Good afternoon,

ASX 200 was actually up at the close on Friday but a 58 point fall this morning has seen us crack negative territory for the week, down 0.71% on this time last week.

Discretionary stocks were sold off, despite strong retail sales numbers, but more on that later. Utilities and Energy led the performance (oil prices up 9.73% over last 30 days).


Macroeconomics

We had a couple important macroeconomic data points released over the last week. As we’ve discussed a lot in this note, share prices follow earnings expectation, earnings follow the business cycle and subsequently, it’s important to measure and understand the business cycle to forecast earnings and subsequently, find under or over-valued companies.

The US remains firmly in expansion-mode. The best lead indicator I know, the ISM/PMI surveys were out last week, slightly down on expectations but let’s face it, they are still well above 50 (manufacturing coming in at 59.8). I saw this nice little composite version from Morgan Stanley this morning – combines manufacturing/non-manufacturing surveys from both the ISM and Markit (who do the PMI’s).

The ‘latest’ piece of the expansionary story has been the strong move upwards in the risk-free rate/US treasury yields. This has a number of flow of effects, but again, thanks to MS we can see the correlation between cyclical stock returns and yields.

And yep, this is the US market and whilst most of you reading probably own none/few US stocks, this is globally significant data.

Last week we talked about the effect of these rising yields relative to the yield on Australian bonds and what it likely means for the USD/AUD exchange rate (lower). In the past, we’ve talked about the potential for yield curve inversion, which after the recent steepening, seems less likely.

Rising bonds in the US are likely to be a trend in markets for some time, as the world, led by the US re-inflates, economic activity picks up and central banks continue to increase interest rates to the rather elusive “neutral rate” – the interest rate at which inflation is neither stimulated nor curtailed.

And whilst I don’t believe that predictable rate rises are sufficient to cause a significant decline in prices, companies with flat/declining earnings cannot expect to benefit from rising asset prices any longer. Think defensive asset classes like utilities and infrastructure, where earnings are flat and predictable. Think ‘long duration’ assets with gearing like property.

Similarly, high growth names, those with much promise but little delivery to this point become less valuable as profits today become relatively more attractive than profits tomorrow. It’s probable that we will be willing to pay less for these in the future (Why? – future cash flows are discounted in a net present valuation calculation by, in part, the risk-free rate. The higher denominator in the division calculation results in a lower present value.)

What can you proactively do about it?
Audit your exposure to companies that are being valued based on their expected earnings, a long way away, in an uncertain future.
Below is a list of ASX 200 companies on a 1yr forward PE of 30x or more.

  • You’ll also want to review your exposure to “defensive yield”
    So you all think banks but I’m talking about Spark (SKI), Sydney Airport (SYD), Transurban (TCL), Atlas Arteria (ALX), REIT’s etc. Anything that’s long duration, high upfront capex, long, predictable returns. And whilst I think that some of these infrastructure-style companies have growth opportunities to help mitigate the headwind of rising interest rates/falling valuations, others are more exposed. Clients – I’ve got you covered here. Non-clients – you can figure it out for yourself/call me to become a client (I am running a small business here after all!)
  • You can also look to increase your exposure to “value”
    What is value? Don’t we always want to find value? Yeah but I mean value as a style. I mean cheap, unloved stocks that aren’t going to be so cheap in the future. The hard thing with doing this in Australia right now is our economy isn’t going as well as the rest of the world/the US in particular.

As a result, the only real way to place this at a high level is Resources, Energy, Mining Services and the odd-industrial company who’s got business overseas. Some of this is pretty crowded already as every hedge fund manager around the world has the same idea (buy Australian resources as a proxy for EM growth). Banks are also a natural ‘value’ beneficiary as “King of the Cyclicals” but our banks are in a bit of a tight spot between the politicians, APRA, offshore fund costs, bad debt provisions and the RBA.

Anyway, there are a few stocks that fit nicely in the ‘value’ box in my opinion. Some I’ve mentioned in this note before, some I haven’t. One I did gift you fine folk at $1.60 was Ausdrill (ASL) which has since paid a dividend and now trades at $1.80 (+12%, excl. div) and I reckon still have another 20-40c to go to reach ‘fair value’ post its recent acquisition of Barminco.


Retail might be of interest

As you probably already know, I’m not a huge fan of owning Aussie retailers right now. My view is housing price declines, not much in the wage growth and an already near-zero savings rate doesn’t bode well for increasing discretionary consumption. Add to that the increasingly global market for consumer goods and services – Australian companies really need to be “world class” to compete for Australian retail dollars.

This aside, some retail/consumer exposed-stocks on the ASX do appear relatively cheap. Which is kind of interesting, because retail sales figures out last week were actually pretty strong. Supermarkets +4.5%, Liquor +4.4%, Small Food +1.5% whilst housing categories like Electrical +0.7%, Furnishing +2.4% and Hardware +3.1% also had surprisingly good August figures.

Strong data came out of Out of Home advertising as well, growing 10.7% year-on-year to $221.2m, vs +14.2% growth in 2Q18, and +8.7% YoY in 1Q18. Advertisers clearly looking for other ways to reach the masses beyond the TV (which nobody watches anymore).


Movers & Shakers

MYOB got a takeover bid from private equity this morning (KKR) and jumped, the rest of the list is a function of commodity prices, the world’s largest alumina mine shutting down (AWC, S32) or a bit of value hunting in PRY, IPL, CPU and ASL.

Expensive stuff got beat up (BAL, WTC, ALU, WEB, BKL, REA, CHC, RWC, LLC (relative), XRO) whilst a fire at the site in Mozambique caused SYR’s share price to fall. Invocare (IVC) gave a market update that was weaker than expected (again).

Have a good week,
LL