Rudi's View | May 24 2017
In this week's Weekly Insights:
-May, The Month Of Downgrades
-Conviction Calls: Citi, UBS, Macquarie, Morgans and CS
-Shifting Grounds For Iron Ore Producers
-2016 – L'Année Extraordinaire
-All-Weather Model Portfolio
-Rudi On TV
-Rudi On Tour
May, The Month Of Downgrades
By Rudi Filapek-Vandyck, Editor FNArena
In what now must look like the ultimate act of share market irony, the ASX200 index peaked on the 1st of May with a closing level of 5950.80. More than 200 points have since gone missing over the subsequent three weeks with investors fretting about high valuations, geopolitical risks, a surprising left field attack on Australian banks from a narrative-changing Turnbull government, and the ultimate injury; a White House in disarray as the Trump-Russia controversy just won't go away.
Market observers in the USA have noted the pool of stocks that is keeping US indices near all-time highs is shrinking this month, while trading volumes tend be higher on down days. None of such indicators says anything about a potential trend reversal or the timing of it, but it does call for reflection, a pause and potentially a more cautious portfolio positioning.
In Australia, the arrival of the month of May has triggered a battery of downgrades in stockbroker ratings for ASX-listed stocks. Noticeably, while share market concerns were equally as prominent in April, broker downgrades and upgrades remained in relative balance throughout that month. The final week of April, for example, saw 10 upgrades and 8 downgrades from the eight stockbrokers monitored daily by FNArena, and resources stocks were the primary receivers of positive assessments.
Let's now have a look at what happened since:
Week 1 in May: 27 downgrades versus 6 upgrades
Week 2 in May: 24 downgrades versus 6 upgrades
Week 3 in May: 19 downgrades versus 4 upgrades
For a Grand Total of 70 downgrades versus 16 upgrades. In April, the balance was still 28-31.
For good measure: the balance between broker downgrades and upgrades does not possess any predictive qualities. It is, at best, a coincident indicator. Which means, in hindsight, we can all easily explain as to why the ASX200 lost -200 points (-3.3%) in the blink of an investor's eye.
Elevated share prices need positive impetus to continue rising. Broker downgrades are a negative. A firm bias towards broker downgrades is more likely to pull the overall market down, in particular when large cap stocks such as resources, banks, telcos and bond proxies are involved.
Before we zoom in on the stocks and sectors that have been negatively affected (in a bid to maybe learn a few fresh insights), let's first concentrate on the few lucky ones that received upgrades in May; in particular those that were raised to Buy (or an equivalent).
The full list:
-Aveo Group ((AOG))
-Fortescue Metals ((FMG))
-Henderson Group ((HGG))
-Huon Aquaculture ((HUO))
-Incitec Pivot ((IPL))
-RCG Corp ((RCG))
-Saracen Mineral Holdings ((SAR))
-Smartgroup Corp ((SIQ))
I don't know about you, but the above list seems to be heavily biased towards sold-off, out-of-favour small and medium size industrials, retailers, one major bank and the occasional mining stock. Not so much a trend, but certainly a reminder of what most of us instinctively already know. Share market momentum is pointing towards stock picking abilities among medium and smaller cap stocks.
Here the task at hand gets more complicated as this is also the market segment that continues generating unexpected profit warnings, as again proven by SurfStitch ((SRF)) on Monday, and by Myer ((MYR)), OrotonGroup ((ORL)), Sirtex Medical ((SRX)), Southern Cross Media ((SXL)) and Vita Group ((VTG)) in the week prior.
Certainly, share price responses to these disappointments have once again brought home the inevitable reality that not all that looks "cheap" in the share market is by definition a bargain. Investors are better off asking themselves: why don't investors jump on board when value seems to be apparent?
The big gap between downgrades and upgrades has somewhat transformed internal dynamics for the Australian share market. Only two out of the eight stockbrokers FNArena monitors daily are left carrying more Buy ratings than Neutral/Hold recommendations; can it be any coincidence both Ord Minnett and Morgans are more retail oriented than the others?
As for all eight stockbrokers combined, total Neutral/Hold recommendations once again outnumber all Buy ratings, while Sell ratings, traditionally the smallest contingent, are noticeably on the rise. On Friday, more than 43% of all recommendations were Neutral/Hold, with Buys and equivalents representing 41.80% and Sell ratings rising above 15%.
