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Five Factors for Investors in 2019

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

Monthly Newsletter May 2018

  • The Fund gained +3%, which was ahead of expectations given the Fund’s lower risk portfolio and high cash weight.
  • After having a weak start to 2018, the Listed Property sector has stabilised over the last quarter aided by positive market updates and takeover activity in the sector.
  • The main news over the month was the approval by shareholders of the Westfield takeover and the bid by Blackstone for Investa Office Trust.

 

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

Banks Reporting Season Scorecard May 2018

The last few months have been tough for shareholders in the major Australian financial services companies, who have seen their share prices drift lower throughout March and April. Evidence of misconduct presented at the Royal Commission on Financial Services has fed market fears that bank profitability will be diminished in the future. However, over the past ten days, the major banks have reported their profit results for the past six months, showing the market how their underlying businesses are performing and how the management teams plan to address the issues raised at the Royal Commission.

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

Simplification

The main new theme to emerge from this reporting season was that banks are looking to reduce their footprint on the Australian financial services landscape, by divesting businesses that are deemed to be non-core. This results season was characterised by complexity arising from either announcements of new significant moves, or that were complicated by sales made in 2017.

In May Commonwealth Bank announced plans to spin off their wealth management business Colonial First State, which followed the sale of the life insurance business in 2017. ANZ’s result was complicated by the sale of both their wealth management and life insurance businesses in 2017. NAB also announced plans to sell MLC wealth management by 2019. Additionally, Westpac continued to reduce its stake in BT Investment Management (now renamed as the Pendal Group). These moves can be seen as acknowledging that the costly exercise of creating vertically integrated financial supermarkets was a mistake. Whilst some of these moves to sell these carefully constructed divisions may be attributed to the events of the Royal Commission, some of these sales were consummated well before the titans of Australian finance faced the harsh light of the witness stand.

 

Profit growth

Across the sector profit growth was roughly in-line with the credit growth in the overall Australian economy. Westpac reported the strongest cash earnings growth across the banks courtesy of keeping costs under control, very low bad debts, and the sound performance of their core domestic businesses. NAB brought up the rear in May due to the combination of weaker revenue and elevated costs even when the restructuring charges are excluded.

 

 

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 outstanding loan amount is greater than the collateral eventually recovered. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. This resulted primarily from a buoyant East Coast property market and higher commodity prices. Further, at the big end of town there were no major corporate collapses over the past six months which kept corporate bad debts low.

Westpac gets the gold star with a very small impairment charge courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

 

 

Gold Star

Shareholder Returns

Across the sector dividend growth has essentially stopped, with CBA providing the only increase of 1 cent over 2017. 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 to get close to the APRA mandate of a core tier 1 ratio of 10.5%.

Looking ahead, there may be some capacity to increase dividends as the rebuild of bank capital to APRA’s standards is largely complete. ANZ shareholders can expect capital returns in the form of further on-market share buy-backs as the proceeds from the sale of their wealth management and insurance businesses are received. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 8.9%.

Gold Star

Interest Margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate increased slightly in 2018, despite the imposition of the major bank levy. This was attributed to lower funding costs and repricing of existing loans onto higher rates. In response to regulator concerns about an overheated residential property market – and in particular the growth in interest-only loans to property investors – the banks have repriced these loans higher than those repaying both principal and interest. For example, Westpac currently charges 6.3% on an interest-only loan to an investor, which contrasts to the 4.44% being charged to owner-occupiers paying both principal and interest. This has had the impact of boosting banks’ net interest margins, though these gains will tail off as borrowers switch to principal and interest loans.

One of the key things we looked at closely during this results season was the impact of the May 2017 Major Bank Levy on the various banks’ margins. It was apparent from looking at the numbers that this levy was passed on both to borrowers in the form of higher rates, and to depositors by offering lower rates on term deposits.

 

 

Gold Star – Australian banking oligopoly

 

Total Returns

In 2018 all the banks have delivered negative absolute returns, while also trailing the ASX 200 which has gained 2%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs, and slowing credit growth has weighed on their share prices. CBA has been the worst performing bank as it has seen its CEO ushered to the door, faced fines for not complying with anti-money laundering laws, and has faced uncertainty around the potential impact of changes implemented based on recommendations from the Royal Commission.

No stars given

Our Take

How to approach investing in the Australian banks is one of the major questions facing both institutional and retail investors alike. We expect the banks to deliver around 3-5% earnings growth as they face low credit growth, increased regulatory scrutiny, and the sale of some of their insurance and wealth management divisions. However, if investors examine the wider Australian market the banks look relatively cheap, are well capitalised, and unlike other income stocks such as Telstra 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 from share buybacks, as the proceeds from the sales of non-core assets come through.  The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.

Short selling harder than you think!

Over the past week short selling has been a hot topic in the financial press after a noted US-based short seller released a very negative piece about listed fund manager Blue Sky Alternative Investments (BLA). This caused BLA’s share price to fall 50%, wiping $440 million from Blue Sky’s market cap. Short sellers are frequently derided as vultures, rumour mongers or un-Australian. However, in practice, shorting stocks is a difficult, stressful and lonely way to make money in the market, which is predominately skewed towards good news and wearers of rose-tinted glasses.

In this week’s piece we are not going to look at the merits of Blue Sky as an investment, but rather at the mechanics and issues around short selling equities. We see that much of the coverage on short selling over the past ten days reveals that many of those who hold strident opinions on short selling have only a limited understanding of how it actually works in practice.

