“By maintaining a realistic assessment of profitability (measured by ROE), maintaining a conservative required return (in our view well above 12% for most companies) and by seeking a margin of safety below a realistic assessment of value, we believe a weak equity market will uncover excellent investment opportunities in coming months.”
2009/10 has turned out to be a year in which the long term average equity return was achieved. The index price returns for 12 months are about 8% and the price plus income return are approximately 13% (the accumulation return).
A year of extraordinary volatility saw the Australian market price indices start at 3950 (June 30 2009) and then trade between 3750 and 5050 over 9 months before the recent fall to 4300. The market returns have been dramatically cut in recent weeks and more recently by the events of the last few days which include:
- A weak communiqué from the G20 Summit in Toronto, which suggested that member nations should make up their own minds as to whether or when to withdraw fiscal stimulation packages. There was a mildly stated intention for members to reduce fiscal deficits by 50% by 2013.
- The impending rollover in Europe tonight of 0.442 trillion Euros of loans made to European banks by the European Central Bank (ECB). These loans were set one year ago and the ECB is so far maintaining that it will only roll the loans over and into three-month loans. This has created immense uncertainty in European interbank markets.
- A private research group in the US called the Conference Board corrected a leading index of Chinese growth. It had initially reported a reading of 1.7% in April, but revised it down to +0.3% yesterday. With the revision, the index has now slowed from the 1.2% rise in March. The research firm cited a “calculation error” for the dramatic change.
The above issues confirm our long held view that there is no urgency to buy equities at present. Indeed, it continues to be a prudent strategy to maintain liquidity to have the ability to acquire companies on sharp market dips.
Later in this view, we wish to comment directly on some major stocks on the Australian market. But first we draw your attention to the recent rally in US bond prices. Overnight, the ten-year US bond traded at a yield of about 2.95%. We watch the US 10 year bond carefully as an indicator of economic sentiment in the US and the world.
Figure 1: USD T-Bonds Yields since 2006
In our view the rally in ten-year bond yields to 2.95% is indicative of:
- Very low economic growth in the US for at least the next 12 months;
- The maintenance of high levels of US unemployment;
- The lowering of US corporate profit expectations, which is also indicated by a faltering S&P 500 index;
- The continuing risk of deflation despite the outlook for a strengthening Chinese yuan.
Investors need to understand the divergence in moves of interest rates in recent months. Central banks have generally maintained their interest rate settings at historic low rates. In the US and Europe overnight, central bank rates are virtually zero. Banks can borrow short term from their central banks and meet short term liquidity needs at a very low cost. However, the broader market rates are rising; that is, the rates that banks charge to lend to distressed sovereign borrowers, other banks, corporations and households. This is commonly described as an increase in credit risk spreads.
So we have “risk free” rates falling in the US but risk spreads rising everywhere else. The US is certainly benefitting from its status as the world’s central reserve currency and its bonds continue to be priced as risk free assets despite abundant evidence that its debt ratios are some of the worst in the world.
The rise in credit risk spreads will affect the value of and the required returns for all assets. The immediate effect will be to increase the cost of funds and of debt to all borrowers. Our view is that interest rates for Australian borrowers will continue to rise unless the RBA intervenes by cutting interest rates in Australia. If international debt markets continue to exhibit fragility and if the world economy continues to show declining growth, then Australia may well see an interest rate cut before Christmas.
Indeed, we are beginning to believe that this is a near certainty because the bulk of European countries are highly leveraged. The average European government debt to GDP ratio is over 80%. The outlook, despite a G20 intention to reduce fiscal deficits, is an average of 100% by 2014. These levels of indebtedness are too high for comfort. We can recall that both New Zealand and Australia were regarded as “banana republics” when our government debt rose to 20% of GDP and our total foreign debt exceeded 50% of GDP in the early 1990s . Australia today still has foreign debt of over 60% but most of this is bank wholesale funding and not government debt.