Funnily enough, these numbers are more representative of a "normal", less segmented share market that is, admittedly, far from undervalued. For about six months, share market momentum resided predominantly with selective market segments only, resulting in total Buy recommendations outnumbering total Neutral/Holds.
As I pointed out last year, whenever this happens it usually marks a tough time for share market investors. As it happened, this time around it marked a share market that was riding positive momentum for a selective group of stocks only. Because the banks performed splendidly during that period, investors might feel hard pressed to look back at the past six months in terms of a tough time for investors.
Just ask any funds manager who hasn't been overweight banks during that period and you will see a face in distress.
Most retail portfolios tend to be heavily weighted towards major banks, the resources heavy weights, supermarket owners and Telstra, hence any flash backs about tough times tend to be longer dated, but most would not have forgotten these exposures did not perform between 2013 and mid-last year.
The Australian share market has hardly operated like one unified "market" for a long time. For those with active strategies, performance in years past has been all about making the correct switch at the right time. For others, the years past have delivered moments of bliss and gratification, but above all lots of frustration during extended periods when parts of the portfolio, or the whole lot, failed to generate any sustainable momentum to the upside.
Does the switch in balance between Buys and Holds now indicate the future offers a less polarised landscape? Only time will tell. One obvious observation to make is that mining and energy stocks have had their correction from rally highs, and banking stocks are having their correction this month.
The resurrection of Telstra this month shows no dividend payer can endure share price weakness into infinity.
A far as the many downgrades are concerned, most have been inspired by good news stories that, simply put, have become too expensive in the short term. At least, such is the opinion of stockbroking analysts that have downgraded stocks like DuluxGroup ((DLX)), REA Group ((REA)) and Treasury Wine Estates ((TWE)).
Of more interest are those downgrades to Sell because either the outlook has significantly deteriorated, in the view of the analyst, or a company's risk profile is heavily out of touch with the share price. Here we find the major banks, unsurprisingly, as well as health insurers, bricks and mortar retailers, and nickel miners.
Not common knowledge yet for all paid subscribers, but the FNArena website contains a Sentiment Indicator which lines up a list of least liked and most liked stocks according to broker ratings. Those unequivocally out of favour include:
-Cromwell Property ((CMW))
-Seven West Media ((SWM))
-Western Areas ((WSA))
-Virgin Australia ((VAH))
-Harvey Norman ((HVN))
-Charter Hall Long WALE REIT ((CLW))
No doubt, this group already has attracted the attention of contrarians and value seekers, for all others: caveat emptor.
Pressing the pre-programmed High Sentiment button in FNArena's Sentiment Indicator provides us with the following ten stocks that have a perfect or a near perfect score when it comes to attracting Buy ratings from stockbroking analysts:
-Star Entertainment ((SGR))
-Michael Hill ((MHJ))
-Alacer Gold ((AQG))
-HT&E ((HT1)), formerly APN News & Media
-Speedcast International ((SDA))
-Rio Tinto ((RIO))
-Evolution Mining ((EVN))
Some of these inclusions, such as Sirtex Medical, HT&E, Michael Hill and Alacer Gold, might be most inspired by share price weakness which, ironically, might make some of these stocks a more contrarian play than some inclusions on the prior list. At least on this list you know broking analysts think the market is wrong, being too bearish.
In general terms, this month's weakness in the ASX200 is opening up potential for buyers to step in as total return in a generalised sense is becoming more attractive. According to Shaw and Partners chief investment officer, Martin Crabb, Total Shareholder Return (TSR) as suggested by consensus target prices and forward looking forecast dividends has now risen to approximately 9.12% (as of Friday).
The suggested return comprises of 4.59% dividend yield and 4.53% capital gain. While this is not double digit territory as yet, it is the highest suggested return potential since November last year.
As things stand, underlying earnings momentum is slightly negative thanks to the banks and disappointers such as Myer, James Hardie ((JHX)), Vocus and Pact Group ((PGH)). Expectations remain for extremely robust growth in FY17, predominantly carried by a resurrected resources sector, but with, as yet, little follow-through expected beyond the current calendar year.
The market's average Price-Earnings (PE) ratio bounces between 15-something and 16-something, depending on whose estimates and timeline, which is above the long term average of circa 14.5x but not excessively so with bond yields still at exceptionally low levels.
This while just about every expert and his dog is now forecasting higher bond yields by year-end.
