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What should you sell in a volatile market?

The first two months of 2018 have been a wild ride for Australian shares, with big falls and then big recoveries. However, from looking at the headlines in the financial press most investors would be surprised to find out that the ASX 200 index actually finished February exactly where it started the year.

Last week we looked at the causes behind the volatility in February – Volatility and Melting Markets – and in this week’s piece we are going to look at how we approach market dislocations.

Surviving previous crashes

In my funds management career, I have had the “fortunate” experience of having observed both the GFC in 2007-08 and the Tech wreck in North America in 2001 from the front lines, helping to manage large institutional equity funds when the prices of all stocks regardless of their quality were falling heavily.  During both of these crashes, I worked with firms that ran conservative value-style funds, based on fundamental analysis of companies.

During these periods the portfolios were populated with companies paying dividends from stable recurring earnings such as TransCanada Pipelines and Amcor. These portfolios had no exposure to companies that were reliant on the previous frothy market conditions continuing such as Pets.com, Nortel, Babcock & Brown, or Allco Finance. What I learned from these experiences is that a portfolio constructed in a conservative manner populated by companies paying stable and growing dividends with low gearing will bounce back from the blackest nights of doom and gloom.

Know when to hold them

In a perfect world, investors with perfect knowledge would head into a major market meltdown having sold all equities would have a 100% cash weight. However practically that would never happen due to both taxation consequences and the risk that the call may be very premature or even wrong. Many investors may remember RBS’s advice in January 2016 to sell everything as oil was going to $15 a barrel and equities markets were going to fall by 20%. Consequently investors and fund managers only tend to have hard looks at their portfolios when the bull market stops and stock prices are falling.

In our opinion the worst thing that investors can do is look at the sea of red on your computer screen for hours at a time, or read the some of the breathless market commentary in the financial press or coming out of the trading desks at the investment banks. The former is designed to sell newspapers and the latter is produced in an attempt to influence you to incur brokerage, when doing nothing may be the best option.

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. For example, it was hard to see how the falls in the US market in February were going to impact rental income from SCA Property’s portfolio of neighbour shopping centres, or Amcor’s sales of PET soft drink bottles and flexible food packaging.

Know when to fold them/ know when to walk away
Conversely, companies in an investor’s portfolio that rely on benign debt and equity markets to finance their growth or are still proving up their business model should be looked at with the most critical of eyes. These companies are typically characterised as “concept stocks”. Often they are companies with exciting technologies in new markets that may have significant future value, but are often have minimal current earnings and assets that could help them weather the inevitable storms. Recent examples of high growth concept stocks that have run into trouble include GetSwift and BigUN.

Amongst the larger stocks on the ASX, investors should look critically at companies with both high PE ratios, high gearing or those that have recently made significant acquisitions. During major corrections, companies with these characteristics tend both to get sold off the most, and might also face dilutive equity raisings due to pressure from their bankers.

All weather stocks

Whilst listed property trusts as a sector are viewed with suspicion by many investors at the moment we continue to like SCA Property. This trust is exposed to domestic food, liquor and services consumption via long-term leases to Woolworths. During major market meltdowns such as the GFC, consumers tend to cut back spending on discretionary items such as clothes and going out to restaurants in favour of cooking and drinking (larger than normal) glasses of shiraz at home, all of which are supportive for SCA Property’s earnings.

Woolworths’ landlord continues to benefit from the supermarket giant’s battle to regain market share from Coles, as a portion of the rent is tied to turnover. The trust is conservatively run by an experienced and honest management team and importantly has low gearing and minimal near-term debt maturing. In February management upgraded profit guidance for 2018, yet the trust is trading on a yield of 6.3%.

Current Positioning

In the current environment Atlas see that investors should be looking through their portfolios for the stocks that could “torpedo” portfolio performance. In early 2018 rather than scouring the market for the next Blackmores or A2M Milk, we are spending time thinking about what could go wrong with the various companies in our existing portfolios.  As a quality style manager, we are spending time looking closely at the quality of company earnings and the percentage of earnings that are derived from recurring earnings that will hold up over time, rather than profits coming from revaluations, accounting changes, asset sales or performance fees.

In terms of sector positioning Atlas are very cautious on the mining sector, especially at the sexier end of lithium and graphite. The frenzied activity, promise and hype in this sector looks like a movie that I have seen before.  Whilst the consensus view is that commodities will stay strong in 2018, a large part of the price moves we saw in 2017 was the result of Chinese stimulus plans enacted in 2016 which has begun to fade. Declining Chinese dependence on fixed-asset investment to drive growth will put downward pressure the prices of commodities such as coking coal, iron ore and copper.

