Welcome to the April edition of the Burrell Blog for 2018.
Twelve months ago ten themes were reviewed in accordance with our usual practice.Let’s see whether these themes assisted in explaining market movements over the past 12 months. The ten themes were as follows:
↗ Dividend yield driver
↗ Interest rate cycle headwind
- Central banks in different parts of the cycle
↗ Adopt a realistic view on China, not a sentiment view
- Markets whollyreactiveto China as a proxy to demand growth for energy & mineral resources.
↗ $US economy and the USD
↗ Digital disruption and competition
↗ Australia innovation stocks: medical appliances; commercial biotech
↗ Weaker resources sector = lower A$ = Mergers& acquisitions (M&A)
↗ Deloitte Fantastic Five: agribusiness, gas, tourism, international education and wealth management
↗ Segment stocks in Burrell Universe into four segments
- Other high yield, but steady/lower growth
- High growth & sound business model, management, Balance Sheet, roe > 10%
↗ Possible X factors
- US stock market valuations and possible correction
- $20 oil
The Dividend yield driver theme sees Australia with materially higher dividend yields than most western world countries as assisting positive valuations, particularly in a low interest environment. Over recent years we have seen external events responsible for market downward corrections, to then be followed by recoveries which Burrell attribute due in no small part to the dividend yield driver. As a significant explainer of market movements, the dividend yield driver should remain a theme for 2018.
Franking credits have been a key element of rational behaviour in Australian equities market including the allocation of capital. In the USA where there is no tax credit for underlying company tax paid, the dividend rate is on average 2% i.e. half that in Australia and because dividends are taxed again under the classical system in the hands of recipient, companies not only pay lower dividends, but then pay their executives excessive remuneration and make high priced take overs, often not in the best interests of shareholders. The discussion to date on the opposition proposal to cease franking credits is likely to provide an excuse to company management to change dividend payout ratios and in some instances, to behave more along the lines of US corporations. This would bring with it some of the unfortunate elements of capital allocation which are observed in the USA. While there may be some rational debate whether franking credits should be refunded for SMSFs, the proposal not to refund franking credits for individual taxpayers strikes at the heart of the imputation system. It will be a sad day in Australia if this proposal is enacted, not only because many independent retirees and other shareholders favourably view franked dividends, but the change in behaviour across the broad spectrum of shareholders and corporations will accelerate the adoption of some of the less desirable aspects of US corporate culture in Australia.
The interest rate cycle headwind was seen as a possible offset to the dividend yield driver i.e. with both short and long term interest rates recovering from record lows, the interest rate cycle headwind remains a current theme. While in 2017, it was perhaps 5 knots for Australia and 10-15 knots for the USA, it is in early 2018 that we saw the 10 year bond rate in the USA jump by over 0.5% from 2.3% to 2.8%. The Australia 10 year bond rate has moved in sympathy. To date the headwind has impacted on interest rate sensitive sectors including long term bonds which showed a return of 0.2% for the Australian bond index for the year ended 30 June 2017 and listed property showing a negative return of -6.3% in the year to June 2017. In equities, interest rate sensitive sectors showed some adjustment although to date this has been modest. Some early correction in the infrastructure sector for stocks such as Sydney Airports was observed. Infrastructure broadly including hospitals, energy retailers may have further to fall as interest rates are confirmed at higher levels.
In explaining resources, the theme was that markets were wholly reactive to China as a proxy for demand growth in the energy & mineral resources sectors. This has continued to be the case with major resource stocks continuing to recover and the resources index in January 2018 being double the level two years earlier at January 2016. The fears concerning China growth rates have not materialised.
Adopt a realistic view on China not a sentiment view were the themes for 2016 and 2017. The recovery in resource stocks indicates that Burrells view that economic growth in China remains above 6% has driven the recovery. Another positive is the third year of economic rationalism in curtailing high cost coal and steel over supply. Australia as a reliable supplier of low emissions coking coal, steaming coal and iron ore has seen record volumes continue and prices recover. China remains immensely important to Australia, more so than the USA in an economic sense and so adopting a realistic view on China, not a sentiment view should continue to support industries across the Australian economy, far beyond resources e.g. tourism is a further example.