Conviction Calls: Citi, UBS, Macquarie, Morgans and CS
One of the standout observations regarding prospects for local independent cloud data infrastructure builder NextDC ((NXT)) is the more analysts and other experts look into this company's fundamentals, the more positive views and assessments are being added in support of a stronger share price. I have mentioned NextDC before. If not on my regular TV appearances, or during my on stage presentations, then here in Weekly Insights. The last time was on April 12, see "NextDC: The Coming Of Age Of A Cloud Infra Story".
On a micro scale, management seems to be doing all the right things, plus some. Its latest move was to raise more debt than was intended. This, argue analysts, not only shows how eager investors are to be part of this emerging cloud data centres success story, it also serves as a clear message to the company's clients and competitors. NextDC means business. No shortage in attracting cash means management should now have sufficient room to leverage its talent and the company's buoyant business case.
Citi analysts certainly have taken such view, bumping up the price target to $5.18 from $4.40. Note that financial prospects in FY18 will be weighed down by the increased costs to serve additional debt. The offset is, of course, higher growth faster, which explains the increase in valuation and price target.
On a macro scale, and as I argued during my time on stage at the Australian Shareholders Association's (ASA) national conference in Melbourne last week, there is a general tendency for investors of all kinds to underestimate how far share prices can ultimately rise when carried by strong structural growth drivers such as is the case for NextDC.
The share price has rallied 132% since January 2015 (less than 29 months), so many investors would be asking questions about when this uptrend will come to an end, but fresh assessments like the one by Citi suggest it remains way too early to start focusing on what might go wrong. This makes NextDC's story similar to the ones witnessed at Corporate Travel ((CTD)), CSL ((CSL)), Treasury Wine Estates ((TWE)), and numerous others.
Sure, the poster boy for structural growth & innovation leadership, Domino's Pizza ((DMP)), is experiencing a life more difficult these days with the share price at a distinct distance from the $80 reached last year, but that was after rising from a mere $8 back in 2012. Most market watchers who don't like Domino's Pizza -pre or post 2016- because its Price-Earnings (PE) ratio steadfastly looks too high, don't like NextDC, Corporate Travel, CSL and the likes today.
Sad truth is, they all missed out on one of the most admirable, and profitable, growth stories in the Australian share market. And so has/does everyone who takes guidance from these misguided voices. I've said this many times before, and I shall point this out many more times in the years ahead: a PE ratio on its own tells you nothing. Even as most experts treat it that way. Yet another sad truth.
Returning back to NextDC: Citi rates the stock a Conviction Buy. King of the pokies, Aristocrat Leisure ((ALL)), is traveling a similar path. It's going to be interesting to find out whether its financial performance, scheduled for Thursday this week, can facilitate yet another leg upwards in an already impressive uptrend from circa $6.50 in early 2015. Yes, the shares are trading at more than three times that value today.
UBS strategists David Cassidy and Dean Dusanic have taken an alternative approach to the question whether there is still value in the Australian share market. Comparing today's share prices with historical averages, the UBS strategists created three different segments for investors to focus on; a premium level, a market multiple segment and a basket of cheap looking stocks.
Within this framework, Cassidy and Dusanic, while acknowledging the methodology has its flaws, have identified three times two stocks that might still look good value at current prices; ResMed ((RMD)) and Carsales ((CAR)) at the premium end; Boral ((BLD)) and Brambles ((BXB)) in the middle; and Henderson Group ((HGG)) and Lend Lease ((LLC)) among the cheaper priced stocks.
Earlier this month, portfolio managers at Macquarie made numerous changes on the back of changes in views and outlooks for many key constituents and sectors. Macquarie has scaled back its exposure to the banks, fearing a bad news cycle has started that in particular will hit retail banks CommBank ((CBA)) and Westpac ((WBC)). The sector Neutral exposure is now concentrated in business banks National Australia Bank ((NAB)) and ANZ Bank ((ANZ)).
Because Macquarie also sees bond yields on the rise by year-end, the portfolio exposure to yield stocks has been reduced too. Shares in AGL Energy ((AGL)) have been tossed out. Instead the portfolio now includes exposure to Computershare ((CPU)), Magellan Financial ((MFG)) and Corporate Travel ((CTD)).
Around the same time, portfolio managers at stockbroker Morgans also started trimming their exposure to bond proxies such as Transurban ((TCL)), Challenger ((CFG)), Sydney Airport ((SYD)) and Macquarie Group ((MQG)), while buying additional shares in beaten down Telstra ((TLS)). The latter decision was supported by in-house research suggesting the dividend is sustainable, at least for now.
