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.
An investor looking for value in 2020?
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.
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
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.
The Atlas High Income Property Fund had a solid month in November gaining +1.7%.
On Melbourne Cup Day the RBA met and decided to hold the cash rate at 0.75%, waiting to see whether previous rate cuts and $22 billion in tax refunds have boosted consumer spending and kept the unemployment rate in check. However, in his speech, the RBA Governor paved the way for further interest rate cuts in 2020.
The Fund remains populated with trusts with recurring earnings streams from rental income from long-dated leases to high-quality tenants. Due to leases that mostly provide for fixed price rental increases above the current of inflation, in the medium term, we expect steady growth in the distributions that the Fund is receiving from our investments.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.
For much of the last decade the profit results for the banks were rather simple to analyse. Coming out of the GFC the major trading banks steadily grew profitability on the back of solid credit growth, declining bad debt charges and reduced competition as foreign competitors either exited the Australian market or were taken over. However, over the past two years, the profit results of the banks have been very complicated to analyse.
The Royal Commission on Financial Services has resulted in extensive remediation provisions, increased compliance costs and a spike in legal fees, at a time where credit growth has slowed dramatically and interest rates have moved towards zero. Additionally, Commonwealth, ANZ and Westpac all divested divisions, primarily in wealth and insurance, the areas of their businesses that were the source of the majority of their remediation charges.
In this week’s piece we are going to look at the themes in the approximately 800 pages of financial results released over the past ten days by the financial institutions that grease the wheels of the Australian capitalism and award gold stars based on performance over the past year.
Remediation
Customer remediation was a key theme for the results in 2019,
with banks compensating customers or taking provisions related to financial
advice, banking, insurance and consumer credit in response to the revelations
from 2018’s Royal Commission on Financial Services. Australia’s banks
have taken remediation provisions over the past 12 months of between $826M
(ANZ) and $1.1b (Westpac and CBA), with NAB around the $1.4b mark. ANZ’s lower
level of provisioning does not reflect any lack of prudence, but rather their
historically lower level of exposure to financial advice and funds
management. NAB’s higher level of remediation charges reflects their
desire to put MLC on solid footing before either selling or listing their
financial advice business in 2020.
No Stars given – remediation charges bad for
both customers and shareholders
Capital
While all banks have a core Tier 1 capital ratios above the Australian
Prudential Regulation Authority (APRA) ‘unquestionably strong’ benchmark of
10.5%, boosting capital was a feature the bank profit results in 2019. Westpac
increased their capital via both a $2.5 billion equity raising and cutting
their dividend, ANZ and CBA saw capital increase after selling wealth and
insurance divisions and not buying back shares to neutralise the earnings per
share impact and NAB’s final dividend was partially underwritten.
Normally increases in capital are only required when a bank is either
substantially increasing their loan book or are writing off the value of assets
in a recession, neither of which is the situation facing the banks in 2019 in
an environment of anaemic credit growth and low bad debts. These moves to
boost capital are in response to potential changes to capital requirements
across the Tasman discussed below and APRA’s moves to retain capital in the
Australian banking system.
Gold Star
New Zealand
New Zealand’s banking market is unusual in the developed world in that around
90% of lending is done by foreign banks namely the subsidiaries of Australia’s
major four banks and the country is a major capital importer. Most banking systems
have a similar structure to Australia, with domestically-owned banks dominating
lending and deposits. While this market dominance is often portrayed as a
takeover of the New Zealand banking system by sinister Australian institutions,
the concentration of market power is primarily due to the collapse of New
Zealand owned banks in the 1980s, with these banks being taken over and
recapitalised by Australian banks.
Late in 2018 the RBNZ released a consultation paper on bank capital
requirements, essentially saying that they would like the banks operating in
New Zealand to lift their Tier 1 Capital from 8.5% to a level of 16%, well
above APRA’s Australian standard of 10.5%. The impact of this decision (if
implemented) immediately would be for the Australian banks to inject around to
A$12 billion into their NZ-based subsidiaries.
The RBNZ consultation paper is based on the naïve assumption that the
Australian banks would do nothing in response to this additional capital
requirements, and that Australian shareholders would blithely fund New
Zealand’s aspirations to be the best-capitalised banking system in the world,
without any impact on pricing of mortgages in New Zealand or overall credit
availability in the shaky isles. In December 2019, the banks will gain clarity
as to how the RBNZ intends to implement their plans and in response, all of the
banks other than NAB are carrying high levels of capital.
In their results NAB took the most aggressive tone, suggesting that they will
reduce lending in New Zealand and reprice loans, an interesting move given that
in 2019 New Zealand was NAB’s most profitable market and the only division in
NAB that saw higher cash profits! If New Zealand’s capital requirements turn to
be less onerous than expected, investors may expect share buybacks from ANZ and
CBA.
