Volatility and Melting Markets in February

Over the last two weeks investors have been bombarded with a range of financial commentary, some of which comes with the conclusion that investors should sell everything as we are facing price falls in 2018 similar to what happened during the GFC a decade ago. This intensified after the S&P 500 fell -3% on Monday, its biggest one-day fall since 2012.

In this week’s piece we are going to look at some of the factors behind February’s fall and subsequent market volatility, and how we approach investing during times when the Chicken Littles are suggesting that “The sky is falling in!”.

Setting the Scene: A shaky background in January
Prior to the market volatility in February, the stage appeared to be set for a correction. The US market had enjoyed a two year run without a major correction, as the S&P 500 smoothly gained 54% from the 12th February 2016. In late January US stocks were trading at lofty valuations: the S&P 500 was trading on a price to earnings ratio of 21 times, fuelled by improving corporate profits and impending tax cuts.

However, the market was also concerned that if the US economy gets much stronger, we could see inflation, something that many younger analysts only dimly remembered from dusty economics textbooks. Finally, with the changeover in the leadership of the US Federal reserve occurring on the 3rd February, there was concern that the US Fed would drive up interest rates in 2018 and that this would be done too aggressively, triggering a fall in equities.

Low Volatility
Against this background, market volatility had declined to extremely low levels, as the share market enjoyed a prolonged period of smooth rally without a correction. Moreover, this low volatility extended to a range of assets including shares, currencies and bonds. The decline in volatility is something that we had observed over the past year, and which influenced income in the Atlas High Income Property Fund.

Whilst Atlas have been unhappy about the prices we have been receiving due to the low volatility, a range of hedge funds have been profiting from this phenomenon. Essentially this involves betting that stock markets would continue to remain benign. This is done by shorting the volatility of the market 1. Short volatility has been a very consistently profitable trade over the past year, collecting consistent premiums every few months from derivative positions that return a profit if the stock market does not swing wildly in either a positive or negative direction.

A Crowded Trade and the Stampede out the Door
At the end of January there was US$3 billion in exchange traded funds ( ETFs) in the US using this strategy. Amazingly two ETFs alone – VelocityShares Daily Inverse VIX Short-Term ETN, and ProShares Short VIX Short-Term Futures ETF – increased assets by US$1.7B between them in January 2018. After the first of these funds fell more than 90% in a week, Credit Suisse are in the process of shutting it down.

However, it would be incorrect to think that a few small funds alone contributed to the market falls we have seen in February. According to Bloomberg in the wider funds management universe more than $2 trillion of investments are linked to this short volatility strategy. These hedge funds are connected via systematic strategies such as short volatility, risk parity, and volatility targeting. This very profitable trade betting on low volatility soon became a crowded short, vulnerable to a short squeeze when a large number of traders are forced to try and make the same trade at the same time. A situation similar ten people trying to quickly leave a room through a doorway when a giant rat falls from the ceiling.

What we have seen over the past fortnight was the unwinding of a crowded trade, and the resulting squeeze. The market movement – as these funds unravel and hedge funds using these strategies see outflows – has fed into weakness in the underlying shares due to forced sales of equities.

1. The short volatility trade involves two constituent parts;

a) Initially selling longer-dated futures on the Volatility Index (VIX) which were priced based on the expected volatility of the S&P 500 a few months in the future. The VIX is itself derived from the volatility of options on the S&P 500 which are primarily derived from the recent volatility in the price action of the market itself. Atlas have observed the declining volatility of markets over the past year, because as a seller of covered call options, the premiums we have been receiving for the call options sold have been declining.

b) As for the past two years up until February these futures in volatility traded above the current level of volatility or VIX, provided the market remains placid, the short seller covers their short sales as the price of the future falls towards the spot price as the future expire.

Our take

Atlas considers that what we are seeing at the moment is the disconnect between the “financial economy” and the “physical economy” and an element of reality returning to stock market valuations. At the halfway mark of the February profit-reporting season, the overwhelming theme is that both Australian and US companies are making healthy profits.

