results that were worse than expected. Telstra had a particularly tough reporting season with profits down -14%, but what concerned the market was the fall in mobile revenue and evidence of more intense competition.

Our take

In contrast to other reporting seasons, this one was relatively benevolent for quality-style investors avoiding both high priced growth stocks and companies with issues. After overall market earnings declines in 2015 and 2016, this reporting season provided evidence that company profits are rising again and that profit margins (ex financials and resources) are rebuilding. This positive view of the Australian economy was confirmed by the ABS GDP data released yesterday that revealed the Australian economy grew by +1.1% in the December quarter and by +2.4% in 2016, which was well above consensus forecasts and the strongest growth in four years. Whilst we expect the banking sector to have a solid 2017, commodity prices (which we expect to weaken) should dampen earnings for the remainder of the year.

Behind the scenes in reporting season

Over the last two weeks and for the next fortnight, visitors to the Sydney CBD may have noticed stressed analysts and fund managers in sharp suits moving about with unusual velocity and with a slightly greater degree of self-importance than normal. Simultaneously, stories from financial journalists are migrating to the front page of the paper. The cause of these phenomena is the ASX-listed company profit reporting seasons, which occurs twice a year with the regular timing of the Serengeti wildebeest migration.

Reporting season is a stressful time, as it reveals how a company is performing in financial measures such as profit, margins, debt and free cash flow, as against the expectations in analysts’ models that are used to derive a valuation. When companies reveal unpleasant surprises or point to problems in the future, the company’s stock price can decline sharply. Alternatively, it can be very pleasant when the company reports a good result which validates the investment case for owning their shares. In this week’s piece, we are going to go through how Atlas approaches each day during reporting season and what happens during a typical day in the earnings reporting season.

Before the day
In mid-January and July (in advance of the August season), Atlas reviews the companies in the portfolio and looks at our expectations for key factors against both the company’s guidance and consensus analyst forecasts. The purpose of this exercise is not so much to identify companies performing ahead of expectations, but to find those in the portfolio that have the potential to cause losses on results day. Take for example Primary Health: the weak Medicare data coming through over the past few months combined with ongoing uncertainty over Government health policy would have alerted investors to the possibility that the company was facing tougher conditions that the market expected.

On results day all is revealed
Companies normally post their results with the ASX around 9am, which gives investors some time to digest the numbers and develop a view before the stock begins trading at 10am. During this period, we will be combing through the profit and loss, balance sheet and cash flow statements, comparing our forecasts to what the company delivered. Also, it is important to compare how a company has performed against their peer group. For example, Woolworths report their results next Wednesday (22 February) and the share price reaction will be strongly influenced by how the grocery business performed relative to Coles (+1.3% sales growth and 4.6% profit margin).

Company management will then formally present their results to shareholders on a conference call or at their offices during the morning, generally between 9:30am and midday. These presentations are directed towards the institutional investment community and are effectively closed to the media and public. They can take between thirty minutes and two hours, with the management having the opportunity to explain their results and discuss factors that will influence future profits. If the company has had a poorly received result and the stock price is falling, this will give management the opportunity to calm the market and clear up some uncertainties.

The most informative part – in our opinion – is always the questions section at the end as it gives investors the chance to see how confident management are in dealing with the issues that investors may have with the financial accounts after they have departed from the prepared scripts. Earlier this week, many investors observed that Australia’s largest office landlord Dexus Property struggled when explaining the amounts and accounting treatment of the cash used to break interest rate hedges. Whilst this sounds innocuous, listed property trusts exclude the payment for breaking these hedges from their current profits, yet highlight the earnings growth from lower interest costs in future years. In our view this is accounting smoke and mirrors!

Typically, it will only be the sell side analysts asking questions of management in the results presentation, with the large institutional investors saving their questions for their own individual meetings with management. However occasionally fund managers become frustrated when company management receive “soft” questions from the sell-side analysts after releasing a result that disappointed the markets. These soft questions can be the result of some sell side analysts wanting to protect their relationship with the company. The last time that I asked a question was a few years ago at a QBE Insurance result. The stock price was down 10% on the day due to some surprise provisions. Here I was frustrated by the analysts asking benign questions about future years’ depreciation charges, and this prompted me to inquire as to “What comparative advantage does QBE have in writing Argentinian workers compensation insurance?”.

