While market price earnings ratios are falling, some companies are seeing a lift in valuation. These are the ones that are generating high returns on equity, and have low debt.  Such companies will shine if economic growth slows markedly or deflation occurs, says JOHN ABERNETHY of Clime Investment Management.

Recent marketvolatility and a lower sharemarket reflect a fundamental shift in share valuations. For the first time in many decades the average price-earnings ratio (P/E) is falling as government bond yields fall. This is most pronounced in the United States equity market, with historical low yields for US bonds and a decline in sharemarket P/E ratios.

Intuitively, the market P/E should rise as bond yields fall. This is because as the risk-free rate of return (a government bond yield) falls, so should the required return from investing in the much riskier equity of a company.

But this is not happening. Markets and investors are nervous about the potential threat of deflation and sustained lower US and European economic growth. However, while market P/E ratios are falling, some companies are seeing a lift in valuation. These are the ones that have and are generating high returns on equity.

Clime focuses on companies it refers to as highly profitable. If deflation occurs or even if there is a marked slowing in economic growth, it is the highly profitable companies with low debt that will shine. This was starkly shown through 2008 to 2010 by companies that reported higher profits and profitability without resorting to raising equity during the global financial crisis.

Thus recent history is important to validate companies that have superior business and financial characteristics.

In particular, we track how much profit companies generate on their employed equity, then track what these companies did with the profit. Retain it and/or pay it out in dividends? Compound earnings when it retained profit? Compound earnings at a higher rate of profitability?

If so, these are companies we focus on. The key is to determine their value and access market opportunities when the price is below the value.

Six companies that meet the criteria

Let us look at some companies’ value and compare their shareholder returns to the All Ordinaries accumulation five-year return of 4.7 per cent.

(Editor’s note: Do not read the companies below as recommendations, but rather as examples that meet Clime’s investment criteria. Do further research or talk to your financial adviser before acting on the information below.)

1. McMillan Shakespeare (MMS)

The core business is the administration of salary packaging services and fleet management. Other services include system design for performance management and remuneration rewards, and financial advisory referral.

In March, MMS announced the acquisition of Interleasing Group, which manages a nationwide car fleet provided through Interleasing and Holden Leasing. MMS has consistently produced a high return on equity and undertaken a sensible capital management policy. This has resulted in strong dividend payments to shareholders, with ample retained earnings to grow the business and compound at high rates. The company does not rely on new capital to fund growth. Clime’s FY2010 valuation is $5.41. MMS’s five-year total shareholder return (TSR) is 31.6 per cent per annum.

2. The Reject Shop (TRS)

A discount variety retailer of general merchandise, TRS has around 200 stores and a long-term projection of up to 400 across Australia. It focuses on low prices, convenient store locations and a wide variety of merchandise. Management have a proven strategy resulting in an outstanding return on equity for an extended period, while growing organically and requiring little new capital to fund growth. Clime’s FY2010 valuation is $14.20. TRS’s five-year total shareholder return is 46.9 per cent per annum.

3. Blackmores (BKL)

The company distributes premium-brand vitamins and supplements in Australia and South-East Asia, primarily through retail pharmacies, supermarkets and health food stores. Growth is supported by an ageing population that regularly buys vitamins, and Blackmores commands around 20 per cent market share.

The business recently invested in a new facility at Warriewood that will accommodate growth for many years. It has also purchased Pure Animal Wellbeing, which develops and markets natural dietary supplements and topical products for dogs and cats that are sold in veterinary clinics and specialty stores in Australia, New Zealand and South Korea. Clime’s FY2010 valuation is $18.76. BKL’s five-year total shareholder return is 16.3 per cent per annum.

4. Monadelphous Group (MND)

This engineering group provides project management, construction, asset management and maintenance services to the resources, energy and infrastructure industry sectors. It has four business divisions: Engineering Construction, Maintenance and Industrial Services, Electrical and Instrumentation Services, and Aviation Support Services.

The competitive advantage of the business stems from the reputation it has earned over 30 years for engineering excellence through quality workmanship, a reliable and flexible service, and developing long-term customer relationships. The business is hugely profitable with a five-year average return on equity of 98 per cent. Clime’s FY2010 valuation is $13.63. MND’s five-year total shareholder return is 37.7 per cent per annum.