When a major market dislocation occurs, the best thing for investors to do is step back and think what this particular dislocation will do to the earnings and dividends from the companies held in their portfolio. If the answer is not much and the dividend stream will be largely unaffected, then the falling market has given you the opportunity to add to positions at a discounted price. This is markedly different to the conditions that investors faced ten years ago. At that time the seizing up of the credit markets both disrupted the ability of most global companies to refinance their debt, and also saw profits fall heavily as global trade declined sharply.

Dogs of the ASX …. Woof Woof!

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. This avoids the manager having to explain to asset consultants why these unloved stocks are still in their portfolios.

In this week’s piece written from snowy Norway, 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 2017 to try to discern any fallen angels with potential to outperform in 2018. 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. They may have the financial strength or understanding capital providers (shareholders and banks) that can provide additional capital to allow the company to recover over time.

ASX 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 Qantas in 2017 (+65%), Fortescue in 2016 (+223%), Qantas again in 2014 and Challenger in 2012 (+81%) – an equal weighted portfolio of the dogs of the ASX 100 has outperformed the index in three of the past seven years.

Themes
Looking at the above table, finding the fallen angel among the worst performers seems to work best where the underperformance is due to stock-specific issues, rather than macro 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 240%, 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 were climbing upwards. 2016 saw a significant turnaround for BlueScope’s shares which gained +111% as profits recovered due to cost controls, stronger sales and the benefits of an acquisition in the United States.

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 as of December 2017
As a fund manager the key question is whether there are potential show champions in the breed of unloved canines tabled below for the 2017 calendar year. Unlike previous years a diverse mix of sectors are represented and there are more company-specific reasons for underperformance, which should yield more opportunities to pick some treasure out of the trash.

Looking at the two telcos Vocus and Telstra, it is tough to see the near term catalysts that will transform them into stars in 2018, with the NBN market likely to remain intensely competitive with high costs to migrate customers. Fortescue is likely to continue to face Chinese preference for higher grade iron ore over its lower-grade blends to improve furnace efficiency and reduce pollution. Domino’s Pizza could be a candidate for a turn-around in 2018, now the company is more reasonably valued with multiple avenues for growth across its discount pizza operations in Europe, Australia and Japan and a falling AUD will boost earnings. Similarly Brambles could see a brighter 2018 based on growth in US pallets, management stability and a falling AUD.

Our View
Whilst 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 among 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 largely 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.

Nevertheless it can pay to sort though the dogs of the ASX. From the table above over the past 5 years, one of the top performers in the following year can be found by sifting through the dogs of the ASX100.

Earnings Chicanery Part Two

Last week in part one of Atlas’ surprisingly popular series on financial statement trickery – Earnings Chicanery, we looked at the three financial statements and some measures a company can take to “dress up” their financial results. In part two we are going to build on this and take a look at some warning signs that there may be problems with a company’s financial statements.

Red Flag 1: The statements don’t match

On results day most attention is focused upon a company’s profit and loss statement. In particular, analysts and commentators scrutinise whether the company has achieved the expected profit or earnings per share guidance, which was usually given at the last result. Whilst the profit and loss statement usually provides good guidance as to how the company has traded over the past six months, as discussed last week it is also the statement most open to manipulation and should be read in conjunction with the cash flow statement. It is a good idea to compare a company’s operating cash flow with its reported profits. If there is a big divergence, then the accounts should be examined carefully.

The red flag that we are looking for here is when a company’s cash flow statement and profit and loss statements are moving in different directions over an 18 month period, and where a company is showing growing profitability, but declining cash flows. In the below table from the 2015 accounts, Dick Smith Holdings reported income growing from $19 million to $38 million, yet operating cash flow fell from $52 million to -$4 million. This suggests that the sales generating profits reported on the profit and loss statement were actually pushing the company towards administration.

Another recent example of this can be seen in Slater+Gordon. In the below table from their 2015 accounts, the company reported that 2015 financial year profits were up +6% to $84 million, yet their operating cash flow had deteriorated by -25% to $41 million. Here it appears that the company was overstating its profits through the accounting of its “legal work in progress”, and was overly aggressive in anticipating the expected cash generated through won cases. Whilst the company was able to deliver the earnings growth the market was expecting, in reality the declining incoming cash flows showed signs that it was actually a business in trouble.

