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A key part of our investment process is meeting with the management teams of companies at least once every six months or when we are in the process of adding a position to get an understanding of the quality of the management team with whom we are entrusting our investors capital. Generally, we seek to meet with management teams just after they have released their semi-annual profit results, and at other times during the year when we have specific issues or concerns that we feel need to be addressed.

As reporting season finished last week, we have been very busy over the month meeting with management teams from various companies and property trusts. In this piece, we are looking to shed some light on the role that these meetings play in the investment process.

The content and tone of management meetings vary widely depending on the nature of the company and how far the results delivered by the management team deviate from our or the market’s expectations. As such, the meetings can vary from being quite convivial discussions running through dividend policy and debt maturities, to downright hostile conversations about poor acquisitions, asset write-offs or recapitalisations.

Why Meet with Management Teams?

The efficient market hypothesis developed by Fama in 1970[1] states that it is impossible to “beat the market” because stock market efficiency causes existing share prices always to incorporate and reflect all relevant information.

If we believed this to be true, investors should simply invest in an index fund, because   it would be a waste of time for anyone in the market to meet with management, as we could learn nothing that was not already incorporated into every company’s current share price.  Whilst this theory sounds elegant, in practice markets are inefficient due to the influence of human emotions and robotic trading algorithms trading off price momentum.  Ironically, the current trend we are seeing of flows into index funds should deliver a long-term benefit to active management, as they cause market inefficiency by directing an increasing proportion of inflows into higher priced over-valued companies.  After almost twenty years in the market it seems to me that the increasingly short-term focus of investors is creating more inefficiencies.

Further, I have previously worked at a fund’s management firm that had a fund with a strategy of deliberately avoiding meeting with management teams. This approach is based on the view that meeting management, cultivating a relationship, and understanding the business would distract from their investment strategy of profiting from the short-term price movements in a large number of companies. In my opinion, the weakness in this approach is that a company is more than a collection of cash flows, assets and liabilities contained in the financial accounts. The future direction of any company and its share price is determined by the skill and motivations of the individuals managing these assets. Also, management teams have incentives to present their financial results in the most favourable light and in some situations, this results in misleading financial accounts.  Fund managers running index and quantitatively managed funds are unlikely to be able to detect these issues.

Selective briefings?

The press sometimes characterises the additional access to management that institutional investors have over casual mum and dad investors as being unfair or bordering on inside information. In practice, these management meetings don’t provide us with inside information, but rather are used by the fund manager as additional pieces to build up a mosaic of information to determine the underlying value of a company and its prospects for the future.

In the past, some of the most useful information on a company has been obtained not from management itself, but rather from meetings with that company’s direct competitors and clients. Often a company may be a little coy when asked the more difficult questions about issues facing their business, but that same company may enthusiastically discuss problems facing their listed competitors. Relevant issues include lost contracts or aggressive accounting measures being used to boost profits (that the company being interviewed inevitably no longer uses).

Two years ago, RIO and BHP were discussing their plans to cut significantly their cost base by reducing their reliance on contractors and indeed renegotiate existing contracts.  At the same results season the contractors were confident that margins and contracts would be maintained despite falling commodity prices hurting their customers. Coming out of these meetings it was clear that there was a disconnect between the guidance being given by the suppliers (Downer, United Group and Leighton) and their customers (BHP and RIO).

See the Colour of their Eyes

Before investing in a company, it is a critical part of the Atlas process to meet with the company’s management team. When meeting with management teams you are also looking to gauge management’s response and interpret body language when they are answering difficult questions. These can range from refinancing debt to achieving stated profit guidance targets which look excessively optimistic.

By purchasing securities listed on the ASX we are effectively entrusting our clients’ capital to the management teams of various companies and must therefore trust that these management teams are going to act in the best interests of our clients.

For example, a number of years ago we met with management of Lihir Gold (now part of Newcrest) to question them about their meagre dividend payout policy, despite ounces of gold finally starting to flow out of the mine on Lihir Island in Papua New Guinea. Management (former engineers) said that returns for shareholders would not increase, but rather they were going to invest the profits in building a new mine in war-torn Côte d’Ivoire, which would require building a 100km rail line through the jungle.  From this meeting, it was clear that management’s primary instincts as former engineers were to build beautiful mines, rather than reward the owners of the company. We took the view that our clients’ interests would be served better by receiving dividends now, rather than vesting that cash flow in a new, quite risky development; hence the position was sold shortly after the meeting.

Similarly, we left a meeting with a company’s CFO last year with the view that there was a disconnect between the profits outlook presented to us and the structural headwinds from deteriorating conditions in the company’s industry. As a result, we sold the position shortly after.  Whilst the stock price had been drifting downwards prior to our selling, it fell sharply 4 months later on a large profit downgrade.

