Good afternoon,

Thanks to a Facebook post from our client/friend/author/fitness guru/local-crypto millionaire Jordan Travers, we’ve got 40+ new subscribers reading this week, so welcome and remember to heed the general advice warning at the top and bottom of this note.
ASX200 fell about 1% last week, following 6 weeks of gains. Telstra (TLS) the main culprit, down 11% for the week. If you’re still holding TLS, refer to my note (pre-trading update) from the 3 April (it’s under the heading “Fire Sale on Technology Stocks”) but since then, free cash flow consensus forecasts have fallen from 30 cents per share (cps) to 27cps.


The Swing Factor

As we discussed recently, it’s really important to look at our market from the perspective of “Resources” and “Everything Else”. Whilst the index will always be dragged around by highly cyclical resources businesses, portfolio volatility can be significantly reduced by simply ignoring them. Resources make up the majority of the historical volatility, despite only accounting for a 20% of the market cap.

And “resources” in Australia is largely industrial minerals/metals. Let’s put gold to one side for a bit. In terms of market cap, and what’s going to drive the index, you’re looking at oil & gas, Steel (iron ore, met coal, manganese) and copper.

It makes sense the price of all these major resources are driven by the business cycle. The more we consume, the more we manufacture. The more stuff we buy, the more trucks on the roads, the more fuel they burn. Those trucks need bridges to drive on, warehouses to deliver to and copper piping for electricity and plumbing.

So it’s logical to think that the price of these commodities and the price of the shares in the companies that mine them, will follow the business cycle.

For my long term readers, you’ll already know that the business cycle is best approximated by the Institute of Supply Management survey of manufacturing business managers (the manufacturing ISM).

And as you can see below, the ISM is the best guide to what the price of resources stocks are going to do on our market.

One of the reasons I’m getting a bit bearish on the index is because the resources stocks are getting a bit out of hand, particularly given that there are the first signs of the ISM rolling over and perhaps starting a more sustained trend down to near-neutral (50). Whilst absolute values are still high, I don’t think there is cause for concern (57.30 is still well and truly expansionary) however, if this value falls again next month, I’d think some investors will be taking profits out of BHP, RIO etc.

I think especially given Price to Free-cash-flow ratio’s (below) haven’t been this high since the bottom of the resources market in Jan 2016, when obviously prices were very high relative to very low free cash flow. Now free cash flow has recovered, however prices again are relatively high.

I think kind of correlates with margins too. Like whilst I expect them to be sustainably higher as the wastage in the boom days was out of hand, they look a bit toppy in aggregate as well (and are pretty good at forecasting price, note the recent gap widening.)

Side note: Notice how when I’m talking about resources I’m not talking about the price of stuff. Everyone knows the price of everything and the value of nothing.  (Paraphrasing Oscar Wilde).


International Opportunities

The reason why today’s note is late is primarily the result of a very enjoyable, but very long conversation my business partners/associates and I were having this morning (those people who know Warren know he loves a chat!)

We were talking about some of the economics of our wealth management business (largely fixed costs, high technical and regulatory barriers to entry, really benefit from economies of scale but also the cause of all the problems..and so on.) and we got onto the topic of category killers.

I raised my usual example.  Nike (+40% last 12 months) & Adidas (+20% last 12 months) own athletic footwear and street wear. I can buy Nike shares on 26x 1 year forward earnings and Adidas on 20x (in Europe) and with a very high degree of certainty, make very good returns in the next 5-10 years. Why so certain? Well, I’m almost certain that those 2 brands will continue to dominate sports footwear, those two brands will continue to be at the front of the pack and they will keep selling shoes at fantastic margins.

I can’t convince clients to buy Nike & Adidas, but they’ll happily buy Telstra (TLS) or Domino’s Pizza (DMP) if I tell them its a good idea (which, by the way, it’s not… and hence why I’m using it to prove this point.) All I’m saying is, lose the home bias. Yes, we have some great businesses here in Australia. Yes, I know it seems weird buying companies in the US or Germany or Holland. Yes, I realise they don’t really pay dividends and yes I realise you don’t get the franking credits. But seriously. Look at your portfolio, if you can convince me that Premier Investments (PMV +7% last 2 years) is better than Louis Vuitton Moet Hennessy (LVMH, +111% last 2 years)  I’ll give you a job!

Here’s an idea for you. Take out your phone and take a screenshot of your home screen.  Here’s mine. 

Let’s all agree that our mobile phone is now our life. It’s were our attention is, it’s how we do business and how we socialise. What’s the first thing you do when you wake up in the morning (I’ll bet it’s check your phone), last thing at night? Right, point proven.