 

Monthly Newsletter January 2018

  • January was a weak month as the listed property sector was sold off -3.3%, due to rising bond yields weighing down on income stocks globally.
  • The Atlas Fund returned -2.7% in a month where there were few places for investors to hide,  as all trusts were sold down with little regard to the quality of their property assets,  nor their earnings outlook.
  • The Fund remains positioned towards Trusts that offer recurring earnings streams from rental income rather than development profits. As the Fund’s distributions are supported by long-term lease agreements with blue-chip industrial companies, and not swinging emotions of the market, we see that the Fund will be well placed to weather current market volatility.Go to  Monthly Newsletters for a more detailed discussion of the listed property market in January and the fund’s strategy going into 2018.

Croquettes and Duck Confit for Westfield

This morning European property company Unibail-Rodamco announced that it had entered into an agreement to acquire Westfield (WFD) to create a global developer and operator of flagship shopping centres in the US, UK, the Netherland and France. This deal values WFD at A$33 billion, or at a price earning multiple of over 22 times future earnings, what appears to be a full price.

Westfield is the largest holding in the Atlas High Income Property Fund, so we were understandably quite pleased with this development. In this note we are going to look at what will likely be the largest takeover in Australian corporate history.

Today’s deal marks the end of an era for Westfield, which was originally listed on the ASX the middle of the 1960-61 recession when unemployment spiked to a post-war high of 3.1%. The above image is from 1959 and is of Westfield’s first shopping centre in Blacktown.

Westfield Development Corp’s initial public offering offered 300,000 shares at five shillings! In recent years, the various corporate changes at Westfield have appeared to be movements of the chess pieces on the Westfield board leading towards this day. Moves such as the separation of the Australian assets (Scentre: SCG) from WFD’s global assets, seemed to be designed to increase the attractiveness of Westfield to a foreign suitor such as Unibail-Rodamco, and allow the Lowy family to exit the company first listed close to sixty years ago. For a deeper dive into the corporate gymnastics that Westfield has engaged in over the years look at our piece Westfield: the Thimble and the Pea.

The Deal
Under the agreement WFD holders will receive a combination of cash (US$2.67) and 0.01844 Unibail-Rodamco shares for every WFD unit owned. This equates to A$10.01 or a 18% premium to the price at the close of trading prior to the deal being announced. It is anticipated that the combined entity will have a primary listing in Paris and Amsterdam, with a secondary listing on the ASX.

Investors in the new combined entity will own a property trust with 104 shopping centres across Europe and the US valued at A$95 billion.

A higher bid?
In our opinion this deal is likely to go ahead with a minimal chance of competing bids, as the Franco-Dutch Unibail-Rodamco revealed that they already own 4.9% of WFD and that the Lowy family which own 9.5% of WFD are supporting the deal. Digging into the detail in the documents, there is also a US$150 million break fee that must be paid to the other party if either Unibail-Rodamco or Westfield were to decide to walk away from this deal.  The details on when this deal is likely to be completed is yet to be fully announced, though the parties expect that this will be consummated around June 2018 if shareholders vote in favour.

Our Take

Looking ahead, this takeover is likely to provide a positive boost in the near term to the Australian Listed Property market, as it raises the prospect of further takeovers. In the medium term, investors that decide to cash in their Westfield holdings are likely to look to deploy some of the proceeds in other Australian Listed Property Trusts which will boost share prices in the next six months.

The Atlas High Income Trust are likely to take the money that the Europeans are offering and reinvest elsewhere, as typically these situations represent a transfer of wealth from the aquiror’s shareholders (Unibail-Rodamco) to those of the takeover target (Westfield). This occurs due to the premium required to consumate the deal ineviatably is higher than the synergies actually achieved.

 

 

Earnings Chicanery Part One

Last week it was announced that Slater and Gordon’s former accountant was included in a shareholder class action over its auditing work. This demonstrates the recognition of legal costs as revenue, before the ASX-listed law firm actually won the case. Obviously, this becomes an issue for a company with a business model that is based on “no win no fee”, as their revenue is predominately based on a percentage of the damages awarded when the case is won. In previous years this assumption contributed to the troubled legal firm reporting healthy revenue and profits to investors, although at the same time financial stresses were significantly increasing.

In part one of a two-piece series on financial statement trickery, we are going to look at some measures a company can take to “dress up” their financial results.

 

Why engage in earnings chicanery?

Company management teams are always under pressure to deliver results in line with or above market expectations, or face the negative share price reactions. By my observations, negative reactions to earnings disappointments have only increased in recent years with the increasing influence that short sellers have in setting market prices. Their strategy is to sell stock that the manager does not own prior to a catalyst event such as an earnings result. They anticipate being able to buy stock back at a lower price if company profits are below market expectations.

This gives management – in particular the chief financial officer as the executive with central involvement in preparing the accounts – strong incentives to present the most positive picture possible of the company’s financial health. This is especially true if management believes that the negative factors influencing profits could be temporary and likely to reverse in the near future.  Additionally, most senior management teams have short-term incentives tied to earnings growth or total shareholder returns, which can motivate them to present favourable accounts.

