Weekly Market Update (Issue 549) – 27 May 2019

So, a week has now gone since the Coalition’s surprise victory and I have had the time to sit down and process my thoughts.

This weekly will aim to articulate where we see things differently and what opportunities we think are being created by the recent result.

I will try and be direct to the point and to be distinct in the ways I see portfolios and the market right now.

Australian economy – a major positive, but for 2020 not 2019

The election outcome sets the country on a path for improved economic growth, but not until 2020.

There will definitely be some activity flushed back out that had been withheld by businesses in the months before the election and that will likely be reflected in improved activity as the year progresses, but this activity is merely offsetting the significant construction slowdown already well underway.

Even if building approvals bounce off their 6-year low in June or July, that activity won’t be reflected in the economy until 2020.

However, from 2020 onwards, the prospect of tax cuts (this year the rebate, but 2022 and 2024 the major personal cuts), additional infrastructure expenditure and stable government should see strong years ahead in that year and 2021.

So much so, that I doubt the RBA cut interest rates nearly as aggressively as I had previously thought, and so I now expect the RBA to cut interest rates TWICE only by 0.25% each to 1%.

The decision by APRA last week to lower the interest rate at which banks assess serviceability on loans was a hugely helpful move for creating liquidity in the local economy and is probably more valuable in improving domestic economic activity than two miniscule interest rate cuts for what it’s worth.

Our long-standing negativity on the Australian Dollar has to be re-thought and as a result I think it’s possible we are nearer to a low point in the currency than previously thought.

More optimistic on future growth, but equity market is still not overly attractive

Whilst it’s easy to paint a more optimistic future for the local economy in 2020 and the Australian Dollar, the Australian sharemarket is less obvious.

The ASX200 valuation of 16.7x is within 3-4% of its highest level in the last 15 years and many Australian blue-chip companies look as fully-priced as they have done in that time too – Commonwealth Bank (CBA) back at 16.5x and Woolworths (WOW) at 23x are two great examples of silly valuations.

The value in the Australian market remains in many of the out of favour stocks which currently comprise much of our Australian equity portfolio.

We feel it’s simply a matter of time before many of our core names see improving share prices and we are actually looking at adding to many of them in the coming months.

China / U.S spat is spreading and has increasing potential to derail global economic momentum

The trade discussions between China and the U.S look further away from resolution than at any point and it has become acutely apparent that trade is only one part of the ongoing geopolitical wrangle between the two superpowers.

The decision by the United States to place Chinese telecoms behemoth Huawei on the ‘entity list’ effectively banning companies active in the U.S from transacting with the company, has major knock-on effects to the telecommunications infrastructure supply chain and to the rollout of 5G services in many countries.

This is one major example of how business is being disrupted by the continued spat and will almost surely lead to slowing economic activity in the coming 3 months.

The Chinese manufacturing data due this Friday will likely be weak (if not-manipulated too significantly) and more concerning will be the likely softness in U.S manufacturing evident in next Tuesday night’s ISM report which could well lead to a more pronounced sell-off in U.S and global equity markets.

We remain cautious for this reason.

Takeover activity might just be about to hot up

This morning one of our former equity portfolio holdings, Vocus (VOC) announced it had received a non-binding takeover proposal at a staggering $5.25 a share, all in cash.

We bought the telecoms infrastructure company around a year ago at $2.20 and felt like heroes when we sold out around 6mths later with a 50% return at $3.30.

In that time, little has been done to change the structure of the business itself which is why the bid price is so surprising to us and the market.

What it does show however is that markets consistently undervalue the price that long-term debt funded investors are prepared to pay for long-life, cash generative assets.

With the likelihood of local interest rate cuts in the coming months and Australian 10-year government bond yields at a record low of 1.55% reflecting this, debt funding has never been this cheap.

Whilst this non-binding bid makes the mind boggle at its implications beyond Vocus (VOC), we think it clearly makes us think that the Telstra (TLS) infrastructure spinout when it happens could be worth a lot more than analysts think.

Furthermore, we think there are at least 3-4 names in our current portfolio that are eminently ‘takeover-able’ right now due to franchise value and diminished market valuation, notably Oil Search (OSH), IOOF (IFL), BWX (BWX), Nufarm (NUF), Pendal (PDL) and Regis Healthcare (REG).

OSH is now at a 10-year relative low relative to the ASX200 despite being in its most sound long-term strategic position ever and with political wrangling in Papua New Guinea arguably making the company more vulnerable to a bid by either Total of France, Exxon of the U.S or Woodside (WPL) of Australia.

OSH would fetch well over $10 in the event of a bid.

IOOF (IFL) is a curious one and perhaps not an obvious one to the man in the street, but IFL is increasingly vulnerable to a predator as soon as its acquisition of the remaining ANZ wealth assets is resolved.

Depending on the outcome of the impending vote by ANZ custodians on the sale, IFL is on either 9x with a little bit of debt or 11x and net cash.

Resolution in September of IFL’s expected remediation expenses in the wake of the Banking Royal Commission is the final uncertainty to be cleared, but after that, IFL would be prone to takeover by private equity as a hugely defensive, cash generative, lowly geared bet on one of Australia’s most consistent and underpinned growth sectors, superannuation.

It’s quite possible that what IFL have been doing in consolidating the sector, a major private equity player does back to them.

In that instance IFL is likely worth $9-10.

BWX and NUF both have some hairs on them, but still feel entirely valuable to the right player.

BWX has suffered multiple downgrades to its core business after it became entirely apparent the former founder and management had overstocked the retail channel in anticipation of a takeover proposal that ultimately fell flat.

The company have been scrambling ever since to get the business back onto an even footing and for that reason have endured multiple earnings downgrades and further management change, however the core Sukin and related brands remain sound and capable of building on in the right hands.

NUF on the other hand has a significant debt pile and a tricky end-market environment for the coming 12 months, but beyond that looks incredibly cheap on normalized earnings and with blue-sky earnings growth from its Omega-3 infused canola seed technology.

Timing will be a tough one there, but there is no doubt in my mind the stock is worth significantly more to an industry player or long-term investor than the current share price implies.

Even PDL and REG have attraction to them, PDL due to the significant cash hoard it holds and the sub-cycle earnings it is now spinning off, and REG due to its substantial property exposure which has potential for restructuring once core aged-care profitability stabilizes.

There is a lot out there for the patient and detailed.

Regards, Jono

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