Not a one-way street

It would be wrong to think that these meetings are mostly adversarial competitions for information between fund managers and company management. From the perspective of the company,  these meetings can be a forum for the CEO to gauge large sophisticated investors’ appetite to back potential acquisitions, changes in strategy, or capital management initiatives The advantage of doing this behind closed doors is that a company can avoid the potential embarrassment or loss of goodwill that comes with presenting an acquisition with a dilutive equity raising to a hostile group of institutional shareholders, some of whom may decline to support it.

Over the last month we met with a smaller company that was performing well, yet had only attracted research coverage from two investment banks. As their management’s focus was on running their assets efficiently and bedding down a large acquisition, they were uncertain about how to engage with the research departments of investment banks to encourage them to research their company. As the Fund is invested in this company, we are incentivised to assist the company in this area to increase research coverage that may assist in pushing its share price closer towards our valuation.

Our take

One of the benefits of having your portfolio managed professionally is that it is constructed and managed by individuals whose sole focus is to select and blend listed companies into a portfolio designed to deliver higher returns with lower volatility. To execute this strategy effectively, professionals prioritize meeting with management teams and going through their financial results in detail.  Another advantage for investors of institutional management is that fund manager tends to have access and opportunities to ask questions of senior management in investee companies that are unavailable to most retail investors.  

[1] Malkiel, Burton G., and Eugene F. Fama. “Efficient capital markets: A review of theory and empirical work.” The journal of Finance 25.2 (1970): 383-417.

 

• The Fund gained +0.1%. lagging index over the month due to our strategy of favouring trusts with a high percentage of recurring earnings over those whose earnings are currently being bolstered by development profits.
• The Fund had a very pleasing reporting season and on average the trusts held by the Fund delivered profit growth +6%, compared with the underlying property index which grew profits by +3.4% over 2016.  In the words of Ben Graham “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
• In August 2017, 4 of the 12 trusts held in the Fund announced buy-backs which will should provide share price support over the next year.

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

Earlier this month casino operator Crown Resorts announced a buy-back of up to 4.2% of its outstanding shares, which builds on the $500 million of stock the company had already bought back over the past 12 months. Despite this prima facie positive announcement Crown has fallen 9% in August as the market looked past the buy-back and focused on concerns about returns from the $1.5 billion Sydney Casino.

In last week’s piece give me my money back, we looked at buy-backs that have a positive influence on a company’s share price. However, as you can see with the Crown example, buy-backs are not always positive. This week in the second part of our deeper dive into buy-backs, we are going to look at bad buy-backs and the cheapest ones of all to execute: the fake buy-backs that create the illusion of share price support.

Bad Buy-backs

Theoretically, a company should raise capital when the market is over-valuing their company, and buy back their shares when the market is undervaluing their company. One of the greatest examples in history of a company using their over-valued stock to make an acquisition was dial-up internet company AOL’s US$164 billion purchase of Time Warner in 2000. By issuing shares, AOL shareholders ended up owning the majority of the new media entity, despite Time Warner having significantly more assets and revenue, and ultimately a viable business. In 2009, Time Warner spun off AOL for $3 billion, 2% of the entity’s value in 2000.

Buybacks should only be pursued when management is very confident the shares are undervalued, as companies are no different than regular investors. If a company is buying up shares for $20 each when they are only worth $10, the company is clearly making a poor investment decision

Lack of options

Sometimes buy-backs may be taken as a signal of a lack of attractive growth opportunities in which the company can invest. Particularly in the case of cyclical companies such as miners and airlines, bad buy-backs are conducted after a period of buoyant activity. They are typically done at the top of the cycle, when the costs to develop news assets or buy competitors are at their highest. Whilst this is clearly preferable to a large acquisition such as Rio Tinto’s purchase of Alcan, this approach to capital management often this leaves the company operating in a cyclical industry vulnerable during the inevitable downturns. We view that in some situations it may be best for companies to hoard cash at the top of the stock-market cycle and use it in the next trough to buy back shares at a discount or buy the assets of distressed competitors.

This week BHP resisted the urge to follow Rio Tinto’s lead in announcing a buy-back funded by the sharply increased profits from high commodity prices, ultimately funded by a 2016 Chinese stimulus plan. By paying off debt, BHP may have more options when commodity prices come off.

Offset dilution from executive stock options

Another situation where buybacks are not positive is where they are done to offset the dilution from executive stock options being exercised. This is more common in the US where stock options often form a bigger component of remuneration, but here there is no earnings per share accretion as the number of shares on issue don’t change. This is a poor outcome for shareholders, as the new shares issued to executives via stock options are exercised at a discount to the prevailing share price and those bought via buy-backs are bought on market at the current price! In 2015, IT networking company Cisco Systems bought back 155 million shares, but after the effects of employee stock compensation it only reduced the total shares outstanding by 38 million. Here the buy-back is not capital management, but executive remuneration.

