My View On The Australian Economy As 2015 Draws To An End

I think throughout my posts, my concerns over the Australian economy permeate throughout my posts over time. It may be hard to follow when they appear all over the place. This post is to summarise my current thoughts on the Australian economy in a more concise form. Please note that it is not an exhaustive list and that little of what follows would crystallise into my thinking when picking stocks (however it may help me identify potential bottom-up candidates) I still think it’s important to stay on top of it all – or as much as you can. 

My View On The Australian Economy

The economy is transitioning from mining investment-led growth to a broader-based form of growth. With the RBA cash rate at record lows, the intentions of the low interest rates have not had the desired outcome as business investment has not been ideal. This comes at a time when above average economic growth is tapering off as the investment boom comes to an end. Consensus economic growth for 2016 sits at around 2.5-3.0%. However, there is downside to this forecast and economists are consistently revising their numbers.

Secondly, the economy is undergoing a “wage growth” recession. As the mining boom continues to taper off, highly paid mining jobs are being replaced with lower paid roles putting downward pressure on income growth. Recent consumer sentiment & retail sales numbers have been "steady" but this has been supported by the “wealth effect” whereby increasing asset prices (especially house prices) have meant people are feeling richer and so are dipping into their savings which is stimulating consumer spending. You can see this by noting that the average household savings has fallen. This trend is expected to continue as long as asset prices continue to rise. However, with the ASX achieving relatively flat results for 2015 (which is expected to continue short-term) and house price appreciation forecasted to fall by about 7.5% in 2016, it is hard to see how the consumer (in at least the short term) will contribute to GDP growth.

Lastly, the labour market has held up well in recent times with net job ads improving but not impressive. In order to fill the gap between the fall in mining investment related jobs and the broader economy, the job ads will need to improve.

The Australian Economy More Closely

There are several key headwinds that the Australian economy is facing. The lower A$ hasn’t yet sparked a strong surge in non-mining exports, we should at some point see this trend turn though. The most recent GDP growth number for the September quarter of 0.9% was particularly surprising and was primarily driven by strong net exports. Whether or not this continues, I cannot say much but as the A$ comes off, you should see non-mining exports pick up. Major detractors of growth were the sharp decline in mining capex and investment, the stubbornly resilient A$, and cuts to government expenditure. As China’s demand for key commodities continue to decline and our terms of trade with it, it is constraining income growth which is constraining domestic demand growth.
As noted above, it is expected that consumer spending will grow but correlate with growth in asset prices, not wage growth. However, consumer spending should be supported by population growth.

My Take On The Equity Market

I’m treading in uncharted waters here, but what I’m seeing is that the Australian market is diverging. However, with this divergence the risk-reward trade-off is not really justifiable. Many sell-side analysts are recommending the same longs, as they do so, it’s driving the prices up and so newcomer’s returns are not as appealing. As a result, buying into the “consensus growth” is reducing in its attractiveness. Similarly, in the value end of the market (dominated by miners & energy related companies) it isn’t any easier to buy given their inherent business models are dependent on commodity prices and resulting lack of accuracy in forecasted figures.

According to Robert Buckland, chief global equity strategist of Citi in an investor presentation said that the recent market correction has removed EPS growth expectations and the market is now fairly valued. Put differently, Robert believes that the market was pricing in a circa 10% EPS growth, however, the recent correction has wiped this out and now the market isn’t pricing in any EPS growth or falls in EPS. Thus, the market isn’t overvalued nor is it undervalued. I believe there is little reason to make a call that P/E multiples should expand in the near term as the fundamentals don’t look strong enough. The funny thing about markets though is that anything can happen, be mindful.

Earnings are expected to grow in the low single digit (pulled down by resources). The same trend of 2015 has continued and it appears as though will continue into the start of 2016 – slow revenue growth and margin expansion driven by cost out and restructuring.  As a result, we should expect only very modest growth in the Australian equity market in 2016 (other things remaining equal). However, the low interest rate environment and strong dividend yields should support the market.

A key question now is how you should translate this (top-down) thinking into portfolio positions. I would argue that banking should be a beneficiary as their dividends should support their prices, despite ROEs falling as a result of capital raisings on back of new regulation introduced by APRA. Alternatively, US$ exposure is also attractive. Lastly, lower A$ exposed industry’s also look attractive, such as tourism, education and so on. On the other hand, as a sector I’m bearish on materials. While there is value there, it’s a hard game to play. Oversupply of key commodities and demand side pressure from China and other key emerging markets signals more risk for the sector.

The fundamentals of the economy suggest that it is hard to see why the Australian economy will continue to grow at above-average levels in the near term. Rather, it is expected that the economy will continue to grow but at a more “normal” rate in line with the long-term average.

