Australian Market Summary (Issue 401) – 27 May 2016

Australian Market Summary – 27 May 2016

A little better again this week, but at the margin.

Before I jump into the news-flow, I wanted to make a few remarks on investment performance year-to-date and amongst this an acknowledgement that I have been a little sub-par in my own stock-picking abilities this last month or two.

Portfolio Construction – Breaking Down ASX200 performance in 2016

Please carefully consider the following facts.

Year-to-date the ASX200 with dividends is up +3.81%.

The ASX20 Leaders index is flat.

In fact, if your portfolio had a stable of so-called blue-chip shares such as the banks, Telstra (TLS), Wesfarmers (WES), Woodside (WPL) and BHP (BHP) – as many investors do – you would be DOWN 3% year-to-date WITH DIVIDENDS.

Think about that.

Conversely, the ASX Mid-Cap 50 Index which is a broad selection of 50 larger companies such as Cochlear (COH), Treasury Wine (TWE), Healthscope (HSO), RESMED (RMD), Crown Resorts (CWN), TabCorp (TAH) & (CAR), has risen an impressive +11.09% year-to-date.

I am highlighting this disparity in performance yet again, to demonstrate the need to understand the world has changed and that the blue-chips of the past do not necessarily make for the blue-chips of the future in performance terms.

Once again let me state that the resources sector will be on ice for several years or more given China’s infrastructure overbuild and Australia’s resultant capacity over-accommodation.

Bank stocks are maxed out on dividends and the housing cycle is turning down not up.

Telstra (TLS) is sound and boring, but ex-growth.

You get my point.

All in, the trends at the big-end of the market are going against them and will continue to do so for some time to come.

Though we have said this time and again, the facts above are hugely supportive of this theme.

Mea Culpa

Considering our staunch advocacy of the need to migrate ‘down the market-value’ food chain, it is entirely disappointing for me to say that our portfolio performance year-to-date has also lagged the benchmark.

In simple terms, even we haven’t moved fast enough on certain things.

In truth, the main shortcoming in my/our Australian equity strategy this last 6 months was in choosing not to buy the likes of NAVITAS (NVT), Challenger (CGF), SEEK (SEK) and the hospital-plays Ramsay Healthcare (RHC) & Healthscope (HSO) back in September last year.

At the time, I felt the market still had issues to face and that we would be able to buy those stocks cheaper.

The sad reality was that we were right on the market, but wrong on how the aforementioned stocks would trade in spite of the further index weakness.

It’s frustrating to have missed the re-rating in several companies of this quality, but if you miss the train you don’t chase it and try and board it when its moving (in my experience), you wait for the next train to come along.

They always do.

Certainly, that’s my typical modus operandi.

Frustratingly however, the market now finds itself through 5400 and looking increasingly fully-valued, so our natural portfolio inclination is to be a SELLER, not a buyer.

It is here that we hope to add value in the months ahead, as I am sure we can, by instead choosing to be discerning where others are not.

It’s important I/we constantly re-appraise and re-evaluate, so that we can continue to perform going forward and I would urge you all to be much the same.

Hybrid Securities update

With this week’s ‘red-hot’ Westpac Capital Note (WBCPG) issue now closed, I thought it worthy of an update.

As many of you know, WBC issued $1.45bn of 5-year capital notes this week with a margin of 4.9% above the 90-day swap rate (now 2%) to enormous demand from both retail and institutional investors alike.

It seems the 7% yield on offer in these hybrids (or 5% margin over swap) is a line in the sand for many people given cash rates under 2% and term deposits in the high 2% range.

The sector has been particularly good in recent months and the portfolio performance of our Defensive Income SMA has been excellent.

Trading Thought in Commonwealth Bank (CBA) – substitute some shares for hybrids.

Whilst it is absolutely vital you ensure your portfolio is not overly dependent on bank issuance (across shares and hybrids), I would suggest that for those seeking income and stability in the coming 12 months that SWITCHING from your Commonwealth Bank (CBA) equity into either of the CBAPD (PERLS VII) or recent CBAPE (PERLS VIII) hybrid-notes.