Short term sugar hit to the share price

Many listed companies award senior management bonuses based on the share price of the company they manage. This provides management with an incentive to recommend actions that may deliver a short-term boost to the company’s share price, such as a large buy-back delivering earnings accretion over a long-term investment opportunity. Companies deliver long term growth in their business by investing in future growth.

Buy high sell low

When a company either issues new shares to the market via a placement or buys back their own shares, they are effectively acting as a fund manager in valuing their own shares, making a judgement as to whether their shares are cheap or expensive. However, company management teams have access to a far greater array of information on their company’s finances and future prospects than an external investor could ever hope to have.

Qantas has a long history of capital management, buying back $506M worth of stock in 2008 (average price $5.56), $100M in 2013 (average price $1.45), $500M in 2016 (average price $3.50), and $366M in 2017 (average price $3.32). However in between was a large equity issue of $525 million shares QAN issued at $1.85 in 2009, and in 2014 Qantas’ debt was rated as junk, as the CEO lobbied the federal government for a bail-out of the then embattled national carrier.

 

 

Similarly, steelmaker BlueScope is currently buying back stock over 80% above the level at which it issued over $2 billion in equity not so long ago. Certainly, this has pushed up the share price along with some solid profit growth. However, one may think that retaining capital rather than buying-back shares could prove to be a more prudent cause of action for the steel company. Two years ago, BlueScope were seeking assistance from the government with their struggling Port Kembla steelworks in New South Wales and the company announced a $1 billion loss in 2012!

Fake Buy Backs

In some situations, the company announces the buy-back and enjoys a short-term bounce in the share price without actually buying much in the way of stock. In the listed property trust space, the buy-back often acts to support the price at NTA. For example, in 2014 SCA Property Group announced its intention to undertake an on-market buy-back of up to 5% of its units, as the price jumped above NTA ultimately no units were bought and the buy-back faded into the ether.

Unlike property trusts that have a reference point of net tangible assets per share, it is harder for industrial companies to justify announcing a buy-back and then sitting on their hands. Building materials company CSR last bought back a share in its $150M buy-back in late September. Platinum Asset Management are yet to open their wallet for their $300M share buy-back, also announced last September. Insurer QBE announced a $1 billion buy-back in February, but bought their first share back on 21 August.

Our take

Whilst we are generally in favour of companies returning excess capital to investors rather than retaining it, we concede that not all buy-backs are in the best long-term interest of shareholders. Companies that are returning all their earnings to shareholders may not be investing in research and development or new growth projects. These strategies are necessary to generate returns over the longer term that are ahead of inflation.

 

 

 

• July was again a very volatile month in the Listed Property sector and after falling heavily mid-month, the index rallied to finish down -0.1%. Normally July is a quiet month as property trust management cannot speak to the market in the lead-up to revealing their results in August.

 

• The Fund slightly underperformed the index, declining by -0.3%, with the primary cause of being the position in Westfield which generates profits in USD and GBP. Westfield’s share price was impacted by the strength in the AUD/USD which surged +4% over the month to finish at US$0.80.

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

The last six months have been stressful for Australian equity investors, despite the calm suggested by the ASX200 delivering a total return of +3.2% (capital appreciation plus dividends). December’s Santa Claus rally/Trump reflation trade went a bit sour in January, similar to the feeling given by excessive consumption of four litre cask white wine from Southern Queensland. The market then staged a recovery from February to April, before grinding down slowly on weaker commodity prices, surprise bank taxes and the potential for higher global interest rates towards the end of 2017.

In this week’s piece, we are going to look at what has happened over the first half of the year, examine some key themes and analyse the catalysts that contributed to the best and worst performers.

 

 

 

 

 

 

 

 

Growth at any price

One of the key themes to emerge in the first half of 2017 has been a willingness among investors to bid up the share prices of companies delivering earnings growth. This activity seemed to ignore the high valuations paid to access these growing profits. This can be seen in the top performing healthcare, utilities and industrial sectors, whose performance was driven by companies such as CSL (Price to earnings ratio or PE 31x), AGL Energy (PE 21x) and Sydney Airport (PE 44x). Whilst these are all very solid companies that I have owned in the past, at current prices they offer little in the way of a valuation “margin of safety” needed when investing in equities.  The wisdom of being circumspect towards fully valued high growth companies can be seen in the performance in 2017 of companies such as Dominos Pizza and TPG Telecom, both of which have fallen heavily when their growth engines began to splutter.

