April 2014 Review & Comments
Written by Tony Gray   
Friday, 09 May 2014 13:35

We welcome Mel Dunlop to TG Financial.  On a part-time basis she will assist Di Brozek with portfolio recording and reporting.

International Markets & Economies

The economy in the United States continues to grow, with rising employment and falling unemployment.  Wage growth is not yet apparent, but the government deficit has narrowed sharply and the Federal Open Markets Committee (FOMC) project interest rate rises from 2015 through to 2018.

We believe the US sharemarket is already optimistically priced and there are some risks to the downside if interest rates rise too rapidly.  Importantly, rising rates in the US will see the cost of money globally and in Australia rising – regardless of what the Reserve Bank of Australia do with respect to the overnight cash rate.  This could impact on consumers, business and market valuations – especially if rates rise at a faster rate.

European economies are slowly improving and bond yields have fallen.  We’re not sure if profit growth will emerge, but shares in those markets are not aggressively priced.

In China the sharemarket has dropped back to 2012 levels but the big emerging risk appears to be the bursting of the property bubble.  If in fact this leads to sharp falls in property prices and construction, then this could see a big drop in demand for iron ore and have unexpected consequences for other sectors.  For example, lower tourism numbers and house buyers in Australia!  Think back to consequences of the Japanese property bust in 1990.

Australia & the Banks

Bank stocks dominate the Australian sharemarket – with the big four having a market capitalisation of ~$410 billion.  This compares to the market capitalisation of the top 10 stocks (including the 4 major banks) of ~$757 billion.  The other big stocks include BHP ($120 billion), Telstra ($65 billion), Wesfarmers ($49 billion), Woolworths ($46 billion), Woodside Petroleum ($34 billion), and CSL ($33 billion).  Rio Tinto sits at number 11 with a market cap of $27 billion.

The four big banks, two supermarkets, one miner, one telco, one oil and gas stock and one blood products company represent half the market.  This is far more concentrated than any other comparable developed economy and one reason why we have never been a fan of an index approach for Australian shares.

Last week ANZ Bank reported a first half profit rise of 10.8% and this week Westpac reported a profit increase of 8.0%.  Both lifted dividends and earnings were supported by very low bad and doubtful debt provisions.  National Bank report today (not available at the time of writing).

The trailing 12 month yield for ANZ is 5.16% fully franked (7.37% gross) and for Westpac it is 5.18% fully franked (7.40% gross).  National Bank is yielding 5.62% fully franked (8.03% gross) and likely higher post the result and dividend declaration.

These are not the sorts of yields signalling a sell.  Pre GFC a yield of 4% signalled a sell and a yield of 6% signalled a buy.  Rising house prices (at least for Melbourne and Sydney) have also lifted collateral levels and low interest rates have coincided with a higher savings rate.

So far so good, but… what will happen when interest rates do rise from historically low levels – especially if driven by a higher cost of overseas money and not an improving economy?  The tail-wind of falling debt provisions will most likely become a headwind and in a period of low credit growth we could see profits fall!  Rising unemployment would be another risk.

Now at this stage we are not seeing any forecasts to this effect and not recommending the sale of Australian banking shares.  What we are doing is highlighting the concentration risk of banks for broad Australian sharemarket exposure and some potential risks on the horizon.

One final word on the banks.  Banks lend other people’s money.  By nature they are highly geared enterprises.  If they lose money through a bad debt it comes out of shareholder funds first.  The dire consequences of this have been amply demonstrated elsewhere in the world.  This is why running a diversified portfolio is still important.

And the rest of the market…

Pleasingly we are seeing some (non-bank) good quality businesses falling in price.  The examples below may not be relevant for your portfolio or approach.

ARB Corp (ARP), $11.70
We regret not generally buying this stock in the past.  It has usually appeared a bit expensive to us – but with hindsight we should have paid up for the growth in earnings.  That remains the case at the current price level, with a trailing yield of ~2.5% (fully franked) and a price-earnings multiple of 20 times.

What is different now is that we can appreciate why this maker of 4WD accessories can grow earnings at a faster rate in future.  In March ARB opened a second distribution warehouse in the US and a warehouse in the Czech Republic to service ARB Europe.  Expanded distribution arrangements in the US could see strong growth in that market over time.

A first-half slowdown in Australian sales due to lower demand from the mining sector masked 20% growth in export sales – partly due to volume growth and partly due to the lower $A.  Company earnings in fact contracted by 3.6% for the first half and this has seen the share price falling back from an all-time high of $13.88 in July 2013.

The company has efficient manufacturing and distribution arrangements, cash in the bank and no debt.  We feel future growth will justify the current price and generate a decent total return over time.  There is also the risk (opportunity) that the price trends lower and that we see a better (safer) entry point in the short-term?

Iress Limited (IRE), $8.27
Iress provide financial markets information in Australia, Canada, South Africa, the UK and parts of Asia (especially Singapore).  I have used an Iress screen for information on financial markets for close to 20 years and there is no provider close to matching them in Australia in my opinion.  While the monthly fees generate very regular cash-flow, this is no longer a growth business in Australia.

The area that does offer growth potential is the company’s financial planning software.  Known as X-Plan it is used by 60% of Australian planners and the development spend each year exceeds all other competitors in total.  X-Plan is used for portfolio reporting, generating Statements of Advice, recording all client information, assessing planning strategies and modelling outcomes.

Iress purchased a UK business (Avelo) in the latter half of 2013 and are in the process of rolling out X-Plan in that market.  Ironically, financial planning is more advanced in Australia than the UK and I believe the company will see enduring growth in the UK.

The share price has eased back from a high of $10.38 in the latter half of 2013 and may possibly be still falling.  At the current price of $8.27 the stock is expected to yield 4.7% (80% franked = 6.3% gross) for the 2014 calendar year.  The stock is not cheap at the current price, but we expect good long-term total returns.

Newsat Limited (NWT), $0.38
This higher risk/return stock is definitely not a blue-chip, but the low share price does mask the potential for this company to generate very high free cash-flow and dividend payments long-term.

We have observed the company for an extended period, but never purchased until now.  The share price has fallen from a $0.575 peak in 2013 and $0.88 in May 2012.  Apart from the low share price, the big difference now is that the company is much closer to their goal – which is to launch a satellite in the first half of 2015.  They already operate teleporters (ground stations) in Perth and Adelaide and have leased capacity on a satellite launching this month (Jabiru-2).

In order to launch a satellite you need to have an orbital slot – and Newsat own 8.  You also need to have deep pockets and plenty of patience.  My feeling is that Newsat has done all of the hard work needed and that the price-fall is due to the ‘blue-sky’ potential coming out of the share price (so to speak) as they move towards launch.

Lockheed Martin in the US last month completed their technical review of Jabiru-1.  The satellite is due for final assembly and testing before the end of 2014, with a launch on an Ariane 5 rocket planned in the first half of 2015.  The launch is insured.

Newsat have US$644 million in pre-launch customer contracts lined up and this has enabled them to arrange finance through the Export-Import Bank of the United States and Coface (a US export credit agency) at a 3% interest rate – with principal repayments after launch.

Once launched, satellite operating costs are low and free cash-flow high.  Subject to sufficient utilisation (which looks promising given the pre-launch commitments), then a rapid pay-down of debt and the ability to pay healthy and rising dividends looks realistic.  Newsat would then appear very attractive for an institutional investor.

 Please contact me with any questions about your investment portfolio or any planning queries.

Best wishes
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 Thursday, 29 May 2014 13:46

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