Afterwards
In the week after the results, the company will organise one-hour meetings with their domestic and international institutional shareholders. In these meetings, it is important to be well prepared to maximise the value of the time that you get with management, as this is often a key factor when deciding whether to commit investors’ capital to the company. Whilst these meetings can be either quite hostile or very friendly, they are a valuable forum for both parties to give feedback on not only how our clients’ capital has been managed in the past, but also how that capital should be employed in the future.
In recent meetings, one of the key topics that I have discussed with management is their attitudes to debt and gearing. Currently investment grade companies can obtain debt at historically low prices and –  more importantly  – with long duration, which would suggest that companies should raise their gearing to boost returns. The counterpoint to the thesis of increasing borrowings is the lingering memories of the GFC. Accordingly, many companies are reluctant to pay high prices for existing assets or do not have sufficient confidence in the economic outlook or political stability to spend capital.

Trading – measured decisions not made in haste
Whilst the stock-broking community would clearly prefer that fund managers trade immediately and often based on company results, the decisions to make dramatic changes to a position for fundamentally-based fund managers will only occur after sober analysis of the company’s results. The fund manager will then examine what changes are made to valuations and look at the set of competing investment opportunities and their expected returns including cash. We believe that most of the trading volume on the day of a result is either due to short term momentum-based hedge funds, or most likely the machines behind algorithmic trading. This may explain moves such as we saw earlier this week with Treasury Wine, who after reporting was down -5% on Monday, but gained +4% on Tuesday.

Reporting season is like Christmas for investors, in that we get to have a close look at the companies in which we have entrusted our capital, examine the financials, and ask questions of the management teams running these companies. Additionally it can give us a greater insight than ABS statistics into what is actually happening in the economy.

Hugh Dive CFA
Chief Investment Officer

Trading by those in the know

In finance, there is a vast industry of market experts that attempt to provide guidance as to future moves in share prices. Often their predictions are based on nebulous macroeconomic factors such as concerns about rising bond yields or market attitude to risk. These factors, however, rarely have a significant impact on the inherent valuation of an individual company. Whilst sell-side analyst reports are a great source of background information on factors influencing a company, they rarely are able consistently to identify near-term structural issues that cause large share price moves.

We see that a consistently underappreciated source of intelligence as to the future prospects for an individual company is trading in that company by insiders. Often large and unusual insider selling can be the “canary in the coal mine”, occurring before a significant fall in the company’s share price. In this week’s debut piece from Atlas Funds Management, we are going to look at trading by insiders and how to interpret trade notifications. We are not going to look at the illegal act of insider trading per se, but rather how trades by key personnel can help frame an investing decision. We see that while management teams can publicly minimise challenges the company faces, they can tend to be more cautious when it comes to their personal holdings.

 Insiders and insider trading

Insiders required to report trading activity are key management personnel, defined by the Australian Accounting Standards Board as “those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director of that entity”.

The ASX listing rules in conjunction with the Corporations Act require that key management personnel notify the market within five days of changes that occur to that person’s holdings in the listed company. These changes are posted to the ASX and quite helpfully are collated in the financial press daily in the back of the markets section. Additionally, ASIC requires that substantial investors (defined as those who own greater than 5% of a listed company) are required to notify the market of a change of 1% or more in their holding.

Rationale for rules

Most investors agree that it is generally beneficial for directors and key employees of a listed company to own securities in the entity. Many investors, including Atlas, view it as negative when researching a company where directors or senior management own minimal shares in the company. We are usually not persuaded by the justifications provided, such as that this “gives the directors greater independence” or that “they have enough financial exposure to the company”.

Investing alongside other shareholders gives key personnel a bigger stake in the success of the entity and helps to align their interests with the interests of investors. The downside is that these insiders will often be, or be perceived to be, in possession of “market sensitive information” or “inside information” concerning the company that is not generally available to other investors. These insiders also have legal obligations not to engage in insider trading or market manipulation and not to use information acquired as a director or employee to gain an improper advantage for themselves.

Examples of sensitive information include dividends, a financial outlook that differs from consensus, upcoming litigation, regulatory investigations, or changes to the company’s structure such as dilutionary capital raisings.

