Category: Uncategorized

Over the past six months, there have been numerous headlines around rising energy prices and their impact both on curbing global growth and in cutting domestic consumption as the costs of transporting people and goods around Australia were rising sharply. However, instead of climbing as expected, the oil price has collapsed by 30% over the past few months.

In this week’s piece, we are going to look at the beneficiaries of a decline in oil prices. Conceptually a fall in the price of oil is neither positive nor negative per se, but rather a transfer of wealth from oil producing countries and companies (such as OPEC, Norway, Exxon and Woodside) to energy consumers (OECD, South Korea, China, chemical companies and domestic consumers).

In early October, oil was trading above US$85 per barrel1. The price was forecasted to go above US$100 per barrel as US sanctions on Iran were expected to constrict supply and Saudi Arabia was incentivised to maintain a high oil price to help gain a high price for their upcoming float of Saudi Aramco – see The Biggest IPO of all time.

Over the past two months, the reverse has occurred with oil falling 30% to US$59 a barrel as oil inventories built on higher production out of the USA and Saudi Arabia (due to pressure from Santa Trump), weaker than expected Iranian sanctions and selling from speculators. Saudi Arabia actually lifted oil production in recent months, a move not particularly in their best interests. This has been ascribed both to pressure from President Trump and efforts to mitigate the impact of the journalist Khashoggi’s death in their embassy in Istanbul.

Falling equity markets have also probably played a role in placing downward pressure on the oil price. Macquarie Bank estimated that as a result of the market falls in October and November around $50 billion was withdrawn from commodity funds, which would have resulted in these funds being forced to sell holdings of oil. The chart below shows the price of a barrel of crude oil, for the purposes of analysing its impact on domestic consumers and companies, the price has been converted into Australian dollars.

 

What Happened

In early October, oil was trading above US$85 per barrel. The price was forecasted to go above US$100 per barrel as US sanctions on Iran were expected to constrict supply and Saudi Arabia was incentivised to maintain a high oil price to help gain a high price for their upcoming float of Saudi Aramco – see The Biggest IPO of all time.

Over the past two months, the reverse has occurred with oil falling 30% to US$59 a barrel as oil out of the USA and Saudi Arabia (due to pressure from Santa Trump), weaker than expected Iranian sanctions and selling from speculators. Saudi Arabia actually lifted oil production in recent month, a move not particularly in their best interests. This has been ascribed both to pressure from President Trump and efforts to mitigate the impact of the journalist Khashoggi’s death in their embassy in Istanbul.

Falling equity markets have also played a role in placing downward pressure on the oil price. Macquarie Bank estimates  that as a result of the market falls in October and November around $50 billion was withdrawn from commodity funds. This would have resulted in forced selling of oil held by these funds.

Australian consumers

Australian Bureau of Statistics (ABS) survey reveals that households spend an average of $230 each month on fuel for vehicles. As a result of a falling oil price, motorists in Sydney have seen a litre of petrol fall from $1.65 to around $1.15, which was estimated by Commsec to result in a saving of around $70 per month or equivalent to a 0.25% interest rate cut on an average mortgage. Further falls in the oil price will only increase the impact of this de facto stimulus plan. For example, the sustained lower energy prices consumers saw over the period 2014 to 2016 resulted in an additional $1,100 per annum being added to the average household’s finances when compared to the period 2010 to 2013, with the greatest benefit being felt by those living on the periphery of the country’s major cities. Higher disposable income will also help Australia’s embattled trading banks, as consumers will have a greater capacity to service existing mortgages, keeping bad debts in check.

Higher consumer spending

On the ASX, the largest beneficiaries of the stimulus package of falling petrol prices will be the consumer staples and consumer discretionary retailers, as historically savings at the petrol bowser have been spent on food and liquor, as well as consumer goods such as electronics and clothes. As such, we would expect to see stronger sales figures in 2019 from Wesfarmers, Coles and JB-Hi-FI.

