It must be Christmas
It’s beginning to feel a lot like Christmas. Joy is in the air for investors; globally, financial repression has seen an exhaustive list of bond and equity returns from more than 20 countries show positive returns through the past year, almost without exception. More often than not, returns have been double digit, with Australian bonds just making that level and Australian equities close to double that. Amazing what (short term) effects a global zero interest rate policy have upon financial markets. Here’s hoping the medium to long term effects are just as benign… we continue to have our doubts.
Not much joy in the air at Australian corporate AGMs, though. November saw the Boards of many of the June balance date companies provide their annual update to investors. Whilst having flaws, we feel the annual meeting an important and valuable obligation for those seeking access to public market equity funding. Three themes dominated these meetings: revenues are tough to come by (even with 5% unemployment and cash rates about to match GFC levels at 3%), costs are escalating (project IRR’s are winding in at an alarming rate – boards are probably joining farmers in wishing they had never heard the term CSG), and hope abounds for a “recovery” in the second half, and thereafter. Given where unemployment and interest rates are, you can readily guess our views on the likelihood of the second half recoveries eventuating for listed Australia!
For Australian equity investors the winning trade has been to buy yield. All of Goodman Group, Telstra, Sydney Airport, Westfield, Crown and the major banks (with one exception – no prizes for guessing which) have outperformed by 10% through the past year without their forecast earnings changing. There are, however, plenty of other pockets of opportunity – including “operational excellence” stocks such as CSL, James Hardie, Cochlear and News Corp which have all outperformed by 20%+, and Woolworths is almost double digits. Schroders’ portfolio has been more exposed to the latter grouping than the former. We are conscious of the risk that the financial repression trade will continue apace through 2013, and are hence reluctant to push our underweighting to bond proxies further, even in the face of stretched valuations. The end point is clear – sovereign bonds are expensive and poor investments at current prices over any reasonable time frame. When this correction occurs, those equities on the carry trade magic carpet will also fall to earth. However, the path to that end point, full of policy troubles and froth and bubbles, is far more opaque – just as it has been for the past four years now, since the introduction of quantitative easing – and we doubt it is in our investors’ interests to place the fate of the portfolio in the hands of any one of the myriad plausible paths.
A variation on the search for yield in the portfolio is how corporates react to it with their own capital structures. Many corporates are increasingly bypassing banks, given not only can they access debt markets directly, but they are doing so at lower cost than the banks themselves. Until early last year, when Woolworths funded inside the banks, this phenomenon was nascent. Our credit colleagues have recently highlighted that through the past quarter, all of BHP, Telstra and Coca Cola Amatil have issued corporate debt at a cheaper rate than the major banks. An interesting twist on this that has occurred to us is why don’t the major banks themselves, and indeed any Australian yield sensitive stock with strong credit ratings, issue very long, very deep tranches of debt? Australian major banks (in A$) can issue debt for close to 20 years at a lower cost than 10 year paper. Given the Basel 3 reforms have a policy intent of minimising funding mismatches, this prima facie would appear to be a fundamentally attractive strategy for the banks to pursue. One major bank Treasurer was honest – the impediment for them doing this was not just the commercial logic, but their competitive position. That is, like us, they are uncertain as to how much tighter bonds can trade, and if they do rally materially, they do not want to be left as an outlier, and effectively a high cost producer, by having a cost base potentially differentiated from the peers. Anyone remember the maxim “No one ever got fired buying IBM?”
Miners and energy stocks have had a poor year of performance and now that prices have declined are aggressively moving into cost cutting and capital restriction mode. We continue to think second and third tier producers, which are still more than 10% of the S&P ASX200, are perilously placed, and will continue to underperform. The major miners, in contrast, will relatively benefit from a privileged cost position as commodity prices decline, should generate enormous cash flows next year, leaving them largely debt free, and are trading at a greater discount to valuation than any other large stock in our universe. They hence retain some investment appeal, even in the face of the poor commodity price momentum we continue to expect through mid cycle.
Property has fully participated in the yield based renaissance. With buybacks now on the agenda, equity prices in some cases rising more than 50% through the year without any cashflow growth, and CEOs that have been cautious on the outlook moving on and being replaced with executives more willing to be “flexible”, it was inevitable that a large REIT IPO would arise. Woolworths obliged, spinning off SCA Property Group during the month. Our forecasts for the cashflows derived from REIT’s through the past year have not changed, although the prices have. As our primary purpose is to arbitrage price and value, it is unsurprising that we continue to not own any REIT’s.
A final trend observed through the month is the netting of gains on asset sales against impairments. Leighton offset part of the $100m gain upon the sale of Thiess Waste Management against its BrisConnections holding and ANZ offset its $200m gain upon the sale of its Visa shares against capitalized software. Whilst we can point to many instances of aggressive accounting among listed Australian corporates, with the major banks being serial offenders, it is all relative. HP announced an $8.8bn write down of Autonomy, a $10.3bn acquisition made a year ago. That certainly puts Petrohawk and St George in context!
Outlook & strategy
What does well as equity investments in Australia in this context? It’s hard to go past price makers and management teams showing an ability to generate productivity gains – the operational excellence candidates - as a good start. As the RBA has noted, human nature means that productivity gains usually lag a poorer economic environment, and hence Australia has a currently poor productivity environment. Unsurprisingly, many of the companies we can nominate as doing a good job on this front – James Hardie, Brambles, Amcor, CSL – have significant operations in the Northern Hemisphere. Many domestic industrial stocks, such as manufacturers, telcos and retailers have started down the productivity path. Banks are in a nascent (and currently fumbling) stage. Resource stocks have only through recent months started to concern themselves with such boring matters, but are quickly making their market power felt. Our relative portfolio positions reflect this progression.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.