Rudi's View | Jul 19 2017
In this week's Weekly Insights:
-Resources Stocks: More Than Meets The Eye
-Franking Arbitrage In Programmed Take-Over
-Conviction Calls: Citi, DB, Morgans, Goldman Sachs, CLSA
-Medibank Private Is Gillette 2.0
-June Quarter IPO Review
-2016 – L'Année Extraordinaire
-All-Weather Model Portfolio
-Rudi On TV
-Rudi On Tour
-Rudi On BoardRoomRadio
Resources Stocks: More Than Meets The Eye
By Rudi Filapek-Vandyck, Editor FNArena
Lackadaisical. It's one of many beautifully sounding words in the English dictionary. It is a sentence compressed into one word, as shown by Shakespeare's Romeo when he cried out "shee's dead: alacke the day!"
The word might sound theatrical and flowery, it's modern meaning is not. Lackadaisical implies not much is happening; no spirit nor inspiration. Just like the Australian share market thus far in July.
The sole exception, maybe, have been mining and energy stocks that have at least attracted some buying interest from investors plus some positive commentary from analysts.
One reason to start zooming in on miners and energy companies might be because analysts are still cutting profit forecasts; they have been at it since February and market strategists at Ord Minnett, for one, believe these analysts are now exaggerating to the downside. The fall in earnings estimates for the sector has accelerated since May.
Historically, reports Ord Minnett, earnings estimates have a tendency to move upwards in January and in July, which then also explains why both months are among the best performing in a given calendar year.
This year, earnings estimates have yet to turn upwards and mining companies in particular have been hit hard with Ord Minnett calculating EPS estimates for the sector have declined by -11.1% over the past three months. Given Chinese data remain supportive (including on Monday), and looking at Ord Minnett's in-house forecasts, the strategists believe market consensus is being too harsh on, in particular, Fortescue Metals ((FMG)), Alumina Ltd ((AWC)) and Rio Tinto ((RIO)).
In anticipation of a short term reversal to the upside, which also potentially involves the banking sector, Ord Minnett has now pushed up its 12 month target for the ASX200 to 6000 from 5800 previously. I note, strategists at Deutsche Bank have penciled in 6000 for year-end, but they also have 6000 for mid next year.
Ord Minnett's positive sentiment is backed up by a recent China trip by commodities analysts at CLSA. Their view remains that demand remains solid, and that supply and environment-related reforms will support the coal, steel and aluminium markets. Notable exceptions are iron ore, nickel and crude oil for which price forecasts for the remainder of 2017 have once again been downwardly adjusted.
If CLSA's revised forecasts prove accurate, iron ore should average US$52.50/tonne in the second half. It is trading circa US$10/t higher in the present.
CLSA's Top Picks in the sector are Rio Tinto, OZ Minerals ((OZL)), BHP and Alumina Ltd. Most analysts are coming to the conclusion the Chinese are serious about restructuring their domestic aluminium industry, which leads to higher commodity prices forecasts, and this feeds into a more optimistic view for listed producers in Australia.
The more optimistic view from a fundamental, China-driven angle is supported by recent share price action. Shaw and Partners observes share prices for global miners have withstood further downward pressures since June 21. Central bankers are talking higher interest rates. Could this be the second leg in the global reflation trade that came unstuck so unceremoniously in early February?
Strategists at both UBS and Deutsche Bank advocate investment portfolios should be Overweight resources stocks on expectation of higher bond yields in the year ahead.
Whatever the cause, strong share price performances over (almost) the past four weeks have now allowed the sector to break out through technical barriers to the upside. It still doesn't look like much on a twenty years view (see below), but Shaw remains optimistic: the sector needs more EPS growth to allow for this rally to really take off and visit higher levels.
Recent economic data and indicators in China have surprised to the upside, including on Monday. Economists are now -once again- forced to raise their GDP forecasts for 2017. At first glance, this should be a positive for the sector overall, but expectations for decelerating growth remain.
It's still a matter of when exactly, and by how much.
Longview Economics, for one, attributes more weight to the close relationship between Chinese property activity and Chinese authorities' macro-prudential tightening, and to the to be expected impact on demand for base metals and bulk commodities. As such, Longview is not singing from the same song sheet as the aforementioned.
