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Looking for a path through the confusion

Chris Burrell   Square   Photoshopped

Welcome to May edition of the Burrell Blog for 2016!

A Confusing Picture

The major Australian gold producer, Newcrest has recovered from under $10 in both December 2013 and again briefly in 2014, currently trading above $21. George Soros and several other hedge fund managers have bought either physical gold or overseas gold miners such as Barrick Gold in the past quarter. The same hedge fund manager together with main stream fund managers such as CEO Fink have raised concerns in recent weeks about debt levels in China. “BlackRock’s Fink says that everyone should worry about China Debt” was the head-line this week.

There have also been headlines around negative interest rates in Japan and Europe. Other reports have shown low GDP growth in several of the western world countries including Australia. What does all of this tell us?

Firstly, it tells us that the world remains nervous about any type of Xfactor as the global financial crisis is still within recent memory, even though it was 9 years ago. Gold is historically a hedge against bad news and market corrections. A full reading of the Fink interview shows that Fink remains quite positive on China and compliments their management of the economy from capital spending to services spending, even though the reported headline highlighted the negative comment on their debt.

In terms of Xfactors, your diarist is more concerned with valuations in the USA. A selection of price earnings ratio shows that sections of the US market are expensive, particularly as earnings per share (EPS) for US companies has slowed and on average has been negative over the past few quarters.

Peter Costello, former Australian Treasurer and now chairman of the Future Fund was quoted on the 18th of May 2016 as querying the assumption of a 5.5% return rate: “That is what the government thinks you’re going to get. Does it really think that? It is issuing bonds at 2%”.

The benchmark 10 year Australian Government bond yield fell to 2% on Monday. It is the latest sovereign bond yield falling to unprecedented territory following record lows in Germany and Japan 2 months ago.

Amidst this picture of concern about Chinese debt and US valuations, messages about lower returns and large corrections in 2016 in banking, resource and staples such as Woolworths, how is one to navigate a sensible path to produce positive returns? At Burrell we have found it useful to segment the market into four segments:

↗  Banks
↗  Other high yield, but steady/lower growth 
↗  High growth & sound business model, management, Balance sheet, ROE > 10%
↗  Resources

Banks

Amidst record low interest rates and suggestions of further declines, bank shares stand out as paying dividends of >5% fully franked and likely to produce capital gains of 10% thus being in our 15% sweet spot. We refer to this differential between interest rates and dividend yield as the “dividend yield driver”. The banks fell from April 2015 to September 2015 by around 25%, and are still down 25%, with the exception of CBA which has performed a little more positively.

 

The banks face some possible negative factors including increased capital requirements which were largely satisfied in 2015 by additional capital raisings, some increased bad debt provisions related primarily to resource companies, IT write offs for costs incurred in developing new banking systems, and digital disruption. These issues are largely part of dealing with the modern day business of banking in Australia and unlikely to be Xfactors. The one factor which may be a bell weatherin years to come is that with this additional capital, borrowers are repaying loans at an increased pace because repayments have been maintained while interest rates are lower. Thus to maintain bank profits, banks have to increase the rate at which they lend so as to place the loan funds with new borrowers or to fund new properties. If the loan demand were to fall, then this may result in a lower return on equity for the banks than their historical 15%. However this is unlikely to be an issue in 2016.

 

Other high yield, but steady lower growth

Telstra is an example of a stock in this category. The current dividend yield is 5.4% and this dividend seems rock solid. Telstra paid 14c per half for each of the 8 years from 2005 – 2013. Since then, the dividend has increased to 14.5c, then 15c and finally 15.5c. The stock has moved up from $5.16 in early April to $5.71, being a price earnings ratio of 16.4 and with the research target of $6.

 

High growth & sound business model, management, balance sheet, ROE >10%

Here we are looking for stocks that satisfy the 5 quality focal points to be included in the Burrell Universe viz: sound management, conservative debt, quality of business, recurring earnings and avoidance of red flag risks. If stocks can be found within the Burrell Universe that have high growth, then those stocks require careful investigation. An example is ResMed which is the global leader in sleep apnea and recently released a new flow generator and mask range. Last month, ResMed made a takeover for a company which will allow ResMed to receive and analyse the data from its machines so that users can use their mobile phones to understand the analytics of their breathing during the previous night and over time. Around half of the earnings are in US dollars and this is useful in a world where the Australian dollar has fallen from $1.10 to 73c. The company has no debt and satisfies the Burrell Universe test.

