Rudi's View | Nov 11 2015
This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP
By Rudi Filapek-Vandyck, Editor FNArena
It is typical of how the financial industry works that everyone always wants to talk about their prime achievement.
Funds managers, stockbrokers, tip sheet publishers and the likes are always eager to highlight their top stocks; how they outperformed their peers, or the index, and skillfully (of course) managed to pick that small cap ten-bagger everybody is talking about today.
What about the stock picks that turned into a failure?
I am sure there are lessons to be learned from successful stock pickings across the industry, and wouldn't we all like to know the secret to eternal investment success, but anyone with a healthy dose of self-reflection knows that on top of all the experience, and the skills, and the research, plus the personal touch, also comes a healthy dose of pure, plain luck.
Sometimes you have it, other times you don't.
But "luck", and the lack of it, is merely a short term consideration. Picking the right stock that moves up by 10% in only a few trading sessions involves a lot more luck than picking a stock that delivers an average of 10% return over a five-year period, as I am sure everyone agrees with.
Which is why the intriguing capacity of BHP Billiton ((BHP)) shares to offer anything but failure to Australian investors since April 2011 is such an important event. Surely there are at least as many, and probably more important lessons to be learned from the BHP experience over the past 54 months than there are from trying to figure out why shares in Blackmores and in APN Outdoor have rallied so hard this year, and why you weren't on the shareholder registry?
That sound you are hearing in the background right now is 98% of all analysts, strategists, commentators and other experts in the Australian financial sector ducking for cover, for this is one of the great market observations since 2011: just about everyone who was asked the question on financial television, or by a magazine or mainstream newspaper, has expressed the view that BHP shares simply are a staple stock that must have a place in any long term-oriented investment portfolio.
In most cases, the underlying justification for a positive view on BHP shares has steadfastly been that the shares look "cheap". Hence the general view that, long term, she'll be right. It is my long standing observation that "cheap" and "expensive" are rather relative concepts. For example: one of my favourite stocks in the post-GFC era, Amcor ((AMC)), has seldom looked "cheap" on metrics such as the twelve months out estimated Price-Earnings (PE) ratio or intrinsic dividend yield, but the shares have generated a positive return for shareholders in each calendar year.
In contrast, BHP shares have constantly enjoyed the support from most of the financial commentariat, with financial metrics suggesting "cheap" at every pull back in the share price, yet the BHP share price has, including South32 spin-off, more than halved since April 2011. Admittedly, BHP is one of the most reliable dividend payers on the ASX, and the company has remained true to its pledge to shareholders, but this has been no more than a band aid on a deep and painful flesh wound throughout the period.
It brings back visions from a rudderless Telstra ((TLS)) whose board used to guarantee shareholders 28c in dividends each year, but the share price kept on falling.
What Telstra pre-2009 and BHP in 2011-2015 have in common is that simply relying on a dividend yield in the share market is a strategy fraught with danger. Contrary to general perception, dividend-oriented strategies in the share market are not by default "defensive" or "lower risk". Any yield story in equities still needs to be backed up with growth and cash flows.
In the absence of either or both, investors risk ending up with a sharply devalued asset, as has been the case in recent years for those who held on to shares in Woodside Petroleum ((WPL)), Woolworths ((WOW)), Metcash ((MTS)), Myer (MYR)), Fleetwood ((FWD)), Monadelphous ((MND)) and many, many others.
To be fair to the BHP Billiton board, the guarantee of a progressive, through-the-cycle dividend policy has made a substantial difference. One look at price charts for peers Vale, Lonmin, Xstrata et al immediately shows how much better off shareholders in BHP Billiton are in a relative sense. Alas, to most investors, relative superiority is like wrapping a paper towel around a broken limb. It doesn't really make one's heart skip a beat.
Contrary to conclusions drawn elsewhere, none of the above means investors by definition cannot combine yield strategies and resources-related stocks. Funds managers in the UK have been relying on steady dividend streams from big oil multinationals for decades. Just like in the case of Woodside Petroleum in Australia, these strategies have come unstuck in recent years as the likes of BP were involved in a major oil spill in the Gulf of Mexico while others got dragged into the quagmire of plunging oil and gas prices.