There are however a number of factors (but not limited to) which may shake or permute my reasoning. The following factors are important considerations:

1. Firstly, changes in the RBA cash rate should change the dynamics by bolstering business investment, support the construction sector, and unfortunately support riskier assets such as shares among others. The strong GDP number in the September quarter suggests rate cuts are unlikely until early-mid 2016.

2. Sustained strength in the A$ will also put pressure on non-mining exports. A sharp decline in the A$ might see key export services flourish with key beneficiaries being tourism, education, agriculture and so on.

3. Uncertainty around the 2015-16 federal budget. Given that government expenditure has come off, a change in this may boost growth or have an alternative effect if the political party in charge decides to tighten fiscal policy further.

4. Business & consumer confidence levels are key to our growth. With the evidence suggesting downward pressure on consumer confidence, business confidence might pick up in 2016 on the back of low interest rates and low A$.

5. Lastly, China’s economic slowdown is also another key factor for our markets. Any shifts here will also shift our growth story.

Portfolio Performance

As I didn’t do a 6 month portfolio review I’ve decided to do something a little different and do a 9 month review (of my performance) instead.

My Personal Account (PA) which I refer to as my “Growth Value Fund” posted returns of 6.3% after transaction costs for the 9 months (to date). This takes my annualised return since inception to 12.3% p.a. (post all costs - which are quite high given my transaction costs as a % of transaction value is high. Performance before this cost is about 15%). Over the most recent 9 months, major detractors included WDS Limited (ASX:WDS), Slater & Gordon (ASX:SGH) and Arrium (ASX:ARI).  I have sold out of all of these positions except for WDS. Although these stocks fell significantly, the impact was subdued due to their small weightings – I held small positions relative to my other, high conviction calls. On the other hand, major contributors were Sirtex Medical (ASX:SRX), RCG Corporation (ASX:RCG) and Molopo Energy (ASX:MPO). These three stocks have done the majority of the lifting in both performance and dollar gains. I sold out of Molopo Energy realising a c. 26% capital gain (104% annualised).

Over the most recent quarter I added significantly to my Mineral Resources (ASX:MIN) holding and bought into MNF Group (ASX:MNF) which is now my largest holding. While both are only up c. 2-4%, the dollar gains are substantial as they are big holdings of mine (about 50% of my portfolio in fact – a serious level of concentration). People question why I have bought into Mineral Resources and I’d like to offer some insight. Many have ditched the company and there has been immense short selling pressure. My best guess would be because of the impact of the iron price on the business. However, what many don’t talk about is its extremely high quality iron ore crushing business which operates at a 29% EBIT margin and has a high level of contractual (recurring) revenue. Furthermore, the revenues are generated on a volume basis, and so are not as responsive to price as many believe – the majors are still pushing volume through via MIN.Yes, the earnings have re based downward, but the share price depreciation has been too aggressive and not justifiable in my opinion.  

Brief Market Review

As financial markets continue their wild gyrations, the most recent quarter was not easy with the MSCI AC World ex-Australia falling about 9.2% (USD) but this was offset by changes in the Aussie dollar.  Growth concerns over China and the rising expectations of the US interest rate hike were key themes shaking markets.

Domestically, the ASX200 Accumulation Index fell 6.6% in the most recent quarter – mostly driven by a sell-off in the banks and materials.  More specifically, the resource sector came under immense pressure as the iron ore price and oil price continue to set new lows. On the other hand, investors rewarded the industrials sector.

Brief Market Outlook

The Australian economy continues to shift away from the mining sector. With the AUD coming off we have seen tourism and services reduce the unemployment rates for these sectors. With the RBA cash rate at 2.00%, it remains expansionary. There is also a growing concern over the Australian GDP growth rate in the medium term. In one of my recent posts titled “General Commentary” I talked about how each RBA rate cut is having less of an impact on investment. I’d like to add to this. What’s happening is that with each RBA rate cut, you’re seeing more money pour into equity markets, driving up prices. Companies are using the lower rates to pay higher dividends to attract this new money, driving their share prices higher at the cost of investment into the future. This, I believe is a serious issue which needs a solution. It has come to my attention that many of the beloved blue-chips are operating at unsustainable payout ratios which I believe will come under threat.

In terms of the market outlook over the short term I cannot add much value here as quite frankly I have no idea. However, while many are focused on the daily moves of markets, I am confident that the ASX will continue to grind up over time as the economy continues to grow.

I will attempt a more elaborate post at my yearly review covering most of the year which may see some overlap with the material posted in this review.  

I hope you all enjoy your Christmas & New Year.

IPOs In The Pipeline

Some “hot” companies are getting ready to list on the Australian Stock Exchange - namely, Link, McGrah Real Estate and Baby Bunting.

When investing in IPOs it is imperative that you identify the motivations (from the business owners perspective) for doing so. Is it a firm that actually needs money to grow and the managers are retaining a substantial shareholding or is it a private equity flip? I don’t think there’s any question that Link is a great business that have a competitive edge in their market (and a clear strategy for growth going forward) which has helped them sustain healthy margins, good cash flow generation and >90% recurring revenues. However, I question the multiple attached to this business.