The Temptation

Key personnel face powerful temptations to sell shares when they come into possession of negative information or deeper concerns about factors influencing the company’s business that may cause large falls in their personal wealth.

Typically, insiders frame their decision to sell large percentages of their holdings in the company as motivated by stated desires to rebalance their portfolio, buy a beach house or – my personal favourite – to pay a tax bill. Just prior to the GFC, the CFO of a major financial services sold the bulk of his holdings in his company. When asked about it he explained that this was due to the tax bill he faced due to the recent exercise of some options. After calculating that his sales were approximately ten times the tax bill he faced, we also decided to reduce our position in the company.  Whilst I am not suggesting any impropriety occurred in this case, over the next 9 months the company’s share price did fall 50%.

Recent Activity

2016 was a banner year for the informational value of insider trades. Organic infant formula producer Bellamy’s has faced a challenging 2016 due to a “temporary volume dislocation” in China due to regulatory changes. Whilst the market was aware of these issues for the bulk of 2016, it appears that Bellamy’s CEO and Chairman had a superior appreciation of the challenges the company faced than equity analysts, when they reduced their holdings of the former market darling in August. The company was suspended from trading on the ASX for a month over the Christmas period and now trades at half the level it did in early December.

Liver cancer drug manufacturer Sirtex’s CEO sold a large proportion of his shares in the company in November for taxation reasons. Similarly this proved to be a good indication for shareholders also to lighten their holdings of the company as it occurred one month before a trading update in December that caused Sirtex’s price to fall by 47%.

Construction software group Aconex continued this in 2017, with a 30% earnings downgrade earlier this week that caused the company’s shares to open down 45%. This downgrade was attributed to uncertainty around Brexit and Trump’s election (two factors that have boosted equity prices globally over the past three months), though we note that the two executive directors were reducing their holdings in August and September in 2016.

The news is not always grim

One of the most powerful buying signals for investors is when directors and management are buying their own stock in the market. To detect this in the ASX notices, it is important to determine that this buying involves their own money and not simply the granting of stock due to achieving performance hurdles. However we would question the strength of the signal when management of a very troubled company symbolically add to their holdings in what seems like a gesture to shore up fractured confidence. A famous example of this occurred in 2005 when the CEO of embattled carpet manufacturer Feltex interrupted a torrid analyst briefing to place a call with his stockbroker to buy shares.

We see that the better indicator is where management in a stable and growing company are buying their own stock on the ASX.  Several years ago, I was a little nervous about my position in an industrial company after their share price had risen 30% over the previous few months since I had purchased the position. Whilst the published outlook from management was positive, I noticed that most senior personnel were also increasing their investments in the company despite this rise. Over the next four years the company’s share price increased tenfold.

Our Take

Company management teams invariably present the most positive view of the company that they represent, as the personalities of the individuals that make it to the top of large companies are almost always positive and hardworking. Whilst we would not advocate trading by insiders as the sole rationale for making an investment decision, if an investor is nervous about either the valuation of a stock held or the implications of a significant change, we see that selling by management or directors is a strong indicator for investors immediately to review their holdings in that company.

Hugh Dive
Chief Investment Officer

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Introducing Atlas Funds Management

Atlas Funds Management was launched in January 2017 to provide investors with access to innovative listed alternative investments that offer consistent high income paid quarterly.

Our approach is based on a conservative investment philosophy underpinned by decades of experience in the financial markets, and a rigorous adherence to the highest ethical standards of the investment profession.

The two key factors that underpin our approach are:

(1) Investment success through making fewer mistakes
Rather than chasing high return and higher risk investments, we see that superior performance and lower volatility of returns are best delivered by concentrating on avoiding mistakes or “performance torpedoes”.

(2) Smaller certain returns today are worth more than larger uncertain future returns
We prefer to invest in portfolio companies paying certain dividends today which can be distributed to investors, rather than deploying our investors’ capital in companies promising more variable returns in the future.

Read more about our investment philosophy, and sign up to receive our weekly thought piece on the financial markets and various factors that influence our approach to investing.

Our first fund, the Atlas High Income Property Fund, will be available to investors shortly. We welcome queries from anyone interested in our funds. Please contact us if you would like to request an Information Memorandum or speak with our management team to learn more.