Taking a broader view on the matter, this merely builds a bridge between large cap resources stocks and their peers among industrials and financials stocks. On the assumption that dividends are backed by good management, a solid balance sheet and recurring revenues and cash flows, any quality company should be able to withstand temporary headwinds or a short, cyclical downturn. But market circumstances cannot continue to deteriorate or else a breaking point will arrive, at which point all bets are off.
Note, for example, how Metcash managed to withstand market pressures exercised by Coles ((WES)), Woolworths ((WOW)) and Aldi for many years, its share price essentially continued to trade around $4 between 2005 and early 2013, during which time the stock continued to feature as a steady dividend payer for many a yield-seeking SMSF investor. Until 2015, when the pressure building became too intense forcing the board to stop paying a dividend and use the cash to try to reinvigorate the business. Note how Metcash shares had been de-rated some two years prior to the company announcing it would temporarily cease paying out dividends.
In similar vein, a company like Monadelphous had developed into a fast growing, reliable dividend payer over the decade prior to 2012. From then onwards the downturn in the mining services industry turned too violent to sustain the track record and loyal shareholders have seen the shares plummet alongside steady reductions in dividends for each year that followed.
Crucial factor number one: never fall in love with an investment that has been good to you in years past. When the big downturn arrives it's better not to stick one's head in the sand, hoping for the best.
The BHP board has stuck to its promise that loyal shareholders shall be rewarded with a progressive dividend policy, through the ups and downs of the many cycles that characterise the path of a commodities producer. Arguably, this policy worked until May 2015 with the share price prior regularly finding support because of the yield on offer. That support disappeared in May as analysts and investors realised the next sell-off for commodities would imply BHP's assets could no longer generate sufficient cash flows to guarantee the annual payout to shareholders.
May was the Metcash-moment for BHP and analysts have been arguing about sufficient/insufficient cash flows since.
Note BHP has to date not cut its dividend, nor has any member of the board given any indication such a move will be under consideration when the board reconvenes. But in light of the many uncertainties about the extent and duration of the downtrend in commodities, and the impact on BHP's cash flows, it is only logical for the share price to de-rate if only to reflect that risk has noticeably increased. The fact that BHP's implied yield has risen to well above 7% (plus franking on top), from a relatively steady 4%+ up until May 2015, signals the market is taking a determinedly bearish view on the outlook for company profits and BHP's ability to maintain its progressive dividend policy in the years ahead.
A similar observation can be made for Woolworths whose board also has not yet announced a reduction in dividends for shareholders, but market price action signals investors believe it is but a matter of time. Within this context, I note shares in Metcash were de-rated well before the actual announcement was made. The market also correctly anticipated Woodside Petroleum's dividend should halve given the price of oil has done the same.
I also note share prices for all of the major banks in Australia have de-rated significantly since May. None of the banks has announced a reduction in dividends, but Citi analysts think it's inevitably going to happen by 2018.
One of the obvious conclusions to draw from all of this is that for dividend-based investment strategies to remain successful, companies can face a mild downtrend, even a moderate one, as long as the negative pressure remains somehow "manageable". Plunging commodity prices are not part of any success stories. Neither is a relentless, long term downtrend.
On my observation, too many share market experts and participants are too focused on "valuation", without much consideration for the general context that surrounds the perceived/estimated valuation. It is true that, over time, investment returns benefit greatly when a quality asset can be bought at a lower price, but none of this implies that an asset that looks "cheap" on forward estimates is by default a great investment, not even if it is held for the longer term.
Yet, this is exactly how the majority of financial experts and commentators has treated the BHP share price post 2011.
The simple answer as to why all the "buy cheap and hold for the longer term" recommendations have been proven wrong is because commodities have been in a relentless downtrend for the past four years. Admittedly, this downtrend is not immediately apparent from BHP's share price chart over the period, but that's because the shares offered a believable and reliable, relatively low risk dividend yield story throughout most of that period, as discussed above. Compare with share prices for most other commodity producers, and you shall have no problem seeing the downtrend.
One obvious mental note to make is thus that buying "cheap" doesn't work when a company is in battle against a long term downtrend. As such, there is no difference between a producer of bulk commodities or industrial metals, and publishers of print media, owners of digital and free-to-air TV stations and the operators of department stores across Australia. Indeed, share prices of Fairfax Media ((FXJ)), Southern Cross Media ((SXL)), Myer et al show just that: long term down-trends exert continuous downward pressure, eventually forcing share prices to levels much lower anyone can imagine beforehand.