Figure 2. Australian Government – Net Debt
Source: Australian Government – 2009-10 Mid-Year Fiscal & Economic Outlook
Australia’s government debt levels, despite some blowouts in the early 1990s, never approached those now seen in Europe and the US.
How to approach investment markets
Our view is that investors will continue to adjust up their required returns for investing in shares. Concurrently, there will be an adjustment down of expected earnings. For the investor who does not invest based on return on equity (ROE), this means that price earnings ratios are likely to fall.
This will be confronting for many market commentators and advisors as it will show the folly of valuing companies based on relative PE ratios.
By maintaining a realistic assessment of profitability (measured by ROE), maintaining a conservative required return (in our view well above 12% for most companies) and by seeking a margin of safety below a realistic assessment of value, we believe a weak equity market will uncover excellent investment opportunities in coming months.
The other key point is that investors must be focussed on yield. Markets have a capacity to panic and misprice corporate debt in comparison with equity. When a corporation’s debt trades at rates of over, say, a 7% margin above bill rates, then it suggests that either the corporations’ equity is worth very little or there is mispricing of risk in debt markets. Normally the latter is true.
We thus suggest that high yielding corporate paper and/or hybrids should be a part of any equity portfolio at present.
BHP Billiton Limited (ASX:BHP)
The BHP price has correctly adjusted to the risk of the RSPT implementation. We calculated a negative valuation affect of about 12% from this tax. However, in the meantime the $A has fallen by about 10% and this has led to BHP maintaining its valuation. The outlook remains strong for BHP with rising profits, acceptable profitability (average 35%), strong cashflow and low debt. Investors who are concerned by the possibility of a Chinese economic slowdown may seek a higher margin of safety but in our eyes the current discount is excessive.
National Australia Bank Limited (ASX:NAB) and the other banks
NAB is showing as the cheapest bank relative to our assessment of value. However, there are a few issues affecting NAB in particular and banks generally. NAB has a continuing interest in acquiring AXA. We are doubtful of the merits of this acquisition, which adds funds management and life insurance to NAB. The acquisition price and likely amalgamation issues will detract from the NAB’s returns. In short, an acquisition will increase reported profits but reduce profitability. NAB will need a sizable capital raising to acquire AXA. We would buy NAB at current prices only if they cease their acquisition of AXA.
All the banks at present face slowing asset growth and continued funding issues in offshore debt funds. Australian banks have accessed foreign loans to fund our excessive household debt. The largest offshore funding exposure is held by Westpac Banking Corporation (ASX:WBC). Its bonds represent about 25% of its funding, which is 25% higher than the other majors. We think concerns regarding bank funding are overstated and we remind readers that the Australian Government could easily reintroduce a funding guarantee if required.
The Retailers
We see value appearing in this sector but are cautious regarding the outlook for retail sales in Australia. The highly indebted household sector, the rise in interest rates and a weaker $A will all impact valuations in coming months. The most stable and predictable profitability is from Woolworths Limited (ASX:WOW) and The Reject Shop Limited (ASX:TRS). We see these companies as core holdings which can be acquired in market weakness. We continue to believe Wesfarmers Limited is fully valued. While we see profitability rising towards 12 to 14% in coming years, this is well below its peers. Myer Holdings Limited (ASX:MYR) has some attraction as a highly profitable business, but suffers due to low balance sheet equity and a retail model which is based on low customer service levels.
As for JB Hi-Fi Limited (ASX:JBH), we note that the company has increased its payout ratio in the recent year, suggesting that growth will slow. It cannot retain too much equity and maintain its returns. It remains an excellent company, but in our opinion the required margin of safety should increase.
Telstra Corporation Limited (ASX:TLS)
The inevitable negotiation with the government was semi-completed last week and we maintain our $3.63 valuation. The agreement ensures that TLS will continue to generate significant free cash flow, which underwrites its high dividend. TLS will evolve a business model in the next few years which will encapsulate a separation of its business and the move into new distribution markets encompassing entertainment and information.
