December 2013 Review Comments
Written by Tony Gray   
Wednesday, 11 December 2013 15:08

Portfolio Valuation & Comment

There are a number of matters observable in the market at present.

* The $A continues to trend lower;
* Commonwealth Government Bond yields are trending higher – as are US bond yields;
* Listed property trust prices are trending lower;
* High yield stocks have given up some of the gains of the past 18 months;
* International shares (as measured by the MSCI) are trading close to GFC peaks;
* Share prices have risen well in advance of earnings growth;
* Mining service companies continue to downgrade;
* With the exception of iron ore, mining and gold stocks are out of favour; and
* There have been a growing number of profit downgrades hitting the market.

It is remarkable that 10 year government bond yields for Italy and Spain now trade below those applicable to Australia.  The rest of the world has turned negative on Australia for a number of reasons - (1) the falling $A results in lost value for international investors holding bonds and shares; (2) earnings growth is lacking and we do not have the post recovery growth potential offered by competing markets; and (3) perhaps they recognise risks in our economy that we seem to be ignoring?

Domestically the economy is lacklustre, with falling metal prices, savage cuts to mining expenditure, rising interest rates (bond yields) and a lack of consumer and business confidence – as represented by the rising savings rate and low business investment plans.

There is a spreading realisation that Australia has become a cost uncompetitive economy, with high personal debt levels and highly dependent on capital spending in China.  Reforms have been social in nature (for example, much more rigorous occupational health and safety laws), without regard for the economic consequences.

Portfolio Action

Cash & Fixed Interest

Continue to avoid bond exposures, including corporate bonds – they are all priced off Commonwealth Government Bonds and yields continue to trend higher.

Term deposit rates further out in time are gradually rising, so we have begun to re-invest in 5 year deposits to continue the rolling maturity approach.

We advocate a higher than average ‘at-call’ reserve as ‘opportunity’ money.  We are also beginning to make some use of ‘notice’ deposit accounts, where funds are available with one month’s notice and in return a higher rate of interest is paid than for at-call or short dated term deposits.

Listed Property

We continue to assess individual trusts and, although discounts to asset backing have re-emerged, capitalisation rates appear too low to us.  When they rise the reported asset value of property will fall and gearing levels increase (albeit from low levels generally).

There appears to be surplus office space and a lack of growth for retail rents.  We are not yet ready to apply new money to this asset class.

International Shares

We have been adding to this asset class for an extended period.  With the $A now well off the peak and the US market in particular at record highs, we are becoming more cautious.  The total return potential from this point is now lower and the risks somewhat higher.

Any adjustment in this area is something we need to consider on a portfolio by portfolio basis and in light of your goals and investment strategy.

Australian Shares

With the exception of iron ore miners, share prices have been easing back from November peaks.  There have been a growing number of profit downgrades announced by companies – and while we have avoided most, a handful of stocks held in portfolios have been impacted.  Each circumstance is different, but generally we adopt the ‘sell the losers, hold the winners’ approach and this also helps add to cash for the opportunities that are beginning to emerge.

Dividend yields remain ahead of fixed interest returns, but to a lesser extent.  For example, broad listed investment company yields of ~3.8% fully franked gross up to ~5.4% p.a.  This compares to a 10 year government bond yield of 4.3% p.a. and 5 year term deposit yields of ~ 5.1%.

I am tracking a number of stocks of interest and an example of one such stock I am prepared to start introducing is Duet Group (DUE).

Duet own the Dampier to Bunbury gas pipeline in WA (47% of assets), Multinet (20%) – a gas distribution network in Melbourne, and United Energy (33%) – an electricity distribution business in South East Melbourne and the Mornington Peninsula.

I have tended to be cautious of regulated businesses such as this – on the basis that low interest rates could see the regulated return lowered.  Further, as debt levels are usually higher for infrastructure type assets, rising interest costs could cut into profits.  Finally, it is important that distributions are funded out of cash-flow and not at the expense of rising debt levels.  Duet has covered these risks as outlined below.

Duet internalised the management rights earlier this year – paying off AMP and Macquarie Group.  This cut into the 2013 financial year profit, but has lowered future costs.  It has also allowed more control and this is reflected in their decision to raise some additional capital to reduce gearing and extend debt maturity terms.  Interest rates are hedged to a high degree for the next couple of years, so rising interest rates are not a risk for the moment.  With regard to regulatory risk, two of the key assets are up for review in early 2016 and the third in 2018.  As interest rates rise, this lessens the likelihood of any adverse regulatory pricing change (since the regulated price will be based off the cost of money).  Revenue is generally inflation linked for United Energy and Multinet – for example, Multinet will see a CPI + 1.5% price increase in January and then CPI + 2% each January to 2017.

An example of the pricing power for the Dampier to Bunbury gas pipeline is a recent deal with Chevron (who are completing the Wheatstone project in WA).  For a circa $96 million cost for the connecting gas pipeline, Duet will collect $13 million p.a. in cash-flow from 2015 – for a 30 year period!

Duet’s distribution is funded out of cash-flow and guidance is for an increase to 17 cents this financial year (from 16.5 cents last year).  This represents a 3% rise in the distribution rate – which does not sound much, but if we accept this as a sustainable rate of increase, then when added to an unfranked yield of 8.5% at the present share price ($1.98) the total return comes to ~ 11.5% p.a.

Gearing has been reduced, but is not low at a net debt to net debt plus equity ratio of ~75%.  This relates to assets of $8.6 billion.  Given the hedging in place, the recent roll-out of debt facilities and the reliable nature of revenue, the gearing level is acceptable.

In summary, Duet Group is not the sort of investment that will make an investor fabulously wealthy, but is expected to generate a healthy total return.  The share price has eased from the May peak of $2.50 to just under $2.00 presently – having behaved in a similar fashion to listed property trusts and other infrastructure assets (e.g. Park Infrastructure).

Christmas/New Year

TG Financial will be closing Friday the 20th of December, re-opening Monday the 13th of January.  For the week beginning the 6th of January we will have a staff member in the office during market hours (10 am to 4.00 pm) to respond to phone or email queries and to accept sharemarket instructions.

I expect to be out of phone and internet range for much of the break – so please contact me before the 20th if there is anything pressing you wish to discuss or action you might be considering.

Best wishes in anticipation of the New Year

A.W. (Tony) Gray BCom, LLB, Dip FP, GDipAppFin, CFP, FFin
Principal, TG Financial

Please treat the above comments as General Advice or general information, with no action to occur until we have considered with reference to your financial position, needs and goals.

Last Updated on Tuesday, 21 January 2014 11:08

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