For investors, the most crucial point to remember here is that the ultimate outcome of these long lasting down-trends is never reflected in short term prognoses and forecasts. Not even in medium term estimates. This is because both management teams at the companies involved and the analysts covering the sector always underestimate the severity and the speed at which the negative trend might impact. As a result, share price reactions always look overdone, making share prices look "cheap".
I pay close attention to changes in analysts' forecasts. It's a crucial part of the service we provide for investors at FNArena. As such, I can report analysts' forecasts for BHP Billiton have pretty much remained in a continuous, relentless down-cycle since 2011. This is not different from what has happened, and still is happening, to forecasts and valuations for companies such as Monadelphous, WorleyParsons ((WOR)), Salmat ((SLM)) and Woolworths.
The key takeaway here is long term trends do not show up in short term price charts and/or forward estimates. If they did, BHP shares would have been declared "cheap" and "attractive" a lot less often than they have been over the past four years.
Nothing lasts forever, right? Unless we're talking CD shops and video rental stores, most companies that are battling a negative sector trend should see, at some point, a stabilisation in sector dynamics. Certainly, the most aggressive among share market participants are not going to hesitate for long before taking a punt that a reversal, surely, soon must be on the cards.
Share prices for the likes of Myer, Fairfax and Southern Cross Media have experienced short term rallies in years past. When in the thick of the moment, these rallies can easily suck in other participants for the shares look "cheap" and the promise behind a sustainable reversal in fortune is for much greater share price gains. When viewed against a longer term framework, and with the help of Harry Hindsight, each of these rallies eventually deflated and gave in to the continuous downward pressure, ultimately forcing the share price to a lower level.
Commodity prices are not going to continue falling to zero. Short term movement in prices is often solely driven by market sentiment. Share prices certainly do look "cheap" so who's to say there cannot be a left field catalyst for a sharp rally? Investors who positioned themselves for a reversal in trend earlier in the year certainly have paid the price -yet again- for jumping in too early.
While the immediate outlook continues to look bleak, in particular because most bulks and industrial materials remain over-supplied and global demand simply doesn't look strong enough to resolve commodity producers' prisoner's dilemma anytime soon, there are early signals of supply reductions in markets such as nickel and copper. These are promising signs, though early days still.
Bigger picture, the outlook for BHP Billiton would look a whole lot more promising if similar signals were becoming apparent for iron ore and crude oil, but instead iron ore producers in India, in Brazil (Vale) as well as in Australia (Gina Rinehart's Roy Hill) are still seen adding additional market volumes while the replacement of higher cost Chinese domestic production remains a reluctant and slow-going process.
I am currently in the process of writing the final chapters of my book, title "Change. Investing in a Low Growth World". This book shall be released in early December exclusively to paying subscribers at FNArena.
Rudi On Tour
– I have accepted to present to members of Australian Shareholders' Association (ASA) in Canberra, on Tuesday, 8th December 2015, 6.30pm, Federal Golf Course
Rudi On TV
– on Thursday, Sky Business, Lunch Money, noon-1pm
(This story was written on Monday, 9 November 2015. It was published on the day in the form of an email to paying subscribers at FNArena).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: firstname.lastname@example.org or via Editor Direct on the website).
THE AUD AND THE AUSTRALIAN SHARE MARKET
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For more info SHARE ANALYSIS: AMC - AMCOR PLC
For more info SHARE ANALYSIS: BHP - BHP GROUP LIMITED
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For more info SHARE ANALYSIS: MND - MONADELPHOUS GROUP LIMITED
For more info SHARE ANALYSIS: MTS - METCASH LIMITED
For more info SHARE ANALYSIS: SLM - SOLIS MINERALS LIMITED
For more info SHARE ANALYSIS: SXL - SOUTHERN CROSS MEDIA GROUP LIMITED
For more info SHARE ANALYSIS: TLS - TELSTRA CORPORATION LIMITED
For more info SHARE ANALYSIS: WES - WESFARMERS LIMITED
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For more info SHARE ANALYSIS: WOW - WOOLWORTHS GROUP LIMITED