Australian Market Summary (Issue 383) – 22 January 2016

I feel like saying it was ‘much ado about nothing’ again this week given the ASX200 is once again FLAT on the week, but that would surely underplay the volatility and underlying concerns still EXTREMELY evident in global financial markets.

Investment markets remain on heightened alert insofar as concerns for 2016 economic growth and I have to say I share these concerns to some extent.

I’ll repeat my view that even though the ASX200 is down 8% year-to-date, I would expect to see some more modest downside in indices (perhaps another 200pts to 4650-4700) before we find a base to bounce.

I’ll also repeat that I expect 2016 to be a negative year for Australian shares, but that at this point I think equity markets will prove manageable.

Let’s be honest, the papers and the nightly news do a great job of exacerbating that greed and fear cycle.

They bring out the worst in us.

Our aim is to navigate the long run, not the short and to adapt along the way to changes as they arise.

China’s currency devaluation is a big deal and the question-marks over 2016 growth prospects have indeed increased.

More pertinently for us, the issue of dividend sustainability is the supreme focus.

DIVIDENDS … #1 FOCUS.

With the pending cut to BHP’s dividend, I have been increasingly attentive to the issue of dividend sustainability for 2016 and beyond.

The oils and the mining services companies will definitely see dividend income decimated in 2016, Woodside (WPL) being the most notable.

Of more concern to me this week were broker reports questioning dividend rates at the major banks.

One broker suggested ANZ (ANZ) stood a reasonable chance of being forced to cut its dividend by 10-15% to compensate for increased credit loss in its Asian banking business.

Another spoke of the earnings lost by National Australia Bank (NAB) in divesting itself of its UK & US banking franchises and MLC Life business.

Undeniably, payout ratios at the banks are high (as indeed they are across the Australian share-market as investors thirst for income remains pre-eminent) at 75% or more of earnings (excluding ANZ at 65% or so).

With already high payout ratios, the banks are arguably less prepared to deal with the impact of earnings headwinds on dividend payments.

This is increasingly an issue to occupy my mind and one I ought avail you of.

I expect the 2016 credit environment to be benign and firmly believe the local services economy to be in good stead and this gives me some degree of confidence that things are still OK here.

However, if I cast my eye to 2017 and beyond I begin to question my confidence a little more. Treat this as a shot over the bow on my thought process and one I expect to delve deeper into in the coming weeks and months – for the record we are at ‘market weight’ banks in the PRIME Australian Equity GROWTH portfolio and even a shade ‘overweight’ in the INCOME portfolio.

THE WEEK THAT WAS … A LOT

Performance was disparate and a lot of our stocks had news-flow in them so bear with me:

WOOLWORTHS (WOW) EXITING MASTERS … YAY.

News that Woolworths (WOW) would finally exit (closure or sale) its Masters hardware business allowed both WOW and Wesfarmers (WES) to rise 5-6% on the week.

Masters was forecast to lose over $250m in EBIT in the coming year, so a simple closure here adds over 10% to my conservative WOW profit estimates.

This puts WOW back under 15x P/E for what will certainly be a near low point for earnings and vindicates to a large extent our recently IMPROVED view of the stock.

WOW has outperformed the market 7% since our BUY recommendation in December and we look forward to news in the coming months on a CEO appointment.

WESFARMERS (WES) JUMPS ON NEWS OF MASTERS CLOSURE

Like WOW, WES shares rose over 5% this week.

Closure or sale of the Masters hardware business certainly augers well for Bunnings, so it’s understandable that WES popped on the news.

I think another reason for the WES jump this week was a move by investors for ‘earnings certainty’ in light of growth concerns. Telstra (TLS) like WES & WOW & Sydney Airport (SYD) and Transurban (TCL) all outperformed this week.

Whilst you cannot doubt the quality of management within this business, it seems undisputable to me that WOW will up its competitive response to Coles under a new CEO in 2016 – Coles makes up 50% of WES EBIT and Bunnings is a further 30%.

I have to admit, I find WES a fully-priced share (much like Commonwealth Bank, but perhaps not as expensive). It trades on 18x P/E against WOW at 14-15x its 5% dividend is part funded by debt.

Yes they’re a ripper company and as good or better than any management team in the country, but they are priced to reflect this in my mind.

RESMED (RMD) … MORE STRONG PERFORMANCE.

RESMED (RMD) is up 7% this week after they posted strong quarterly profit figures.

Despite concerns of increased competition, RMD posted better-than-expected revenue and gross margins and continued strength in its mask business.

For the record, RMD is up 70% since we recommended the BUY in February 2014 and it has outperformed the ASX200 by over 90% in that timeframe.

Despite this excellent outperformance, we still feel that RMD is worth more. We continue to expect a share price nearer $9.00 before we would ultimately look to book our long-standing profits.

INSURANCE AUSTRALIA GROUP (IAG) … BROKER UPGRADES

IAG has been indifferent of late, but finally saw a bit of love from brokers this week when two investment banks spoke favourably of IAG’s cheap valuation and excellent balance sheet.

After the investment and reinsurance partnership IAG signed with Berkshire Hathaway (Warren Buffett) in 2015, IAG is now overcapitalized to the tune of 30-50c a share.

The decision to cease investment in its fledgling Chinese insurance operations also reduced the cash-flow draw on the group, meaning that investors stand well-placed for special dividends in the coming 2-3 years.

In the low $5’s IAG is offering investors a nearly 7% full-franked dividend yield for the 2017 financial year and importantly, with a reasonable confidence and certainty in its ability to deliver the earnings needed to pay this figure.

It remains an absolute and relative BUY for me.

NEWS IN CHALLENGER (CGF), MEDIBANK (MPL), TREASURY WINE (TWE) & TRADING THOUGHTS IN ADELAIDE BRIGHTON (ABC)

A few snippets to round the week out… Challenger Financial (CGF) has been smashed this past fortnight on some broker downgrades concerning increased risks to their investment portfolio.

In short, CGF invest to deliver guaranteed annuity rates and with lower returns on offer they are increasingly having to go up the risk curve to generate the guaranteed rates.

I have to say, this was the primary concern we felt for CGF and the reason we ducked it 3-6 months ago.

Annuity growth will be strong in the years to come in Australia, as the government gets behind this form of income security for retirement savings. I’m just not sold on the risks involved in CGF providing these guaranteed returns.

On the positive for CGF though this week, the company post a profit update this morning which seemed to be ahead of the market and has allowed some respite for share-holders (it is up 7% as we speak).

Treasury Wine Estates (TWE) and Medibank (MPL) are also strongly up today after surprising favourably on profit forecasts.

MPL took my eye with better than expected ‘claims experience’ which points to Australians utilizing medical services less than expected – this is actually a huge theme across the Australian healthcare space, with the Government keen to reduce ‘wasted’ expense in the hospital system.

It seems MPL is certainly benefiting to an extent here in the near term.

To round out the week, I would flag the continued strength in Adelaide Brighton Cement (ABC) shares.

ABC has outperformed the market by a further 20% in the last 3-months and is now within spitting distance of our $5.00 target price (now $4.60).

Watch this space.

Disclaimer:

This information has been prepared by Primestock Securities Limited ABN 67 089 676 068, AFSL 239180 (“Prime”). Prime accepts no obligation to correct or update the information or opinions in it. This information does not take into account your objectives, financial situation or needs. Before acting on this information, you should consider whether it is appropriate to your situation. It is recommended that you obtain financial, legal and taxation advice before making any financial investment decision. Prime is bound by the Australian Privacy Principles for the handling of personal information.

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