 

Resources

In the February and March blogs we commented “that markets are highly reactive to China as a proxy to demand growth for energy and mineral resources. This 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.

 

IRON ORE rebounded to the $US 60/65 range during the month. This is the level that a senior executive from the Chinese metallurgical association spoke of at the May 2015 Australian Stockbrokers Conference. The rationale is that China wants to see an IRON ORE price in this range, because it guarantees the survival of Fortescues and Vale as long term IRON ORE producers. The Chinese believe the IRON ORE market requires this stability. Perhaps the most interesting dynamic was that the President of China visited the iron and steel area of China during the month. He noted that there was a surplus of steel production and announced a billion dollar fund to shut in the excess production and re-train workers into other areas of the economy. What is unclear but perhaps implied, is that China has high cost Iron Ore mines with the Iron Ore costs thought to be in the vicinity of over $100US equivalent. If this production were to be shut in, then a more stable Iron Ore market with RIO and BHP continuing to sell their production at a price $65US maybe the more probable scenario.

 

The OIL market was also fascinating during the month. Glenn Stevens, Governor of the Reserve Bank of Australia gave a paper at the ASIC conference in Sydney this week. He noted that virtually no one had predicted the move by Saudi Arabia in November 2014 to flood the market to increase the production of oil so as to reduce the price below the $60US cost of US oil shale production. The oil price fell to the twenties and has since recovered to around $40US. Coincidentally this was the level predicted by Chris Probyn, Chief Economist, State Street Global Advisors in his annual pilgrimage to Brisbane on Friday the 5th of February.

 

The decision by the USA to allow exports of oil is a further change in the dynamic, with the first shipment by Exxon Mobile to its refinery in Italy and shipments since to ten countries. One can understand why Europe would be interested in receiving crude from parties other than Russia so as to reduce their dependence. An immediate consequence is that the $10 difference between a West Texas crude in the US and the price of Brent crude in the UK had all but disappeared as traders are now able to arbitrage between these markets. The USA has some 500 mmbbl of oil in strategic storage. As an aside Australia seems to have none and does not think we even need refining capacity! The conversion of coal fired power stations in the USA to low priced gas and now the ability to export oil and gas means the oil market is truly returning to one international market.

 

Also during the month Russia joined with Saudi Arabia in initial steps to reform a cartel. The cartel has in fact run stronger in terms of membership, because Russia has never been a member and although it has not formally joined, Indonesia did do so and so going forward the USA may well be dealing with a stronger OPEC block, once the supply/demand balance returns to the oil market. If readers are looking for a trigger, it will be that the members of OPEC believe that the supply of oil has fallen sufficiently that they can again bring a disciplined approach to their members and thus bring the market back into balance. The most likely price going forward will be somewhere between the current $40US and the coal shale price at $60US.

The reason for spending some paragraphs on these matters is that it is likely we have seen the bottom of the resources prices and further positive moves in reducing supply imbalances are likely to see further appreciation. It seems likely that BHP bottomed at $14.21 on the 21st of January and is currently trading in the $17/18 range. Further positive moves as noted above should see BHP above $20.

 

Conclusion

In a muddled world, it would be easy to do nothing. Thomas Ross Burrell OBE, my father always commented that elections are an excuse to do nothing and certainly there is some evidence of this over the past two months. On the other hand, experienced businessmen often find the best buying is in periods of uncertainty “buy in gloom and sell in boom”.

 

Segmenting stocks in the Burrell Universe into four segments as noted above provides a useful pathway towards achieving reasonable returns. Financial year to date, the Top 20 stocks have shown a return -3%, but it is submitted following the dividend yield driver may well turn this positive for the year to 30 June 2016. The broader S&P ASX 200 index is +3%, showing one of the widest disparities for many years and reversing the usual position that the 20 largest companies perform better or in line with the overall index.

 

The other themes for 2016 are also a helpful guide post and are listed below.

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

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 cThis 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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