The other two companies I won’t make a comment on for various reasons – it would be wise not to infer from this.

The main reason for writing this post is to say that it is with great pleasure that I’m preparing an exciting post about my experience at a small investment firm. Titled “memoirs of an aspiring fund manager” (don’t laugh!) it will detail what I have learnt thus far working in the investment management industry. It is targeted towards younger, relatively inexperienced individuals (such as myself) who might want some insight into the industry and some lessons I’ve learned along the way. Watch this space!

Reporting Season With A Twist

This post is a short summary of a great experience I’ve had over the past few weeks.

This reporting season was very different for me in the sense that I was fortunate enough to get to personally meet various CEO’s & CFO’s from all over Australia and across a wide range of industries.

The structure of the meetings is straightforward, you essentially gather around in a boardroom at a brokerage firm and the company presenting will talk over their results in a closed environment. By this, I mean that it’s generally not recorded and publicised. Followed by the presentation is a Q&A session.

Although I had never heard of some of the firms that spoke, it was a great experience which broadened my understanding of different industries and their key drivers. These drivers are extremely important because they feed into valuation models. My aim was to walk away with a deeper understanding of what exactly were driving these companies and industries more broadly. I believe I achieved this to a satisfactory extent (I’m by no means an expert though).

Some companies and their respective managers which I was lucky enough to meet were: MNF, SDA, PME, BLA, VOC, DWS, RXP, SKI, VTG, RFG and PFL to name a few. 

General Commentary

Global markets are going through a rough ride. Not in my entire investing lifetime have I witnessed such wild vicissitudes in equity markets. While this is probably more of a reflection of my youth rather than anything else, it is still interesting times where our equanimity and rational thought are being tested.

We are experiencing  multifaceted problems in major economies such as China, Greece, America and Australia. Domestically, it is in my view that we have been shielded away from the GFC given our commodity boom. However, it has been apparent for an extended time that the good times are disappearing. The downturn in mining is having a multitudinous effect on our economy. For example, it is having adverse impacts on income, tax revenue and jobs.

Recent studies have shown that wage inflation is going nowhere. Our real incomes, as consumers aren’t appreciating. So what implications may this have? Well, for one, I believe that consumer demand will be weak and this is what I think we are seeing now with the most recent reporting season. A common theme among many companies is that growth in revenue is not transparent. While cost cutting has been a theme for some time, as well as restructuring, we are seeing the implications when these measures are exhausted – margins are contracting. Importers are even more vulnerable to gross margin contraction as the lower $A (predominantly driven by the rapid decline in the demand for Australian commodities) lifts their costs of goods sold.

To overcome this problem, many companies, both domestically and internationally are turning to M&A activity to boost revenues rather than anything else. And boy is the time ripe for that! In this low interest rate environment, companies are definitely taking advantage of cheap credit to help pick up the slack. However, what happens when interest rates begin to rise- especially in the US?

Given the aforementioned, I believe it’s fairly evident that the Australian market is in a tough time for the foreseeable future. Given the lust for yield as a result of the historically low interest rates globally, riskier assets are appreciating while global economic growth is decelerating. Moreover, benefits from the RBA rate cuts are having fewer impacts with each subsequent cut.

I believe the reasons mentioned above are key to the issues Australian companies are facing, namely revenue growth and margin contraction. By extension, I would argue that profitability will be sub-par in at least the near term. Moreover, as I mentioned earlier, the lust for yield have pushed these exact companies to prices which may be unjustifiable. Do you see the spiral effect I’m trying to achieve here? The low interest rate environment is evident of a weak economy; however, this is pushing investors into riskier assets – such as shares. These companies, given the weak economy and lack of consumer demand aren’t delivering. This problem is enhanced by the premium some investors are willing to pay to own a piece of a company which is able to pay dividends. So what’s the outcome? Investors are paying more and more for less and less. Not only that, but they are increasingly becoming vulnerable to stocks de-rating - which has become more apparent with some companies which have come out in the FY15 reporting season. Over the long term, it sometimes pays to arrest our inherent rapacious actions which may do more worse than good.

A prevalent theme of the FY14 reporting season was a lack of EPS growth on a broad level. Interest rates we’re still historically low back then and investors demanded dividends. As a result of the latter overpowering the former, (on a broad scale) payout ratios unambiguously rose at the cost of investing for future growth. As the labour market continues to weaken it will be interesting to see where the growth will come from. I believe technology will no doubt have a big role in this.

Despite the relatively bearish atmosphere i may be depicting, I wholeheartedly believe that the astute manager can still generate outsized returns in this environment. Why? Because if history is any guide, then it is definitely possible. Returns may not be as easy as they were previously, but this is only a guess at best. Unfortunately, i wasn't blessed as a Seer and so i cannot detect what the future holds.