However there are exceptions to the rule
The earnings on the profit and loss statement for some businesses can diverge from the cash flow statement. For example, a construction company such as Cimic (nee Leightons) or Downer might not physically be paid until July in the next financial year for work done on a railway project. Here the profits at a point in time may be greater than the cashflows, though the lumpiness of the cash flows received from large individual contracts will even out over time.

Red Flag 2: A company has consistent extraordinary
Extraordinary items are gains or losses included on a company’s income statement from unusual or infrequent events. Importantly, they are excluded from a company’s operating earnings. These items are excluded from earnings to give investors a more “normalised” view of how the company has performed over the period. For example, if an industrial company such as Amcor books a $50 million gain from selling excess industrial land, including this profit would obscure information about how the company’s packaging businesses have performed over the past six months.

While reporting extraordinary items can be valid and useful, investors should be wary or make their own adjustments to company earnings where a company has frequent (and almost always negative) extraordinary items that they are seeking to exclude from their reported profits.

As a long-term observer of the Australian banks, almost every year they put through a write-off of software below the profit line. In my view, investing in banking software is a core part of their business model and it seems curious that the institution is willing to take the productivity benefits in their normalised earnings whilst ignoring a portion of the costs needed to achieve these gains.

Red Flag 3: Divergence from comparable companies
The warning sign we are looking for here is when a company consistently has higher average profitability, revenue growth or better working capital management than their industry peers. Invariably when management is asked they will give an answer that relates to management brilliance or superior controls, but realistically mature companies operating in the same industry tend to exhibit very similar characteristics. As such, their financial statements should to some extent correspond to the statements of companies operating in the same industry. For example, supermarkets such as Woolworths should have a similar cash conversion profile to Coles (operating cash flow divided by operating profits) and not dissimilar profit margins as they are selling identical products to largely the same set of customers.

Hollow Logs?
Occasionally management teams may be incentivised to under-report profits in any current period. This generally occurs when a company is under heightened union scrutiny due to wage negotiations with their employees, excessive government attention from perceived excessive profits, or expects a problem in the next year and wants to smooth their profits. For example, in the current environment of extremely low bad debts a bank could be incentivised to boost their bad debt provisions aggressively. This action would reduce current period profits, potentially a politically astute move when politicians are calling for a Royal Commission into Australia’s banking sector. These excess provisions, if not required, could then be written back at a later date to boost future profits.

Our Take

Earnings misrepresentation is difficult for investors to detect from the publicly available accounts, but when revealed can sometimes have extreme results for a company’s share prices. In my experience this is more an art than a science, as the investor gets a sense that something is not right with the accounts, rather than definitive proof of earnings manipulation. Normally actual manipulation generally only becomes obvious ex post facto, after management has been removed or a company goes into administration.

Banks Reporting Season Scorecard 2017

Over the last ten days the major Australian banks have reported their financial results for 2017, reporting collective annual profits of $31.5 billion. In comparison to the May reporting season (which saw the surprise introduction of a 0.06% levy on the liabilities and $50 billion being wiped off the bank’s collective market capitalisation), the results were mostly in line with expectations. A key feature that we noticed was how efficiently the financial impact of this “game changing” levy or tax was passed onto borrowers, something that we expected when we looked at the bank results earlier this year in the May Reporting Season Score Card.

In this piece, we are going to look at the common themes emerging from the November reporting season, differentiate between the different banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Across the sector profit growth was generally in-line with the credit growth in the overall Australian economy. ANZ reported headline profit growth of 7.6% when backing out the impact of the sale of the bank’s Asian retail businesses, Esanda and property gains from 2016. The solid profit growth displayed across the sector was achieved by improving economic conditions and lower bad debts. All of the banks reported lower trading income due to decreased volatility over the year. During periods of higher market volatility, the banks can boost their income by both selling more foreign exchange and interest rate derivative contracts to their clients. However, they can also generate trading income by using their large balance sheet reserves to trade securities on the global markets.

