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Making sense of the 'State of the Economy'


Welcome to the February edition of the Burrell Blog for 2016.

Themes for 2016
↗ Dividend yield driver
↗ Interest rate cycle headwind
  o Central banks in different parts of the cycle
↗ Segment stocks in Burrell Universe into four segments
  o Banks
  o Other high yield, but steady/lower growth
  o High growth & sound business model, management, Balance Sheet, ROE > 10%
  o Resources
↗ Adopt a realistic view on China, not a sentiment view
↗ Resources
  o Markets wholly reactive to China as a proxy to demand growth for energy & mineral resources. There is relatively well developed themes so looking for inflection points in calendar 2016.
↗ US economy and the USD
↗ Digital disruption and competition
↗ Australia innovation stocks: medical appliances; global champions
↗ Weaker resources sector = lower A$ = Mergers & Acquisitions (M&A)
↗ Deloitte Fantastic Five: agribusiness, gas, tourism, international education and wealth management
↗ Property: more positive moves driven by low interest rates, demand and low valuations
↗ Possible X factors
  A. US stock market valuations and possible correction
  B. $20 oil
  C. China

Dividend yield driver

The Global and Australian interest rates remain low. Term deposit rates are currently around 2.2% for 30 days, 2.6% for 60 days and 3% for 90 days per John Smerdon, Associate – Burrell Fixed Interest Desk. Moreover, the Australian 10 year bond probably bottomed in April around 2.23% and is currently at 2.55%. It is the difference between these risk free rates and the return on equities which is a key determinant in stock market prices. After falls on the Australian stock market in the first 2 weeks of January 2016, the dividend yield on NAB is shown as 7% fully franked, a gross dividend of 10% including franking credits! While some headwinds exist for the banks, current attractive yields should lead to a recovery in prices. Likewise, good industrial shares with well-regarded management and proven business models will continue to attract inflows. In the April quarter of 2015, bank share prices bid up until the yields were 5% and quality industrials 4.4%.

Interest rate cycle headwind

The proviso to the preceding theme is that interest rates remain below the long term averages. For example the average Australian 10 year bond rate is around 6.5%, double the existing level. Despite all the talk of increased interest rates, the 10 year bond today is equal to its level 12 months ago. Given some weakness in the global economy and concerns around China, any return to long term average interest rates seems a long way off.

Overseas, the US Fed finally made its first increase in 8 years in December by 0.25%. While there has been discussion of a further two to four increases this year of the same amount that leaves US interest rates at low levels.

Accordingly while increased rates would be a headwind to equity values, the more likely prognosis is for a slow and gradual set of interest rate increases in the USA which lag the continuing strength in that economy.
Central banks are in different parts of the cycle with Europe a weaker economy and the European Central Bank (ECB) more inclined to continue stimulus policy.

Segment stocks in Burrell Universe into four segments
o Banks
o Other high yield, but steady/lower growth
o High growth & sound business model, management, Balance Sheet, ROE > 10%
o Resources

The Burrell Universe comprises a subset of the ASX S&P 200 based on 5 quality focal points; sound management, conservative debt, quality of business, current earnings and red flag risks. The Burrell Universe has outperformed the S&P 200 index. It is helpful to segment those stocks into the four categories above as those sectors have different attributes and performance characteristics.

An example of a stock in the second category is Telstra and third category Seek and ResMed. We should be prepared to pay a higher valuation multiple for stocks in the third category with higher growth and overseas earnings than stocks in the second category. A developing trend sees an enhanced focus on stocks in the second and third categories outside the Top 20 (“X20”). Resources are considered further below.

Adopt a realistic view on China – not a sentiment view

Contrary to the common misconception, oil demand is up 9% in China year on year. Retail sales are up over 10% and lending for consumers has also shown strong growth. While services is showing good growth, manufacturing has slowed. However projects such as replacement of the underground pipe networks in Chinese cities indicate that a projection of growth declining from 6.9% to 6.0% for 2016 are reasonable.

There are a number of vested interests talking the Chinese economy down seeking to force a devaluation of the yuan against the $US peg. The Chinese themselves have been happy to take various steps to contribute to the fall in commodity prices.

Chinese Market – Shanghai 10 years since 10 Feb 06

AAAA

Resources

With resources, the resource index fell in the 18 months from 6000 in Jan 2014 by 1200 to 4800 in June 2015. It then took only the 6 months July-Dec 2015 to fall another 1600 points to 3200. For many of these stocks the starting point is that the bad news is in the price e.g. BHP. We had thought the bad news may not be in the Woodside price, which was confirmed with a December full year profit wipe-out reported 17 Feb 2016.

Markets are wholly reactive to China as a proxy to demand growth for energy & mineral resources. There is a relatively well developed theme so looking for inflection points in calendars 2016 and 2017. The inflection points are likely identified by considering the supply/demand balance for individual commodities. Copper for example may well be in balance in 2016 as the services sector in China requires copper & new copper mines post GFC were few & far between, with any greenfields high in sulphur unlikely to receive World Bank funding. Both RIO & BHP have confirmed the view that copper may be one of the first base metals to be positively viewed, with RIO further committing to Oyu Tolgu and BHP expressing interest in buying any quality copper mines put up for sale by distressed majors.

US economy and the USD

Chris Probyn, Chief economist, State Street Global Advisors made his annual pilgrimage to Brisbane on Friday 5 February. His prognosis was continuing lack lustre growth in western economies with USA 2.5%, Europe 1.5% and Japan 1.0%. Australia was doing relatively well at 2.5% and China 6.0% forecast. In this economic climate, low inflation and limited interest rate rises are also forecast.