Chinese investment is also relevant to the next theme which was during the weaker resources sector and lower Australian dollar, a number of overseas mergers and acquisitions (M&A) would result. There was surprisingly little activity during 2016 and early 2017. However as confidence in the global economy has improved, we’ve seen a ratcheting up of M&A activity both from domestic companies and more so, from international players. There has been M&A activity in the last week on Santos and over recent months for Aconex with a take over from the Fortune 500 Oracle, for Mantra in the tourism space by the French giant Accor and for Sirtex by a US medical corporation. A key driver of greater M&A activity is that as part of the free trade agreements entered into by Australia, Foreign Investment Review Board (FIRB) approval is no longer required for countries for whom Australia has such agreements. The threshold for non-sensitive business is increased from $261M to $1134M.
The Deloitte Fantastic Five has been a theme since 2016 based on work by Deloitte and CSIRO on the basis Australia should focus on its strengths and what it is good at. The five industries were agribusiness, gas, tourism, international education and wealth management. There is no doubt that Australian universities have done well from international education, but the listed company exposure to this sector is limited. Agribusiness on the other hand has seen a keen interest over the past 12 months. While some valuations e.g. in the milk industry appear excessive, others need more time to mature as investments e.g. Select Harvests on the theme of breakfast cereal including more muesli and almond nuts. The gas industry has shown a recovery and wide spread debate as the price of gas along the eastern seaboard has doubled in recent years. Indeed the increased gas price has become a key political issue at both the Commonwealth and state government levels. Many key Australian industries were built on cheap coal energy including aluminium refineries and smelters, fertiliser and chemical plants and downstream processing generally of Australian minerals. Your diarist has raised this issue over the last five years, but even now government seems not to understand the fragility of these key industries. There is a key strategic imperative for governments to provide proper settings for competitive energy and for industry to respond with appropriate long term investment. The Deloitte gas theme has been useful in explaining market interest. Likewise tourism. The strong growth in tourist numbers, especially from Asia has led to the Mantra takeover for example. Other infrastructure such as airports driven by both inbound tourism and the baby boomers travelling outbound will continue to provide investment opportunities. Another baby boomer driven industry is wealth management, with superannuation savings in Australia from the baby boomers again driving activity. Not all companies will prosper, as in any industry there will be strong performers, average performers and poor performers. So the inclusion of wealth management in the Deloitte fantastic five is a useful introduction as to where value may lie from growth, but is not a sufficient condition in itself as further research and analysis on the industry will continue to be required.
The US economy is globally important, particularly when, as now, it is at close to full employment. The US unemployment rate is 4.1%, white unemployment 3.5% and coloured unemployment 7%. In some states unemployment is at 2.5%. Economics 101 would suggest the last recommended policy is a huge fiscal tax cut as well as infrastructure spending and defence spending. But these fiscal policies which Congress and Trump have delivered hark back to the good old days of short term pump priming to win the next election and leaving the headache for the next administration. There will no doubt be a headache as tax cuts lead to increasing the deficit above US$15T, causing a subsequent administration to reverse in some measure the tax cuts. The strong US economy is leading to increased earnings and together with the tax cuts, adjusted valuations ratios for price/earnings in many instances no longer appear excessive. There is a tech bubble in some stocks in the US including Amazon and Netflix that might cause a significant adjustment. Stimulating a growing economy at full employment should result in inflation and higher interest rates, which together with the trade issues around tariffs may be the most likely catalyst for correction in the US stock market. The US dollar has been weak, but higher interest rates in a strong economy are likely to reverse this going forward and so holding US dollars continues as a reasonable strategy.
Next month's Bourse will complete a review of the themes.
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