Tuesday, August 23rd, 2016
Every investor wants capital and dividend growth, but it’s easy to forget about risk. So far this reporting season, right or wrong earlier calls about risk are making all the difference to investor returns. Amongst the medium to large companies of interest to most investors, some large shifts in risk are occurring and this is driving noticeable share price moves. It pays to understand what is happening, so let’s review some examples.
Growth in the form of higher sales, earnings, dividends and share prices is tangible and visible but risk is intangible, not directly visible and harder to understand and measure. Despite this the most successful value investors have a keen understanding of risk in a company and make the right calls on risk before the rest of the market does. At StocksInValue, our valuations not only reflect where risk is now but where it is heading. This knowledge is valuable because the market can very quickly price in shifts in risk and catch out the uninformed investor. It’s important to act in advance.
Risk in a business relates to the volatility and predictability of earnings. Much affects this: the level and variability of return on equity, how wisely boards and management reinvest earnings for growth, whether a business uses acquisitions to strengthen competitive advantage or build a larger but less profitable empire, and how easy or hard it is for management to predict the future and provide accordingly.
Ardent Leisure jumped 11% last week after de-risking its balance sheet by selling the gyms business, one of the less attractive businesses in the portfolio, to private equity for $260m. The proceeds will support the expansion of the Main Event family entertainment centre business in the US. Main Event is more profitable than the gyms and has substantial growth potential. Ardent just increased its earnings upside and reduced the volatility of those earnings.
ANZ shares are at seven-month highs because the volatile institutional loan book, which caused surprise spikes in bad debts expense in the interim result, is being run down. The market is correctly pricing in less variable and more predictable future earnings.
AMP fell sharply after the interim result because the company still has not dealt with its unpredictable life insurance book and the wealth protection (life insurance) result surprised heavily on the downside because claims were higher than management expected. There were multiple similar disappointments over the last 10 years so it is not surprising AMP shares are still at levels of November 2008! 18 years on from the 1998 demutualisation and sharemarket float, AMP’s actuaries are still unable to predict and adequately provide for personal insurance claims. This is not to criticise the actuaries; it simply says life insurance is a hard business to understand and manage, too risky to be of interest to the public equity markets, and the situation is not improving.
Telstra shares are weaker because the business is suddenly and unexpectedly having to invest a higher proportion of sales in capital expenditure to fix the mobile network outages which damaged the brand this year, and to remain competitive longer term in the rapidly changing world of telco and data technology. The final dividend was flat, not half a cent higher as the market expected. It is dawning on the market Telstra is in a defensive position and having to run harder to stay still. There is more uncertainty around future earnings and dividends than the market thought.
Woolworths shares are creeping higher because the company is obviously about to sell assets to reduce debt, support the credit rating and free management to focus on fixing the underperforming supermarkets business. The market is pricing in less earnings volatility, lower gearing and less risk of a credit rating downgrade.
David Walker is Senior Analyst at Clime Asset Management