The broker's Balanced Portfolio reduced exposure to BT Investment Management ((BTT)) following a strong rally. The Growth Portfolio has started buying shares in Bapcor ((BAP)), described as a High Conviction Growth Stock, with the shares being sold down alongside most other "retailers". The same Growth Portfolio got stuck with Vita Group ((VTG)) shares, which post Telstra debacle are no longer considered suitable, but Morgans doesn't want to sell at current level.
In the broker's own words: "we watch for a more palatable exit point".
Equity strategists at Credit Suisse too made numerous changes to their selection of Top Picks in the Australian share market. Out went APN News and Media, which nowadays trades under the name -I kid you not- Here, There & Everywhere ((HT1)), together with Fairfax Media ((FXJ)), Rio Tinto ((RIO)), Sydney Airport ((SYD)) and Transurban ((TCL)).
Last week, Credit Suisse strategists had to admit -blood clearly visible on the cheeks- nominating Myer ((MYR)) as a Conviction Long Idea was not a good idea. Their mea culpa admission came with the comment that when seeking value among cheap stocks there is always the danger of a value trap. And Myer has proved to be such a trap.
Fortescue Metals ((FMG)) has since replaced Myer on the notion that a looser liquidity environment in China will push up growth numbers and thus demand for the iron ore the company is digging out of Australian soil.
Regular followers of these Conviction Calls updates might want to take note of the fact such updates have been included in every Weekly Insights edition since 8th March 2017. See Rudi's Views on the FNArena website for past editions.
Shifting Grounds For Iron Ore Producers
There's a lot more happening than simply demand-supply dynamics in the world of steel and iron ore. Currency movements, liquidity measures by Chinese authorities, more clamping down on speculators and financial products, plus a widening price gap between high quality and lower quality product.
In the meantime, share prices have sold off, with a noticeable bounce in recent sessions. At least, if we concentrate on household names such as BHP ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)). Not so much for those watching minnows Mount Gibson ((MGX)) and Atlas Iron ((AGO)).
The answer as to why the latter share prices have not rallied back to life was perfectly illustrated by the table below, courtesy of detailed research undertaken by commodity analysts at UBS. In particular the price gap between high quality and lower quality product is hurting the small fish in the global iron ore pond. It means these producers need a much higher spot price to reach break-even, as illustrated below.
Note: UBS's calculations do not take into account interest costs from producers carrying debt, so the numbers can be worse when there's debt on the balance sheet. On the other hand, the price gap between products can narrow, of course, which can have a significant impact on these numbers.
2016 – L'Année Extraordinaire
It was quite the exceptional year, 2016, and I did grab the opportunity to write down my observations and offer investors today the opportunity to look back, relive the moments and draw some hard conclusions about investing in the world today.
If you are a paid subscriber to FNArena, and you still haven't downloaded your copy, all you have to do is visit the website, look up "Special Reports" and download your very own copy of "Who's Afraid Of The Big Bad Bear. Chronicles of 2016, A Veritable Year Extraordinaire" (in PDF).
For all others who still haven't been convinced, eBook copies are for sale on Amazon and many other online channels. You'll have to visit a foreign Amazon website to also find the print book version.
All-Weather Model Portfolio
In partnership with Queensland based Vested Equities, FNArena manages an All-Weather Model Portfolio based upon my post-GFC research. The idea is to offer diversification away from banks and resources stocks which are so dominant in Australia, while also providing ongoing real time evidence into the validity of my research into All-Weather Performers.
This All-Weather Model Portfolio is available through Self-Managed Accounts (SMAs) on the Praemium platform. For more info: email@example.com
Rudi On TV
This week my appearances on the Sky Business channel are scheduled as follows:
-Thursday, 12.00-2.00pm, co-host in the studio
-Friday, 11.15am Skype-link to discuss broker calls
Rudi On Tour
Your Editor has been invited to present before members and non-members of the Melbourne chapter of the Australian Investors Association's (AIA) on June 6th, 12.30-2pm. Location: Telstra Centre, in Room 1, First Floor at 242 Exhibition St, Melbourne CBD.
(This story was written on Monday 22nd May, 2016. 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 the direct messaging system on the website).
BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS
Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:
– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.
Subscriptions cost $380 for twelve months or $210 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index2.cfm?type=dsp_signup