So if the phone is our life, the apps on our phone are the biggest players in our life. On my home screen I have a few native apps (like Phone, Messages, Camera, Settings, Calculator, Internet Browser, Calendar all owned by Samsung, +10% this past 12 months) but then,
Microsoft (MSFT) x1 – Work Email
Google (GOOG) x2 – Personal Gmail, Maps
Facebook (FB) x3 – Facebook, Instagram, WhatsApp
Spotify (SPOT) x1 – Spotify
That sounds like a pretty good investment thesis to me.Snapchat (SNAP, -47%) used to be on my homepage, but  Instagram Stories has killed it. I do reckon LinkedIn is also relevant (and is on screen 2 of my phone) and is owned by Microsoft (MSFT +45% last 12 months) which rules software and in particular, business software. Coincidentally, it’s also the most widely held stock among mutual funds (source: Citi).

Anyway, you get the idea. The answer to all your investment needs is right in front of your face…literally. Hot tip for the remainder of this year, SPOT. You heard it here first. Opportunity set is huge and they OWN the music category. In fact, they own MUSIC. And they might soon own VIDEO and STREAMING and ORIGINAL CONTENT. Netflix, YouTube, Apple… pay attention.


New Video

I’ve never really understood the aversion to margin lending. I feel it’s one of those things that people immediately write off, without ever really tasting it or even understanding it.

Anyway, there’s a heap of potential benefits, obviously investing borrowed money will supersize your returns, but there’s also the potential tax deductions which, at this time of year can be handy. I had a chat with Shane Potter from Leveraged  about some of the details. You can  watch the video on the Seneca YouTube channel.  Which, while you’re there, you should subscribe too!

There’s a few other interviews I’ve done over the last 6 months on the Seneca YouTube channel – we’d really like it if you subscribed!


Movers and Shakers

A bit of a battery stock fiesta last week, ORE, KDR, CLQ, GXY all had good weeks after reasonably modest (read: rubbish) performance recently. Elsewhere CSL announced an earnings upgrade, Invocare (IVC) got upgraded by Credit Suisse, Challenger (CGF) bouncing back.

A2 Milk (A2M) copped a hammering after updating the market on revenue and margins (which you can’t afford to do when you’re stock is on 38x earnings!) And look, the PE ratio alone is not the reason it fell. The PE would have gone even higher if they beat revenue estimates. The issue is the markets expectations got ahead of the what the business could deliver, expectations had to correct. That’s the worst case scenario for stocks because the “E” is lower, but the ‘gloss’ is also removed and the “P” also falls. Price in green, PE in blue below.

I could rattle on about a bunch of other stuff, but I’ll keep it short. Competition catching at CYB (struggling with volumes and margins), inventory drama in China for TWE  (AFR article quoting a stack of non-Penfolds sitting in warehouses in China that’s been counted in TWE  sales), negative earnings revisions for BLD (after last week’s investor presentation) and Blue Sky (BLA) has been covered to death in the AFR, but so far they’ve only taken a 4% hit to their newly audited FUM. Suspect more news from them before 30 June. Perhaps a few more skeletons.


Wages

I’ve been banging on about a lack of wage growth (which is clearly an input to consumption… which feeds the logic we discussed above) here in Australia. There’s a number of reasons why but April jobs numbers out last week didn’t really change the picture. Whilst there was better growth in full time work over part time work, the middle wage bands (chart below) continue to be in decline.

Whilst I fully support the view of rising global growth, I see Australia poorly positioned (generally) to capture significant benefits from the recovery and interest rate rises remain unlikely in the near term for mine, with soft wages likely to flow through to weaker than expected GDP growth and potentially higher unemployment.

This is also the primary driver of my bearish AUD views, with the differential in the rates of change of growth and subsequently interest rates of the major trading pairs, steering the AUD lower.

For these two reason (FX and relative growth opportunities), I’m more constructive on overseas equities than Australian and in Australia, prefer names with foreign currency denominated earnings. We’ve done well out of this trade so far in 2018 and can see it continuing.


Talented clients

We are very fortunate to have such a diverse and talented group of people wanting to do business with us each day. It really is the great perk of this job. One of those very talented and loyal clients is Pauline Rothberg. Pauline’s written her first book, Queen of the Scullery. Whilst nothing to do with finance or markets, its a great, heartfelt story which I’d encourage you all to pick up a copy from Amazon.


Have a good week,
LL
The information contained in this email is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.