Higher retail sales will also benefit retail listed property trusts such as Vicinity and Scentre as a large proportion of retail spending is still done in bricks and mortar stores. The last twelve months have proven to be very volatile for Australia’s retailers and shopping centre owners. In late 2017, virtually all companies connected to retail saw their share prices fall significantly on news that Amazon was entering the Australian marketplace. The impact of the US e-commerce giant has been fairly muted so far, with Australian retail sales in shopping centres up between 2 and 4% in 2018. Undoubtedly Australian retail sales have been assisted by the government legislating that from the 1^st July 2018 online retail sales below $1,000 would be subject to GST, a move that helps level the playing field between foreign websites and Australian retailers .

 Large energy users

Among the companies that consume large amounts of hydrocarbons, Qantas is the most obvious beneficiary of a falling oil price. In 2018 Qantas spent $3.2 billion on jet fuel and Australia’s carrier has seen a 25% decline in the price of jet fuel over the past few months. Due to hedging, Qantas will not see the full benefit of this fall in 2019, though the carrier will see a nice boost to profits especially as travellers are still paying over $400 for a one-way flight from Sydney to Melbourne and the flights are all pretty full.

Miners such as Rio Tinto and BHP are both significant consumers of petrol and diesel and sell commodities such as iron ore that is priced independently of the oil price. Moving dirt consumes a large amount of energy in cracking the rocks, removing overburden through explosives, and moving iron ore and coal to the ports on the coasts off Western Australia and Queensland. In the first six months of 2018 higher oil prices reduced Rio Tinto’s profit by $200 million, though the miner should see some relief in the second half of 2018. Previously BHP saw a limited benefit from falling oil prices by virtue of its US onshore oil and gas assets, though these were sold in June 2018 for US$10.8 billion.

Oil importing nations

Whilst falling energy prices will be causing much angst in the oil exporting nations, these declines should provide a boost to the major oil importing economies of China, Europe and Japan. Improving sentiment in the US and Asia will have a bigger impact on the prospects for global growth and Australian exports than oil-induced recessions in Russia, Saudi Arabia, Venezuela or Iran.

The nation that is likely to see the biggest benefit from falling oil prices is China, which in 2017 imported $162 billion worth of crude oil and is the top oil importer globally. Interestingly in 2015, the USA was the largest global importer of crude oil. However, the development of the shale oil industry has reshaped the oil industry, as it has shifted the USA from being an importer to an exporter of oil. Clearly, a factor such as falling oil prices that stimulates the economy of Australia’s largest export partner will have a positive impact on a number of Australian listed companies from miners and tourism operators, to exporters of wine and food.

Our Take

The positive impact of the 30% fall in the oil price over the past two months has not received much attention by the market. There has been a greater focus on what has happened to FANG’s (Facebook, Amazon, Netflix and Google) share price in overnight trading in New York, selling Australian stocks when these are weak.

We see that falling oil prices will provide a nice boost to Australian corporate earnings if maintained for a period. The additional cash from falling oil prices improves the balance sheet of the nation’s consumers, causing either spending on consumption or on paying down debt, and at no cost to taxpayers! By contrast, Kevin Rudd’s “GFC economic security package” from October 2008 delivered a one-off $1,400 to pensioners and $1,000 per child to families and was credited as boosting GDP by 1%, but cost taxpayers $10.4 billion.

 

 

 

• September was a tough month for investors in Listed Property and whilst the Fund is designed to navigate market turbulence, the unit price did decline by -0.5%. In weak markets such as we saw this month; the Fund’s risk management strategies acted as expected and reduced volatility.
• Over the month the Australian Listed Property sector declined by -1.8%, the sector’s first decline since March. We note that Trusts with earnings backed by development profits, rather than recurring rents, saw greater price falls in September.
• The Fund paid a distribution of 4.84 cents per unit at the end of September, roughly in-line with the June quarterly distribution.

 

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2019.