The CBA dividend yield is barely 5.33% at $80 a share (which grossed is 7.57%) which is barely more than the 7.15% yield-to-maturity on the CBAPD and 7.34% on the CBAPE.

CBA is a share that at $80 we think is again looking toppy and the possibility of share price gains in the coming 1-2 years is low, so substituting some volatility (selling the shares) for the same income without the volatility (buying the hybrids) seems like a great trade to me.

Flight Centre (FLT) – delivered the profit downgrade

Sadly this week FLT confirmed the markets fears and cut profit guidance for the current year by around 8-10%.

The company cited the airfare price war in particular and alongside the combined effects of heavy investment in new distribution channels, margins have been crunched.

The stock is now under-water for us, but worse, it is down from a hefty paper gain only a month ago.

Whilst business conditions are clearly difficult, I feel it is vital we persist with the holding for the next few months, as the opportunity to sell better should arise (assuming we chose to do so).

The reality as I see it, is that FLT are currently in a substantial re-configuration of their business model locally and are similarly expanding aggressively in foreign markets.

With the fall in airfares (on which 80% of all FLT turnover comes), the revenue hit they have taken was never going to look pretty against the cost investment currently underway.

However, in the medium-term, FLT should again be rewarded for their breadth of operation and high quality balance sheet.

Consider this: FLT now trade on 13x P/E after the downgrade (20%+ cheap to the ASX200), but carry $400m+ of cash on the balance-sheet (their choice), which if removed for valuation purposes leaves FLT on 11.2x PE.

FLT is forecast to make well over $250m in free-cash flow in 2017, which excluding balance sheet cash, is a nigh on 10% free-cash yield or 10x cash PE.

FLT is a bona-fide takeover candidate on these valuations, so I fully expect the shares to bounce a little from here and we can then re-consider them higher in the months ahead.

Oil Search (OSH) and what their move means for SANTOS (STO) & Origin Energy (ORG)

I love this OSH deal. Love it.

I mentioned it last week, so I won’t cover old ground again, but suffice to say I think the stock is terrific buying again at $6.50.

For those of you long-suffering shareholders of STO and ORG, there might be very modest relief at hand, courtesy of the OSH decision to buy PNG explorer Interoil (IOC).

The move to consolidate the PNG LNG industry by OSH is highly likely to force marginal Australian LNG producers to rationalize in order to compete and no more obvious candidate for merger are Australia’s SANTOS (STO) and Origin (ORG) given their competing stakes in Gladstone LNG and APLNG.

Both companies carry way too much debt and both of the Gladstone LNG facilities are at the margin both in terms of sunk cost and in terms of future reserve life.

A merger of the two would be welcome respite for shareholder capital.

Watch this space.

QUBE Logistics (QUB) – ACCC taking a closer look at the Asciano deal

Don’t fear this news, it is likely to be a benign outcome we think and in fact looking at the merger through the watchdog’s eyes you can really see the vertical integration QUB will achieve by way of the Patrick’s takeover.

We remain BUYERS of QUB here and think this business will be a national logistics champion in the coming 5 years.

Wesfarmers (WES) – substantial write-downs

WES this week announced it would take some $2bn in non-cash impairment charges on its underperforming Curragh coal mine and the specialty retailer Target.

The stock copped a hiding, but in reality these charges are non-cash and to me, entirely irrelevant.

What they do demonstrate however is that despite the success of Bunnings and Coles, WES is not without its problem assets and that much of the profit improvement in its hardware and super-market businesses is being eaten up elsewhere.

WES is a terrific company, but I have argued for a year or two that it was expensive (fully priced perhaps) and the selling this week might simply be an acknowledgement that it has some failings.

In the mid-30’s WES looks sound as a BUY, but is still middle-ground at $40 for me and we much prefer Woolworths (WOW) for the medium-term turnaround.

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