Step one:  find a company with bad characteristics and a catalyst

In traditional long only investing the goal is to own good quality companies with honest management teams, clean balance sheets and solid future prospects. By contrast, when selecting a stock to short sell the desirable characteristics include companies with low or negative growth, high and increasing debt levels, a weak business model, over-valuation by a market, and possessing a shaky management team. However, a critical factor is the requirement for a catalyst; over-valuation or high debt in itself is rarely enough. In Blue Sky’s case it was the negative report from Glaucus. As very few investors have the luxury of lobbing a damming report from the sidelines and outside the regulation of ASIC and the ASX, we would look for events such as a potentially bad acquisition (preferably off-shore), heavy directors selling, or corporate turnover at management level.

Step two: Find the stock to borrow

Short sellers will then borrow stock from a stockbroker and sell it. They are essentially betting that the price of the target company will decline before they have to replace the borrowed shares by buying the stock back. This is often the step that is ignored in the financial press when talking about shorting a company’s stock, as it is wrongly assumed that investors can borrow stock to reflect their negative view on a company.

When borrowing shares to short sell an investor has to look closely at both the rate per annum that they are required to pay to borrow the stock, and where the owner is located geographically. The rate reflects supply and demand, and for most stocks is currently 0.5% per annum. For stocks where the shorting demand may be higher than the supply (such as Fortescue) the rate may be 15% or higher. In the case of small capitalisation or tightly held companies such as Blackmores, the short seller may be unable to borrow stock and thus cannot short sell.

In the case of Blue Sky, when we looked a week ago there was no stock available to be borrowed and the current short-sold position only represents 3 million shares, or 3.8% of the register. In a small and tightly held company such as Blue Sky most holders would not lend out their stock for short selling as to do so they would be providing short sellers with the ammunition to bet against their long position.  For example, BigUN – which is currently suspended on the ASX in February due to accounting irregularities – only had 500k of their outstanding shares lent out to short sellers, which is a mere 0.3% of the register. In the lead up to BigUN’s suspension as its share price was falling, the demand to short this stock would have been intense, but there would have been no stock available to be borrowed.

Step three: Dividends and Corporate Actions

The short seller is required both to return the shares to the owner when requested, and also to pass on any dividends paid. We also strongly prefer to borrow stock from foreign owners such as large index funds like Vanguard or State Street, as if you borrow stock from a domestic owner and a dividend is paid, short sellers are required to compensate the original owner for both the dividend and any associated franking credits.

What happens if the stock goes up?

If the short stock rises sharply, the lender will be required to give their broker additional collateral, or the broker will require the short seller to close out the short sale transaction before the planned timeframe.  A series of urgent requests to wire cash to your margin account to cover a short-sold stock that is rising sharply will test the mettle of even the most hardened short seller. In contrast, a long only position in a falling company can mentally be filed in one’s bottom drawer until it eventually comes good (or goes into administration).

This gives rise to the skewed payoff ratio from short selling, where the maximum gain is known (the stock falls to zero), but the maximum loss is theoretically infinite.

The Market can remain wrong longer than you can remain solvent

It would be wrong to view that short selling risky stocks is a smooth path to outperformance. Keynes, the father of modern macroeconomics, once famously said that “markets can remain irrational a lot longer than you and I can remain solvent’’. This quote particularly resonated with me after an unprofitable short selling of Fortescue prior to the GFC due to concerns about the over-valuation and debt situation of the company.

This trade was put on at $50 per share late 2007 and then was closed out at $70 four months later as the price continued to rise with no signs of slowing momentum. It was very painful to lose 29% in a short stretch of time; however, Fortescue peaked at $120 in June 2008 before falling back to $20 in December 2008. Whilst our investment thesis was ultimately correct, we were unable to handle the pain of a steeply rising stock and the associated unrealised losses and increasing margin calls.

Short squeeze

A “short squeeze” occurs when a heavily shorted stock rises sharply, forcing sellers to close out their position by buying back stock, thus causing further upward price momentum. Often when the market appears to overreact to a small piece of positive news, this is a short squeeze and it is similar to too many people trying to fit through a door.

For example, if JB-Hi Fi (currently 17% of the register have been “borrowed” by short-sellers anticipating that the price will go down) or Domino’s Pizza (18% of short) were to receive a takeover bid, the price would escalate sharply as short sellers look to cover their positions. A nightmare scenario would be a contested bidding war if you are short. In December 2017 we saw a short squeeze in Westfield when a bid from Unibail-Rodamco came through. However, unlike Dominos or JB Hi-Fi, the percentage of the property trust’s outstanding shares that we sold short was not a large amount, though we did see a spike in the share price that reflected the short sellers buying back stock to exit their positions.

Our Take

While short selling is often criticised and retains a negative connotation in a securities industry that is inherently biased towards optimism, we see that it serves a valid role in financial markets. Short sellers provide an alternative view and can aid both liquidity and price discovery in stock markets. In coming years – with MiFID II (new European regulations on stockbrokers) reducing the incentives for the investment banks to put out negative research and the decreasing value placed on sell side research – shorting will provide an alternative view. 80% of calls are buy or hold!

Investors should not look at situations like Blue Sky, BigUn or Slater and Gordon and view that it is an easy way to make money, nor that it is unfairly ganging up on a company. Even very experienced and adept short sellers such as Glaucus have made mistakes. For example, its shorts on Japanese trading house Itochu would have cost the fund manager substantially, with the price up +43% since they released their report in mid 2016.

Neither the Atlas High Income Property Fund nor the Maxim Atlas Core Australian Equity Portfolio currently employ shorting as an investment strategy. However, the author has previously managed a long short fund and has some understanding on short-selling as an investment strategy.