Property transactions, which lead starts by approx. six or so months, have already rolled over, points out Longview (see chart below). How long before the impact will be felt abroad?
Analysts at Morgan Stanley see ever more evidence Chinese authorities remain focused on deleveraging the Chinese economy. Admittedly, authorities will conduct this process gradually, in order not to endanger the economic uptrend, but they will keep a lid on credit growth nevertheless, and this virtually guarantees a slower pace of growth lays ahead.
Plus, from a technical point of view, US Treasuries now appear oversold, and thus due for a bounce. This should once again work to the favour of bond proxies and high PE growth stocks, at least in the short term, assuming bonds are now due for a rally.
The biggest elephant in the room, however, remains Fed tightening. Historically, the Fed tightening and loosening has had significant impact on financial conditions in China, points out Longview Economics. It is therefore no coincidence that early last year when the Fed backed away from tightening, the result was a big improvement in liquidity and for the credit cycle in China, which then fed into stronger construction activity, and a resurgence for global commodities.
This year the Fed seems intent to stay on course, with two rate hikes in the first half of the year. No surprise thus, the situation has become tight-er in China. Concludes Longview: "The Fed’s path of policy tightening is therefore a key (albeit indirect) driver of Chinese monetary policy and China's copper inventory cycle."
Longview has been advising its clientele to remain Underweight the sector, if one must have exposure.
A different approach was recently put forward by sector analysts at Morgan Stanley. They note while share prices and profit forecasts have come under pressure in the first half of 2017, many companies are still generating abundant cash flows. Morgan Stanley advises investors to focus on companies that are strong in terms of capital, with options to deliver capital returns/added value to shareholders.
"Surplus capital can now be deployed to drive value", state the analysts, and investors have as yet not priced in the emergence of capital flexibility.
Morgan Stanley's favourite exposures are therefore, in order, South32, BHP, Mineral Resources ((MIN)), Rio Tinto and Whitehaven Coal. Gold miners Northern Star ((NST)) and Regis Resources ((RRL)) also screen positively.
To add to their conviction, the analysts are now talking a new era has begun for the sector; one wherein capital shall be proactively returned to drive value for shareholders.
As surplus capital continues to build, investors will be rewarded when focusing on which companies can raise dividends, pay out extras, buy in their own shares, et cetera suggest the analysts.
This process should start with reporting season in August.
A persistently below expectations pricing environment for energy companies means oil and gas producers won't be able to match miners in this drive for additional shareholder rewards.
Franking Arbitrage In Programmed Take-Over
The difference between Santa Claus and a Japanese suitor?
The Japanese don't have to wait until December to bring you presents.
Surely, post Toll Holdings and Programmed Maintenance ((PRG)), every Australian shareholder currently sitting on an investment that hasn't worked out as planned (otherwise known as a "dog") is now secretly looking towards the Tokyo stock exchange with a little desire in their eyes.
Take that, Downer EDI!
Given the Japanese offer lobbed at Programmed Maintenance's board and shareholders represents a premium of 68%, it is no surprise the first gave its unanimous approval and the second group is not expected to grumble too much either. It's all in cash, further adding to the attraction.
But this is not where this story necessarily ends. To further please Programmed shareholders, the board is allowed to pay out as much in dividends as possible to transfer the franking credits on the balance sheet to Australian shareholders.
At the last market update, dividends not recognised as yet had accumulated to circa $66m, or about 25.5c per share. This implies true value in the $3.02 offer to shareholders potentially lays a lot higher. Which is probably why the share price in initial response to the news for a while was trading above the $3.02 offer price.
Are things really this simple?
Well, yes and no. Programmed Maintenance has the opportunity to use its accumulated franking credits to please local shareholders one final time, before it becomes but a unit inside a much larger Japanese conglomerate, but any plans are limited by its balance of retained earnings which last stood at $34m only.
Usually, these calculations are of little use because whatever the company pays out comes off the purchase price, but there is that intangible value represented by tax benefits for Australian shareholders who can deduct the company's tax rate from their own tax, which is what the Australian franking regime is all about.
Long story short, according to Ord Minnett, true value for Australian investors is $3.08, on the assumption franking credits are taken into account and the deal will go through. The latter is very likely. The share price is trading at $2.97 as I write these sentences. This means here's an extra 3.7% up for grabs for arbitrageurs who can wait a few months before this deal is consummated.