5. BHP Billiton

BHP’s key revenue drivers are the price of steel-making commodities, in particular iron ore, the oil price, and base metal prices, primarily copper. Through this, BHP is exposed heavily to the faster-growing regions of the world, in particular China. The business has grown organically without needing large equity injections, has moderate borrowings and maintained a return on equity above 30 per cent over the past five years. Clime’s FY2010 valuation is $48.98. BHP’s five-year total shareholder return is 16.9 per cent per annum.

6. Cochlear (COH)

The company manufactures and markets Cochlear implants. The device is the industry gold standard for enabling profoundly hearing-impaired patients to hear. A record of product reliability remains the key competitive advantage, and growth also stems from further penetration of existing markets and new under-developed markets such as South America, eastern Europe and China. The business enjoys a market share of around 70 per cent and has performed exceedingly well, achieving a return on equity above 50 per cent in each of the past five years. Clime’s FY2010 valuation is $57.74. Cochlear’s five-year total shareholder return is 15.3 per cent per annum.

PORTFOLIO POINT: Investors prepared to look beyond the equity market for income should consider building a portfolio of hybrids.

Suddenly, it seems shares are riskier than many investors might have ever imagined. Certainly there are real concerns that a ‘shares only’ portfolio is not sufficient in this market. It’s no surprise, then, that investors are looking at new ways of diversifying their holdings and placing greater emphasis on income.

One of the more natural diversifications for share market investors is to consider ASX-listed hybrids, which offer a blend of both bond and share characteristics. At their best, hybrids can offer an attractive mixture of better-than-dividend level income along with capital appreciation.

Hybrids – which vary dramatically in quality – are by no means perfect. Indeed, purists might reject them in favour of bonds, arguing that listed hybrids are too similar to straightforward equities.

Nevertheless, the support base for ASX listed hybrids continues to build, especially as a new generation of investors can look back at a solid track record in some sectors such as hybrids issued by the major banks.

Here is a list of some of the most popular hybrids from different parts of the risk spectrum and their key attributes:

NABHA

NABHA is the income and security notes of the National Australia Bank. This is probably the most commonly held and liquid hybrid security. They trade at a margin of 1.25% over the 90 day BBSW rate and dividend is paid quarterly around the middle of February, May, August and November each year. The running yield is approximately 8.02% pa based on a current acquisition price of $75.90.

PCAPA

PCAPA is the Commonwealth Bank PERL III (Perpetual Exchange Repurchase Listed shares). The margin is 1.05% and the next reset / step up date is on April 2016, which is more than five years away. You may note that, while the running yield is lower than the NABHA at approximately 6.8%, the yield to call (or reset date) is about 9.0% because PCAPA is trading well below their face value of $200.00 (or about 15% discount). Thus, when that return is annualised for the potential capital gain to the call / step up date, the total return is closer to 9.0%.

For an investor, the key question is whether they are prepared to accept a lower running yield of about 6.8% in the next 5.5 years. However, as the call / reset date draws nearer and nearer, there is a strong probability that you will realise the additional gain through price appreciation of the PCAPA back to the face value of the stock. Naturally, there is a possibility that the bank may not call back and reissue, but opt for a step up of 1%. However, to protect the Bank’s reputation, it is our view that this is unlikely. Even if the bank is to forsake its reputation and opt for step up, the running yield post step up would have gone up to 7.8% pa. PCAPA distributes the dividend on early January, April, July and October of each year.

WOWHB

WOWHB is Woolworths Limited’s unsecured floating rate subordinate perpetual notes. The margin is 1.10% and the next reset / step up date is mid September 2011 which is just over 15 months away. Similar to PCAPA, while the running yield is low at approximately 6.1%, the yield to call / step up is actually approximately 8.5%. It is our view that it is highly likely that WOW will call back their notes and will probably reissue another instead of paying the additional 2.0% step up margin on top of the 1.10% currently. This is a similar argument to that concerning PCAPA.

AAZPB

AAZPB is the preference share of Australand Property Trust, which is part of the Australand Property Group (ALZ). They are currently trading at 4.8% over the 90 day BBSW rate, implying that the floating running yield currently is approximately 11.5%. Given that the underlying company has recapitalised and the gearing is now in the mid to high 20%, it is our view that AAZPB hybrid will behave more like a debt instrument and continue to pay a high yield income every quarter around mid January, April, July and October until they opt to have them redeemed.

MXUPA

MXUPA is the preference share of Multiplex Brookfield Limited. Brookfield Asset Management is a global asset manager focused on property, renewable power and infrastructure asset with over C$100 billion under management. Their senior debts are of investment grade. MXUPA is currently trading at 3.90% margin over the 90 day BBSW rate, implying that the floating running yield currently is approximately 11.5%. MXUPA pays their distribution around mid January, April, July and October.