Profit growth?
Across the banking sector profit growth reflected anaemic credit growth, falling interest rates and significant remediation charges, with earnings per share across the major banks declining by -8%. While some analysts and the banks themselves ignore these charges and talk about “normalised earnings”, we see this as specious logic. These remediation charges are not non-cash accounting charges, but actual cash outflows that impact shareholder dividends.
ANZ Bank grew cash profits per share by 2% courtesy of a very strong performance by their institutional bank and taking most of their remediation medicine in 2018. However, the gold star goes to Australia’s global investment bank Macquarie, which stands out with an 11% growth in earnings per share. Macquarie’s rising earnings per share is due to both successful expansions offshore and sidestepping most of the issues revealed by the Royal Commission.
Gold Star
Dividends
Given the level of remediation provisions and political scrutiny, no bank grew their dividend per share in 2019, though NAB and Westpac did cut their dividends to more sustainable levels. ANZ and CBA kept their dividends steady, with Macquarie sharply increasing their dividend ahead of profit growth, a luxury afforded to Macquarie by its low dividend payout ratio. Across the major banks, ANZ has the highest dividend yield at 6.3%, though this may be at risk in 2020 if the bank does not buy back stock to neutralise the impact of lost earnings from the sale of its insurance and wealth management divisions.
Gold Star
Bad debts
One of the biggest drivers 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 bank will incur a loss on the loan. Over the past few years, when analysts look through a bank’s financial statements one of the first pages that are turned to is the bad debt charge, as even a small rise may be interpreted as the start of a trend back to a normalised long-term level of bad debts around 0.3% of total loans. Bad debts remained low in 2019, with Westpac and ANZ reporting the lowest level of bad debts of a mere 0.13% of the loan book, aided by a stabilisation in the East Coast property market and improving affordability stemming from several interest rate cuts. On the business side there were no major corporate collapses over 2019.
Gold Star
Very Low-Interest Rates
Over the past 12 months the RBA has cut the cash rate from 1.5% to a historic low of 0.75% and the standard variable rate for an owner-occupier mortgage has fallen from 4.7% to 4.1%. While lower rates are positive for borrowers, low rates impact bank profitability and in particular their net interest margin. In 2019 the banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] decreased across all banks. The fall was attributed to increased competition, customer remediation charges and the reduced funding benefit from the bank’s pools of deposits. For example, NAB has $88 billion in deposits that are currently earning interest rates close to zero, as lending rates fall and the bank (unlike the Swiss banks) cannot charge negative interest rates; the bank’s profit margin gets squeezed.
In his presentation to the market, NAB’s CEO made an interesting point that the RBA’s rate cuts were not achieving their goal of stimulating the Australian economy. He saw that borrowers were not reducing their monthly payments to spend on consumer goods and savers such as retirees who are likely to spend all of their interest income are getting a much lower rate on their term deposits. Thus, very low interest rates result in a wealth transfer between savers who would otherwise be spending their interest income to reducing the debts outstanding for borrowers, with a minimal positive impact on the economy.
Westpac and Commonwealth reported the highest net interest rate margin in 2019 which reflects both their greater focus on mortgages (which attract a higher margin than business loans) and the lower loan losses on mortgages compared with business loans.
Gold Stars
Our take
Investing in Australian banks is one of the major questions facing institutional and retail investors alike, with the banks comprising 25% of the ASX 200. We expect the banks to deliver around 3-5% earnings growth as they face low credit growth and increased regulatory scrutiny, though there are significant cost-out opportunities from rationalising their 1,000 branch networks around Australia, as the nature of changes from physical branch transactions to digital interactions between the banks and their customers that don’t require real estate and costly staff to execute.
However, if investors examine the wider Australian market the banks look relatively cheap, are well capitalised, and should have little difficulty in maintaining their high fully franked dividends. Additionally, their share prices are likely to see support over the next 12 months as the remediation and compliance charges stemming from the Royal Commission begin to abate. Commonwealth Bank and ANZ may conduct share buy-backs over the next year if the RBNZ adopts a more conciliatory strategy on December 5th when they release their controversial bank capital requirements.
The Atlas High Income Property Fund had a solid month in October gaining +1.2%. While global markets mostly posted a positive return, the ASX 200 declined, dragged down by the heavyweight banking and the mining sectors.
The key news over the month was the RBA cutting the cash rate by 0.25% to a new record low of 0.75%, we see that it is likely that there will be further cuts over the next year in response to higher unemployment. Currently, twelve-month deposit rates are at 1.6%, so to earn a mere $20 in interest per day a retiree needs to have over $500,000 on term deposit!
The Fund remains populated with trusts that offer investors recurring earnings streams from rental income rather than development profits. Due to fixed price rental increases, the distributions that the Fund is receiving from our investments are growing ahead of inflation.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.