Gold Star

Angry on costs: Reducing costs featured prominently in the plans of bank CEOs for the upcoming year, with much discussion about branch closures and headcount reductions. The removal of ATM bank charges and the migration of transactional banking from the physical bank branch to the internet is likely to deliver an efficiency dividend to the banks. NAB took the most aggressive stance, announcing that the bank will reduce its workforce by 6,000 employees due to business simplification and increasing automation. However, this will come at a cost with NAB expecting to book a restructuring charge of between $500-$800 million in 2018 and increases in investment spend by $1.5 billion.

Gold Star

Bad debt charges still very low: One of the key themes across the four major banks and indeed the biggest driver of earnings growth over the last few years has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay and that the outstanding loan amount is greater than the collateral eventually recovered. Bad debts fell further in 2017, as some previously stressed or non-performing loans were paid off or returned to making interest payments, primarily due to a buoyant East Coast property market and higher commodity prices. CBA gets the gold star with a very small impairment charge in 1^st quarter 2018 courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

Gold Star

Dividend growth stalled but may return: Across the sector dividend growth has essentially stopped, with CBA providing the only increase of 9 cents over 2016. With relatively benign profit growth a bank can either increase dividends to shareholders or retain profits to build capital (thereby protecting banks against financial shocks); but not both. In the recent set of results the banks have held dividends steady to boost their Tier 1 capital ratios. Additionally, dividend growth has been limited as the banks have had to absorb the impact of the additional shares issued in late 2015 to boost capital.

Looking ahead, there may be some capacity to increase dividends (especially from ANZ and CBA after asset sales), as the rebuild of bank capital to APRA’s standards is largely complete. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 8.2%.

Gold Star

Net interest margins in aggregate increased in 2017, despite the imposition of the major bank levy. This was attributed to lower funding costs and repricing of existing loans to higher rates. In response to regulator concerns about an over-heated residential property market and in particular the growth in interest-only loans to property investors; in 2017 the banks have repriced these loans higher than those repaying both principal and interest. For example, Westpac’s currently charges 6.3% on an interest only loan to an investor, which contrasts to the 4.4% being charged to owner occupiers paying both principal and interest. This has had the impact of boosting bank net interest margins.

One of the key things we looked at closely during this results season was signs of expanding net interest margin (Interest Received – Interest Paid) divided by Average Invested Assets), and this was apparent even after allowing for May’s Major Bank Levy

Gold Star Australian banking oligopoly

Total Returns: In 2017 only NAB has been the top performing bank, benefiting from delivering cleaner results, after it jettisoned its UK issues with spin-off of the Clydesdale Bank and Yorkshire Bank. CBA has been the worst performing bank as it faces both the imminent retirement of its CEO and the uncertainty around possible fines from foreign regulators for not complying with anti-money laundering laws. This has resulted in CBA losing the market premium rating that it has enjoyed for a number of years over the other banks.

Gold Star

Our Take

What to do with the Australian banks is one of the major questions facing both institutional and retail investors alike. The Australian banks have been very successful over the past few years in generating record profits, benefiting from lower competition from non-bank lenders and record low bad debts. Looking ahead it is not easy to see how the banks can deliver earnings growth above the low single digits in an environment of low credit growth, increased regulatory scrutiny and the sale of some of their insurance and wealth management divisions.

Competition amongst the big four banks is likely to increase, as for the first time since 1987 (NAB’s purchase of Clydesdale Bank) we have no Australian banks distracted by foreign adventures, with all four focused on the Australian market. However, looking around the Australian market the banks look relatively cheap, are well capitalized and unlike other income stocks such as Telstra should have little difficulty in maintaining their high fully franked dividends.

High Priced Shares

Earlier this week Macquarie Bank’s share price almost touched $100 after releasing a solid set of profit results and there was speculation in the press that Macquarie Bank would join Cochlear, Blackmores and CSL in having a three-figure share price. What was missing in these articles was the subsequent performance of other market darlings that have scaled these lofty price heights. Indeed, in a six-month period in late 2015 to early 2016 we saw Blackmores go from $100 a share to $220 per share, before sliding below $90 per share in in August 2017.

In this week’s piece we are going to look at over-valuation and reverse engineering the share price of two high flying stocks on the ASX; Macquarie Bank and A2M milk.