Needless to say, FIRB can still destroy the deal, for whatever reason, and every investor should talk to their accountant/tax advisor first.
Conviction Calls: Citi, DB, Morgans, Goldman Sachs, CLSA
Ten conviction ideas from Citi: (positive = Long) Aristocrat Leisure ((ALL)); Boral ((BLD)); Caltex ((CTX)); Janus Henderson ((JHG)), Link Administration ((LNK)); NextDC ((NXT)); QBE Insurance ((QBE)); and Star Entertainment ((SGR)), plus Ansell ((ANN)) and Mirvac ((MGR)) on the negative = Short side.
Deutsche Bank strategists continue to see higher bond yields on the horizon which means yield stocks don't look like a great buy and cheaply priced stocks should do better than their more expensive peers. Otherwise put: "value" should now outperform "growth".
Lowly priced stocks represented in Deutsche Bank's Model Portfolio include Harvey Norman ((HVN)), National Australia Bank ((NAB)), Westpac ((WBC)), QBE Insurance, Stockland ((SGP)) and Incitec Pivot ((IPL)).
Over at stockbroker Morgans, the Income Model Portfolio has recently been topping up on major banks and Macquarie ((MQG)) with weaker share prices seen offering yield focused investors "compelling" yields; too compelling to resist.
The stockbroker's Balanced Model Porfolio also has been increasing its exposure to Macquarie, while buying additional shares in BT Investment Management ((BTT)) and in BHP ((BHP)).
The Growth Model Portfolio made the most changes, adding Clydesdale Bank ((CYB)) and buying more of Computershare ((CPU)), switching out of Macquarie Atlas Roads ((MQA)) and into Qube Holdings ((QUB)), while trimming exposure to ALS ltd ((ALQ)).
Small cap specialists at Goldman Sachs confirmed their preference for a2 Milk ((A2M)) and Adairs ((ADH)). The latter has since been vindicated because of a surprise market update from the online retailer, propelling the share price into the stratosphere.
And let it be known that analysts at CLSA grab just about every opportunity to highlight that Macquarie ((MQG)) remains one of their Conviction Buys in the Australian share market.
Note to paying subscribers: all Weekly Insights updates since early February this year have included updates on Conviction Calls, with the sole exception of the July 3 edition. See Rudi's Views on the FNArena website to access the archive of past updates.
Medibank Private Is Gillette 2.0
It has taken a while, but Australian investors are waking up to the fact there is a limit to how high prices can climb before consumers start voting with their feet. I've previously called this the Gillette-effect.
Once upon a time private equity in the US was tripping over each other to get their hands on Gillette, the brand behind "the best a man can get", which seemed like a money printing press until young men worldwide decided it's cool to grow lamb chops and/or a beard.
Which is not good news if you're the one selling razor blades and your valuation is based upon price increases for as far as the human eye can see.
The same dynamic is now playing out in Australia where investors and analysts have started questioning how much farther private health insurers, like Medibank Private ((MPL)), can push their customers until churn becomes more than just a ball and chain around the corporate ankle?
Analysts at Goldman Sachs, for one, already made up their mind. Medibank's current profit margin is simply not sustainable, is their conclusion. This means, probably, lower profits and a lower share price valuation on the horizon. Goldman Sachs has downgraded to Sell with a new price target of $2.46; well below where the shares are trading.
June Quarter IPO Review
The June Quarter IPO Review is out, published in cooperation with OnMarket BookBuilds:
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:
-Tuesday, 11.15am Skype-link to discuss broker calls
-Thursday, from noon-2pm
-Friday, 11.15am Skype-link to discuss broker calls
Rudi On Tour
– I shall be participating as debate monitor at the upcoming National Conference of the Australian Investors Association (AIA) at the Marriott, Surfers Paradise, 30 July-2 August
– I will be presenting in Adelaide on November 14th to members of Australian Investors Association and other investors, 7pm on November 14th inside the Fullarton Community Centre, 411 Fullarton Rd, Fullarton. Title of presentation: Investing In A Slow Growing World – An Update
Rudi On BoardRoomRadio
I have recently started participating in interviews on BoardRoomRadio. The plan is to build this into something more comprehensible, but for now an additional presence in Weekly Insights will have to do:
(This story was written on Monday 17th July, 2017. 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.
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