The three sisters

When a company releases its financial accounts, these consist of three separate statements. These are designed to provide investors with a picture as to the company’s profitability (profit and loss statement), assets and company solvency (balance sheet), and the cash flows in and out of the business (cash flow statement). All three are interconnected and should not be read in isolation as each statement can explain elements of another. For example the net debt on the balance sheet drives the interest payments on the profit and loss and cash flow statements. Below we take a closer look at each of these statements.

Profit and loss

Most of the attention in the financial media focuses on the company’s profit and loss statement (P&L). The P&L provides a six-monthly summary of the company’s revenues, expenses, depreciation charges, interest costs and taxes. The investment community tends to be most concerned about the net profit figure. Whilst this statement provides the headline result, it is also the easiest to manipulate.

A typical way to do so is when companies recognise sales as revenue before payment is actually collected from customers. A more extreme version of this is referred to a “channel stuffing.” Then is where a company makes a large shipment to a customer at the end of an accounting period (recorded as revenue), however the customer may end up returning those goods. In 2005 donut maker Krispy Kreme got itself into hot oil and was forced to restate prior year’s earnings. Here it was proven that the company systematically increased shipments of its sugary glazed treats in the final month of numerous quarters so the company could meet the guidance that it had provided investors.

The balance sheet

The balance sheet provides a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the period. This offer investors an understanding of both how the company is financed (debt or equity), and also what it may be worth if it is liquidated at that point in time. Typical ways of manipulating the balance sheet are by adjusting the value of assets and moving debt off the balance sheet. Enron famously used special purpose vehicles to hold debt outside the company’s balance sheet and misrepresent the company’s gearing. In 2001 Enron’s financial accounts reported total debt of US$10.2 billion, however it was later determined that the real figure was US$22.1 billion.

Closer to home, Harvey Norman in 2017 moved A$610 million of franchisee liabilities off the company’s balance sheet, based on the new position that Harvey Norman is no longer liable for the inventory costs taken on by its franchisees. This sparked a range of commentary in the financial press and prompted ASIC to look at the retailer’s accounts; see the interview Torpedo Tuesday Harvey Norman.

Profit is an opinion, cashflow is a fact

The cash flow statement shows a picture of the actual cash flowing in and out of the company over the past six months and is generally harder to manipulate than the profit and loss statement. Conceptually it is akin to blood pumping through the veins of the corporate entity, with the balance sheet comparable to the skeleton.

The P&L is more often associated with chicanery as a company may record sales as revenue on the P&L, and hence profit, before that cash is actually collected from their customers. However company cash flow statements are also open to manipulation. One practice that I have seen over the years has been capitalising operating expenses as an asset. This converts a cost or outflow of cash on the cash flow statement into an asset on the balance sheet: accounting magic! Whilst this is legal under the accounting rules, as an analyst I was uncomfortable with instances of this conversion, for example Santos capitalising the interest costs for the construction of the Gladstone LNG export terminal. Through the construction process the company’s cash flow statement showed a healthier picture than was actually the case. Ultimately, Santos wrote down the value of this asset by A$2.9 billion and was forced to raise $2.5 billion in 2015 and $1 billion in 2016 to pay down debt.

Aside from converting expenses into assets, a company can boost their cash flow statement by selling accounts receivables (at a discount to face value) or delaying payment of accounts payables. These two actions can temporarily improve the cash flow statement, though they can be detected by abnormal changes to working capital on the balance sheet.

One of the tactics that can be used by owners prior to floating a company is to boost cash flow by economising on capital expenditure, especially the capital expenditure required to maintain a company’s assets. The rationale behind this is to present the healthiest set of accounts possible prior to the initial public offering (IPO), with the aim of generating a high sale price. However, in the year or so after the company is floated on the share market, the new investors end up with cash flows lower than they expected due to higher maintenance capital expenditure.

In the short term companies can economise by delaying capital expenditure, but in the medium term assets have to be maintained otherwise they deteriorate. A tragic example of this was alleged to have occurred with the transport company McAleese Group, where the previous owners were believed to have reduced capital expenditure on trucks in their fleet prior to the IPO. It is alleged that this scrimping on capital expenditure contributed to a range of accidents which resulted in fatalities.

Our Take
Earnings misrepresentation is difficult to for investors to detect from the publicly available accounts, but when revealed can have fairly extreme results for a company’s share prices. Printing these three statements and reading them side by side can often reveal signs of problems a company could have that can be minimised or ignored when management present their results to the market. As the result of bitter experience, I look at the cash flow statement first, as profits can be manipulated and companies with great – albeit illiquid – assets can still become insolvent without the cash flow to service debt.

Monthly Newsletter September 2017

  • The S&P/ASX 200 A-REIT index posted a small 0.5% gain over the month of September, slightly ahead of the wider ASX200 which was unchanged, as commodity prices and the AUD were weaker.
  • The Fund gained had a solid month gaining +1.6%, outperforming the index as our strategy of preferring recurring rent collectors over developers was successful.
  • Additionally, the bulk of the options sold last quarter ultimately expired worthless at the end of September. This strategy added value, as it converted uncertain future gains (which ultimately did not occur) into certain income.

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