 

We look at the question of dividend sustainability very closely when constructing the Atlas Core Australian Equity Portfolio. One of the main factors in building the portfolio is identifying companies that can deliver consistent distributions that are growing ahead of inflation, whilst actively avoiding companies with distribution risk. Aside from wanting a consistent yield for our investors, as we have seen with Telstra over the past few years, high current distributions do not compensate investors for the capital fall that occurs when the dividend is cut. Indeed we often see that a small dividend cut has an over-sized impact on the company’s share price.

In investing terms, buying companies that have a chance of cutting their dividend this is a bit like picking up pennies in front of a moving steamroller, you may snatch a few coins but eventually your arm will get crushed by the roller! In this week’s piece we are going to look at dividend sustainability.

 

 

Key indicators for dividend sustainability

The dividend payout ratio divides the dividend by the earnings per share and this is something that we look at closely to gauge if a company can both maintain and grow its dividends. When a company paying out 90 to 100% of its earnings faces a small change in profitability, it will have to cut its dividend, whereas a company with a payout ratio of say 50% not only can handle the inevitable changes in market conditions, but also has the scope to increase dividends without an increase in company profits. With some companies such as Transurban, for accounting reasons, you will want to use free cash flow instead of earnings, which are impacted by accounting items such as a high depreciation charge.  Over a number of years up until 2018 Telstra maintained a dividend around 30 cents per share, however this was achieved via paying out all of its earnings in dividends and indeed in some years the company was borrowing to pay the dividend. A position that was clearly unsustainable in the long term.

Leverage is another factor that we look at when evaluating whether a company can sustain and grow their dividend. Here we are looking both at standard ratios such as debt to equity and interest coverage; as well as when the debt is due. Whilst leverage magnifies returns to equity (and thus dividends) when times are good, when conditions deteriorate and the heavily indebted company’s bankers come hammering at the door, cutting the dividend is inevitably their first action. For example, in 2015 rising debt levels forced grocery wholesaler Metcash to cancel the dividend for a number of years in an effort to reduce gearing.

Finally, we look at earnings and cash flow growth, as if a company is not growing earnings it is obviously not in a position to increase dividends and this may be the sign that the company operates in a stagnant or declining industry. Ultimately investors buy shares in a company in the anticipation of receiving a stream of earnings that will grow ahead of inflation. If dividends are static, then their real value (i.e. value after deducting inflation) declines annually. One of the reasons why we like toll road company Transurban is because the revenue they receive from road tolls automatically grows each year which feeds into rising dividends. For example,  the tolls on the M2 motorway in Sydney increase quarterly by the greater of quarterly CPI or 1%; in effect a 4% annual increase.

Amcor ticks many of the boxes

Amcor is a company that we own in the Australian Equity portfolio offering a solid 4.6% yield that ticks all of these boxes. Amcor has a dividend payout ratio is 70% with an extensive history of providing growing dividends. The company has an interest cover of 7.5 times and net debt divided by earning of 2.9 times, which indicates that the company does not face any imminent balance sheet stress.

Continued growth in in flexibles packaging in the US and Europe as well as the developing markets for this market leader will allow Amcor to continue to grow the dividend for shareholders.  Additionally, further weakness in the AUD will boost profits for Australian investors, as the packaging company generates all of its earnings outside Australia.

What about Telstra and its 8% yield?

Whilst we are looking at Telstra as at some stage it may represent good value, it still looks too early despite the company currently offering a 8% fully franked yield.  Telstra 2022 will be a complicated process with high execution risk and Telstra as a company has a poor long-term record of executing on complex projects. Historically companies have struggled to successfully make significant changes to their business without slipping up whilst their core offering is under pressure. Additionally, Telstra attracts a higher degree of political scrutiny than most firms face which may hamper their ability to reduce their headcount by the planned 8,000 staff members.