Price versus Value
Historically Australian investors have greatly preferred to invest in companies that have share prices below $10-20. My impression is that this is based on the logic that a 20c move in the share price has a bigger proportional impact, and that investors get more shares in the company when they invest. Fundamentally the actual dollar price per share means very little when deciding whether to buy or sell a stock. The decision is most often made by comparing a stock’s price with the expected profits and, ultimately, the dividends that you can expect as an owner of a fraction of the company. These expected cash flows are then discounted for both their timing and the risk of the company. This analysis derives a valuation that guides an investment decision. A $120 per share company could be much better value than one priced at $12 per share, if the expected dividends discounted for risk and inflation are higher than the price being quoted on the ASX.

Share price momentum
Often when a share price is rising in response to unexpected good news, underlying valuations tend to be ignored and risks glossed over. Analysts at both fund managers and the investment banks (including the author in his younger days) will tweak their valuations to justify why a strong performing stock is still worth buying, thus pushing the price higher.

Additionally, a range of quantitatively managed funds use momentum as a key factor in their investment strategy. Momentum investing is based on the principle that stocks that have been rising (or falling) in the past will continue to do so in the future. This strategy has nothing to do with the fundamentals of a company, but rather with the human propensity to extrapolate trends into the future. Active fund managers can also fall into the momentum trap, as good performance from owning these high flyers attracts inflows from investors that tend to be re-invested in these same stocks, creating a circular loop.

Momentum tends to work well as an investment strategy until it abruptly stops working. Like Icarus flying towards the sun, when these high-flying share prices melt there is often little valuation support.

What does the current share price imply?

One of the best methods I have used over the years to analyse expensive companies like Macquarie is to back-solve the earnings growth that the current $99-dollar share price implies. In other words, we reverse engineer the share price .

This model uses consensus earnings drawn from sell side analysts’ estimations of company earnings for the next three years. Whilst we recognise that broker earnings are inevitably too optimistic, they provide something of a base estimation of a company’s earnings power. Similarly, we use a terminal growth value of 2.5% in line with the estimated long-term growth rate of the economy.

Logically Macquarie Bank cannot grow towards infinity at 4% if the economy grows at 2.5%, otherwise as a matter of mathematical necessity it will become 99.9% of the Australian economy. Perhaps this would involve consumers buying Silver Doughnut branded cars, breakfast spreads, bread and beer, all funded by a Macquarie Bank mortgage. A chilling thought to most outside of Macquarie Bank’s Beaux-Arts revivalist-style Headquarters in 50 Martin Palace.

The above model suggests that Macquarie Bank’s profit growth needs to maintain a growth rate of just under 2% from 2021 to 2027 to justify the current share price. This is not unfeasible for Macquarie Bank. However, even if it executes well and expands its current A$482 billion assets under management, earnings are likely to be buffeted by external shocks over the next decade.

Milk and yogurt company A2M is a favourite holding of many fund managers and its share price is up a staggering 1,542% since listing in 2015. Currently the market sees such upside in the demand for A2M’s milk products that the company is trading on 41 times next year’s earnings per share. A2M is a company with a very solid growth prospects, however using the same model as we used for Macquarie Bank, A2M’s current share price requires a profit growth rate of over 20% for the next three years followed by 14% for the rest of the decade. Whilst it is far easier for a smaller company to achieve these compound growth rates, the current share price does not appear to allow for issues such as Chinese import restrictions or future manufacturing problems.

The growth implied by the current share price is a good sanity measure for investors. While even the best companies can deliver high earnings growth for a short amount of time, inevitably this growth falters either due to new competitors, management hubris or even the mathematics of compounding growth. Even for the m

ost wonderful company it is becomes progressively harder to grow those earnings at a high compounded rate, as the addressable market for a company’s products is always finite.
The last company to achieve a compounded growth rate of 10% over a 10-year period was Microsoft in the period ending 2004. Here the company benefited from the launch of Windows, Microsoft Office, Windows 95 and the global demand for computers spurred by a desire to access the Internet. Whilst A2M’s milk is gaining market share, it is hard to make the case that it will have as big an impact as Microsoft Excel.