The economic backdrop should be sufficient to support the $US, but perhaps without the impetus of recent years. Of more concern is the US stock market. Having fallen to 7000 post GFC, it quickly recovered to 10,000 by October 2009 and gradually increased to 18,000. Your diarist has written on this topic for two years noting the risk of correction. Some sectors look like a repeat of the tech bubble with large revenues but little profit.
The recent correction to 16,000 partly reflects some retraction on these stocks.

Burrells are cautious of some of the high P/E’s in the USA, but also see value based on independent research on other stocks. Refer below under possible X factors.

US Market – Dow Jones 10 year since 10 February 2006

Dow Jones 10year bond rate FEB2016

Digital disruption and competition

There are few businesses not impacted by the change in consumer behaviour such that many of us Google a service or goods required before leaving home and in a number of instances, the younger generation don’t leave home at all. In some cases, such as newspapers, digital disruption has reached a tipping point such that home delivery is no longer economic and the rivers of gold have moved to the internet with revenues from real estate, HR employment search and cars increasingly flowing to dedicated internet websites that allow the computers powerful search function to deliver superior consumer experiences.

Retail generally is impacted by the Google search function. This means keener prices for consumers whether they shop online or not because stores now know they are competing in a wider market. Myer stumbled during 2015 in common with several leading department stores in overseas markets.

Not all digital development is disruptive. The majority of IT development by existing businesses is to enhance the customer experience, either providing better systems for the personnel of the business e.g. the Burrell client relationship management (CRM) system or via emails, sms, apps & other direct client communications. While the disruptors such as Uber garner much of the press, we are increasingly observing established businesses adapting their service delivery to embrace the new millennium.

Burrells recommend clients include a listed company with a sustainable key exposure to growth from internet traffic, which almost certainly requires brand leadership in the niche e.g. Seek in HR. Internationally Google Alphabet earns revenue from click enquiries, while Intel and Cisco are hardware focused. These stocks are held by Burrell funds.

Competition in other forms is also increasingly global. For example, Aldi and Costco are having an impact on the established Australian grocery chains. Woolworths suffered in 2015 as a result of this competition, whereas Wesfarmers (Coles) did not. This is an ongoing issue for 2016.

A key take-away from the themes above is that many Australian companies have little control over selling prices. Digital disruption means that while in theory many businesses can set their own prices, in practice competition makes it difficult to charge a premium price. Thus companies which have attributes that allow a return on equity above 10% should be sought. While there are good, average and poor performers in almost all industries, winning companies are likely to have in common a greater degree of control over product and service pricing.

Australia innovation stocks: medical appliances; global champions

In 2015, ResMed, Nanosonics and Sirtex again were examples of Australian medical appliance companies showing superior returns. Australians have an ability to add value in the medical sphere and this sector continues to deserve analysis.

Global champions included CSL and Macquarie, the later completing a Houdini post GFC by adding aircraft leasing and other recurring income streams.

Weaker resources sector = lower A$ = Mergers & Acquisitions (M&A)

The Australian dollar did fall by around 10% in calendar 2015 to around 70c on $A:US exchange rate. Predictions of a further fall to 65c plus the dramatic fall in commodity prices are likely reasons why offshore takeover activity for Australian listed companies was subdued in 2015. A lower exchange rate or the sense listed company share prices in the resources space have bottomed would likely see more M&A activity from overseas companies.

Deloitte Fantastic Five: agribusiness, gas, tourism, international education and wealth management

Agribusiness saw milk suppliers to China benefit, as did beef producers.

Wealth management continued to be the most successful of the fantastic five in Australia with several listed companies in this space worthy of consideration. Moreover such were immune from the cool winds affecting resources and banking.

Property: more positive moves driven by low interest rates, demand and low valuations

Low interest rates, demand and selected attractive share price valuations should see more positive moves in the listed property “AREIT” Australian real estate investment trust sector. The differential between commercial rental property yields and the risk-free rate will act as a driver for the property sector just as for equities. Low interest rates will continue to drive the physical property market as the next generation settle into property ownership in Australia and lower exchange rates attract offshore investors to commercial property. The current tax debate around negative gearing is a risk to the economic momentum Australia desperately requires in the residential housing sector.

Possible X factors
↗ US stock market valuations and possible correction
  A. Visa 32x
  B. Intuitive Surgical 35x
  C. Priceline 21x
  D. MasterCard 24x
  E. Illumina 47x
  F. Amazon 408x
  G. Baidu 29x
  H. Roche 23x
  I. PayPal 33x
  J. Home Depot 22x
  K. Walt Disney 16x
  L. Johnson & Johnson 17x
↗ $20 oil
↗ China
↗ Lower global growth than forecast i.e. risk is to the downside

Happy Investing!


Chris Burrell
Managing Director

As always, if you have any questions please don't hesitate to contact your advisor on (07) 3006 7200 or email This email address is being protected from spambots. You need JavaScript enabled to view it.

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Disclaimer & Disclosure: Burrell Stockbroking Pty Ltd and its associates state that they and/or their families or companies or trusts may have an interest in the securities mentioned in this report and do receive commissions or fees from the sale or purchase of securities mentioned therein. Burrell Stockbroking and its associates also state that the comments are intended to provide information to our clients exclusively and reflects our view on the securities concerned and does not take account of the appropriateness of the recommendation for any particular client who should obtain specific professional advice from his or her Burrell Stockbroking Pty Ltd advisor on the suitability of the recommendation. Whilst we believe that the statements herein are based on accurate and reliable information, no warranty is given to its accuracy and completeness and Burrell Stockbroking Pty Ltd, its Directors and employees do not accept any liability for any loss arising as a result of a person acting thereon.

This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs ('relevant personal circumstances') of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor. If the advice relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.


Burrell Stockbroking Pty Ltd (ABN 82 088 958 481), a Participant of the ASX Group and the NSX.

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