In 2018, Telstra is expected to pay a dividend of 22 cents per share but falling earnings from increased competition and restructuring charges may necessitate further cuts in 2019. Additionally, from 2020, NBN payments which are being used to support the dividend begin to taper off. Given this environment, we see that there are other companies that will offer safer and more stable returns for investors seeking income from Australian equities

Our Take

Despite our focus on delivering high fully franked distributions we have avoided some high dividend payers such as Telstra, as our investment process focuses on dividend sustainability and precludes investing in companies that may pay a high current dividend, but have a probability that this will be reduced in the medium term. One of the lessons that that we consistently observe is that when a company cuts its dividend (often for the right reasons) their share price frequently gets punished excessively by vengeful yield investors. Here the several years of high dividends is normally outweighed by the heavy decline in the dividend-cutting company’s share price.

• In June, the Fund gained +1.4% which makes for an 8% return for the quarter. This is ahead of expectations given the Fund’s lower risk portfolio and high cash weight.
• After having a weak start to 2018 due to concerns about rapidly rising interest rates and the impact of Amazon, the listed property sector continued to rebound in June due to increased corporate activity in the sector. Additionally, domestic retailers should see a benefit from 1 July 2018 onwards as GST will now be applied to all imported goods.
• The Fund has increased its distribution for the June quarter and has been active in reducing risk over the last month.

 

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2018.

At the start of every year, most fund managers will sit down and try to identify the key considerations or issues that their portfolio will likely face over the coming twelve months. This exercise forces one to stand back and take and take stock of the bigger picture view. Day-to-day, it is easy to get caught up and react to the investment noise. In this week’s piece, we look at what Atlas see will be the five key considerations for equity investors for the 2019 financial year.

 

 

 

1: Get your house in order

Since March 2009 the ASX has risen 53% and whilst the gain hasn’t been as sharp as the upwards move from February 2003 to October 2007 of 140%, there is a range of companies on the ASX that are priced on the assumption that benign conditions will continue indefinitely.

Towards the latter stages of any sustained bull market in equities, it is prudent for investors to have a close look at what they have in their portfolio.

It is advisable to cut companies that rely on benign debt and equity markets to finance their growth or are “concept stocks” still proving up their business model.

Additionally, we would be wary of companies tied to the housing cycle such as Boral and Mirvac whose valuations are not priced with sensitivity to the visible deflating of the construction bubble.

Going into FY19 we see that investors should be reducing risk and focusing on companies that pay stable and growing dividends with low gearing. Such companies are most likely to weather inevitable downturns. For example, a major market correction will have a minimal impact on rental income from SCA Property’s portfolio of neighbour shopping centres, or Amcor’s sales of PET soft drink bottles and flexible food packaging.

Whilst we don’t see any obvious signs of a significant market correction coming in 2019, having gone through several of them in recent decades we consider that the next year is likely to be one in which conservatively managed portfolios with a high cash weight will outperform.

2: Beware late stage IPOs

Typically during an IPO cycle, the higher quality businesses are listed first, generally at attractive multiples to overcome inevitable investor scepticism. Over the last two years, we have seen several floats perform very well such as horticultural company Costa (+290%) and plumbing supplies business Reliance (+97%).

When these floats perform well, more marginal businesses get listed and finally, towards the end of the cycle, investors are offered shares in companies that have been hastily cobbled together to take advantage of investor greed.

Last week, unsecured online small business lender Prospa shelved their IPO which would have valued the fintech around $550 million. Without passing judgement on the merits of Prospa, investing in this IPO would have required investors to buy into a financial services business that has only been in existence for six years and has only seen benign and improving economic and credit conditions. Investors were offered IPOs such as RAMS eleven years ago that were underpinned by similar assumptions.

3: Outcomes of Royal Commission for financial services

The last two years have been tough for the banks and financial companies that constitute a large portion of the ASX. In 2017 we saw the major bank levy (which was substantially recovered via repricing of the banks’ loan book) and in 2018 the Financial Services Royal Commission has exposed questionable lending practices and conflicts of interest inherent to a vertically integrated model of financial advice.