The hunt for yield halts

The two worst performing sectors in 2017 have been the “yield” sectors of telecoms and listed property, though paradoxically the interest rate sensitive utilities sector continued to move higher. The yield sectors have been sold off as the US Federal Reserve increased their interest rate target to 1-1.25% and signalled a further rate rise later on in 2017. For foreign investors, this decreases the relative attractiveness of investing in Australian “yield” stocks such as Telstra (-12%) and Scentre Group (-13%). Domestically the RBA is taking a different stance, holding the cash rate at 1.5% in June and  that a further rate cut could occur later in 2017.

A mixed story for financials

From looking at the above table on the right, financials would appear to have had a reasonable start to 2017, returning a respectable 2% after dividends, however for investors it has been a bumpy ride.  The major banks performed well up until the announcement of a surprise bank levy in the May budget that wiped $14 billion off their collective market capitalisation. Commonwealth Bank (+2%) outperformed ANZ Bank (-4%) and Westpac (-3%), despite the latter two banks reporting in May lower loan losses and profits in line with expectations.

Whilst 2017 has been tough for investors in the banks, the sun shone down on the domestic insurers IAG (+16%) and Suncorp (+12%), as well as the fund managers Challenger (+17%), Magellan (+14%) and Perpetual (+14%) due to a combination of inflows and performance fees. QBE Insurance’s share price (0%) once again went up by the stairs and down by the lift. After reporting a solid result in February that suggested that the company’s turn-around was working, in June QBE unveiled higher than expected claims from its Asian and Latin American businesses, which caused the share price to fall 8%.

Large Outperforms small

Over 2017, the larger companies listed on the ASX (ASX100 +3%) have outperformed the smaller companies (Small Ords +1%). Outside the banks and the energy companies, the larger capitalisation stocks have had a pretty benign 2017, with the average return dragged upwards by the performance of CSL (+29%), Rio Tinto (+12%), Transurban (+11%) and Woolworths (+8%). The key drivers of small capitalisation index underperformance have been the underperformance of mining stocks Oceana (-12%), Independence (-27%) and retailers Premier (-7%) and Super Retail Group (-17%).  Company-specific issues caused falls in vitamin producer Blackmores (-7%) and retirement home provider Aveo (-20%).

Star pupils and the laggards in 2017

Stars and what caused them to shine

In the table above on the left we have listed the top 10 stocks in the ASX 100, and from looking down the list of the stars it is mainly stock specific factors that have driven performance. Qantas benefited from continued falls in the oil price and higher fare prices, whereas BlueScope’s turnaround continues with the steelmaker reporting 200% profit growth in February and announcing a share buy-back. This caps an amazing recovery for a company that was in a very challenging position five years ago, which resulted in a massive equity issue almost 80% below the level at which the company is currently buying back stock.

As mentioned above CSL, Flight Centre, Cochlear and Aristocrat have benefited from the theme of buying earnings growth at any price. Building materials company Boral’s share price has surged based on a recovery in their US business and continued demand for construction materials to fuel the Australian housing boom.

Laggards and their negative catalysts

In every period there are stragglers as well as winners, and on the right side of the above table we have the worst 10 performing stocks. The common theme driving the underperformance of Harvey Norman, Vicinity, and Scentre are concerns that the impending entry of Amazon into the Australian retail market will destroy retailer profitability and result in vacancies in our echoing shopping centres.

Looking through the rest of the list, Santos has followed the oil price downwards, whereas Brambles and Domino’s Pizza have been de-rated on unexpected profit downgrades. The telecommunications sector was a glamour sector in 2016 but has been on the nose with investors in 2017. Increased mobile competition, lower margins, and uncertainty around the NBN have negatively impacted the share prices of Telstra and TPG Telecom.

Our Take

Looking to the second half of 2017 we see that the market has been predominantly negative on the “Amazon effect” and in August many of the affected companies will have the opportunity to reveal how their businesses are performing. Whilst Amazon has had a significant impact on US retailers and thus the owners of many US shopping malls, we see those concerns as being overplayed (though we are underweight retailers in the Atlas High Income Property Fund). Over the last 30 years the US has added a significant amount of retail floorspace such that it is now estimated at 2.2m² of retail floorspace per capita, this compares with around 1m² of retail floorspace per capita in Australia.   

Looking further afield, we expect the banks to show profit growth from the upward repricing of investor and interest-only loans, though it will be a balancing act for bank management teams, as they will find it harder to fight the bank tax with expanding profits.  The resouce companies are likely to report shrinking earnings with commodities drift lower as the effects of Chinese stimulus plans from 2016 continue to fade.   As global rates begin to rise in the back half of 2017, this will put downward pressure on the AUD which will benefit companies with USD earnings such as QBE, Incitect Pivot and Amcor.  In aggregate we expect Australian equities to deliver modest gains in the second half of 2017, mainly as equities continue to present a better investment option to bonds.