A natural advance on investing in your first hybrid is to develop the idea further by considering a portfolio of hybrids. In diversifying your holdings across more than one hybrid, you can spread your risk. In assessing one or more hybrids some fundamental investment rules apply: You should expect to take on higher risk and higher price volatility in order to achieve a higher return. This will be seen in a higher yield over the short term and a higher overall return in the longer term. Note that a higher risk hybrid portfolio is likely to suffer greater price volatility based on economic or market events that affect the risk appetite of investors.

An investor should always consider how much capital risk and/or price volatility they are prepared to take prior to investing. Based on observable historical price volatility an investor should consider whether the higher assumed risk is commensurate with the expected return of the portfolio. These are the sorts of analyses that we carry out on a regular basis at Clime.

This is an extract of an article first published in the Eureka Report.

So Westpac is comfortable for now. Of course, they will be back again next year to seek another $40 billion of funding. Australian banks generally source 20% of their funding from wholesale funding lines. Westpac, following the St George Bank acquisition, has 25% funding from this source. Our view is that it was the excessive wholesale funding undertaken by St George that led to it falling meekly into the arms of WBC once the GFC started.

As for the European Union, there is a general market disbelief in the credibility of their stress tests, which found that European banks need to raise 3.5 billion Euros of capital, about a tenth of what analysts had projected. Only seven out of 91 European banks failed the test.

Part of the reason why the amount of capital needed was lower than analysts predicted was because the revaluations took into account potential losses only on the government bonds that the banks trade, rather than those they are holding to maturity. This means the tests ignored the majority of banks’ holdings of sovereign debt. In Germany, banks continue to fail to disclose their sovereign debt exposures even though it is well known that they have substantial holdings of PIGS sovereign debt.

Having sailed through their “stress tests,” the European banks now must readdress their long-term funding to finance new lending. Unlike the situation in the US, where corporations are either cashed up or access debt markets directly, a large majority of companies in Europe depend on banks for finance.

• Operating profit before tax in the financial year 2009/10 of approx $13 million;
• Net investment performance for the year to June 30 of 22.8%, which represents an outperformance of 9% to the All Ords;
• Consistent outperformance over the past four years – we protected investors’ capital in 2008/09 and built on it in 2009/10;
• These results were achieved despite never being more than 80% invested;
• Dividend payments approximating $1.8m during the year;
• A 1 for 20 bonus issue to shareholders on 5 July 2010, which ranked equally for the dividend in respect of the quarter ending 30 June 2010;
• A significant investment in Headline Group Limited (ASX), which owns the Australian franchise for the highly successful European retail brand Mothercare.

Clime Investment Management Ltd (CIW) manages the investments for CAM. CIW specialises in value investing; the principle of purchasing investments in quality companies when the share price is at a discount to estimated value. The investment returns achieved by investors in CIW’s managed funds and share portfolios mirror that of CAM, as can be seen in the following table on our website: http://www.clime.com.au/performance/

Unusually, Clime is passionate about investor educations and shares its company valuations widely. Full information is available to DIY investors as well as professionals through membership of the company valuation and research service www.myclime.com.au (previously known as StockVal).

In these times of volatility, irrational market behavior and languishing returns Clime’s performance is a shining example of what can be achieved with rational investment principles, patience and sound processes.

We like this article, because he talks about companies like Clime Capital and why they are now more attractive to investors.

In recent years LICs have been licked. But with new rules and an improving dividend cycle, it is time to take a fresh look at listed investment companies.

As Scott Francis points out in this week’s Eureka Express, the legislation covering LICs has been changed to remove the requirement that they could only pay dividends directly out of profits. The changes mean more diversity, more opportunity and more flexibility for LICs, and in turn, investors.

“Under the new regulations, LIC dividends are now linked to solvency; in other words, they can operate under conventional dividend regulations.

“Geoff Wilson, the chairman of Wilson Asset Management, says the change is a breakthrough for the sector. “It creates a level playing field,” he says. “We have never had that before; it’s going to make a difference.

“Wilson says all LICs are now free to unleash sustainable and progressive dividend payment programs regardless of seasonal factors.

“Moreover, he estimates there is a massive $100 billion in franked dividends stored up in the local LIC sector, which will be progressively passed on to investors in the near future.”

John Abernethy explains why chasing the best yield is important in his investment strategy, with CNBC’s Oriel Morrison.