One of the more significant considerations for investors in 2019 will be what the Commission actually recommends. Recommendations are likely to centre around changes to legislation governing the banking, financial advice and insurance sectors.

Currently, the banks and financial services companies like AMP and IOOF are being priced by the market under the assumption that draconian legislation will be enacted. Such legislation is likely either to reduce the profitability of their core business or to force them to divest business units to make their financial advice more independent.

For the banks, the recommendations likely to be given by the Royal Commission are unlikely to change the actual demand for mortgages, but what it is likely to do is change the processes around getting a loan and make applications harder. These additional processes are likely to slow down credit growth in the near future and increase the costs of originating a loan.

This slowed growth and increasing costs will not damage the long-term profitability of the banks. Raising the bar for compliance towards the end of a long housing boom is not necessarily a bad outcome for shareholders as it will reduce the level of bad debts in a downturn. In the area of financial advice, recommendations around limiting vertical integration are likely to impact AMP to a much greater extent than the banks, who have either been divesting or have plans underway to divest their funds management and insurance divisions.

4: Resources – Exercise caution

Another key consideration for investors over the coming year will be the performance of the resource companies. Two years ago, it appeared highly likely that we were staring down the barrel of a long winter for commodities prices, but 2017 and 2018 did not follow the expected script as commodities prices strengthened.

This occurred due to China’s efforts to stimulate their property sector, slightly stronger growth in the developed world, and supply disruptions to mines such as Samarco in Brazil. Additionally, structural reforms in China aimed at reducing pollution and improving the quality of growth have increased demand for higher quality grades of commodities.

In the energy markets, we see that the recovery in the oil price is being driven by Saudi Arabia’s production cuts, the motive for which is based on the plan to sell a portion of the state-owned oil producer Saudi Aramco. This behaviour is designed to boost the profit margins temporarily, similar to what is done by many vendors prior to most IPOs. Previously oil prices above $80/bl have been unsustainable as they incentivise additional production.

We are cautious towards the resource companies, as the recovery in the prices of commodities has occurred to some degree as a result of the desire of the Chinese government to stimulate their property market. Chinese economic policies will not always favour Australian investors and a cooling Chinese property market (as brakes are applied) could have a dampening impact on commodity prices.

5: Rising Rates and their impact on asset prices

When speaking with clients one of the main concerns is the impact of rising interest rates and their impact on both asset prices and consumer spending. Rising interest rates reduce the valuations of companies with hard assets such as property and infrastructure, as rising rates cause the discount rate used to value these assets to increase.

Also, as property and infrastructure companies tend to carry high levels of debt, rising interest rates increase the company’s interest bill, thus reducing profits available to shareholders if the company cannot increase rents or tolls at the same rate.

Whilst it is evident that over the longer term interest rates will increase, our current view is that this change will be gradual. Globally central bankers are aware of the impact of increasing rates too rapidly, remembering the impacts on the economy in 1994 and 1995 when the US Federal reserve doubled short-term interest rates to 6% within a 12 month period. This move caused a dramatic sell-off in both bond and equity markets.

In mid-2016 it appeared that rates would rise rapidly as we saw the Australian 10-year government bond rate move from 1.8% in August 2016 to 2.8% in December 2016. However, since January 2017 this key interest rate measure is unchanged. Indeed, over the past six months, we have seen a range of takeover activity that is based on this same view, namely Westfield, Investa Office Trust and APA Pipelines early last week.

Our Take

Forecasting financial markets is inevitably an inexact science and we have almost certainly missed a factor that will dominate the equity markets over the next year and also identified a key consideration in the above list that is likely to have a minimal impact.

All investors face a barrage of noise that oscillates between fear and greed, all of which is designed to generate trading. We see that making a list of the factors that will impact the equity markets over the next year and structure the portfolio around these consideration helps to reduce the filter important pieces of information from the daily flood of investment news.

This article originally appeared in Livewire Markets