Welcome to June edition of the Burrell Blog for 2016!
An Xfactor for Australian equities?
From an investment viewpoint it is instructive to analyse the BREXIT effect on the Australian stock market. The S&P ASX 200 index was 5400 on the 31st of May 2016 and 5368 on the 9th of June 2016. In the ensuring week to last Friday the 17th of June 2016, polls suggested that the probability of BREXIT was around 50/50 with some indicating the majority favouring BREXIT. This was a surprise as previously the accepted wisdom was that Britain would vote to remain within the European Union.
The United Kingdom has never been a member of the Monetary Union which was at the core of the EU. The UK has retained the pound sterling as its currency and the ability via the Bank of England to set monetary policy, including interest rates. Senior economists reason that the key flaw in the EU is that Italy, Spain and Greece are not states, but Sovereign Countries and so adopting a uniform currency throughout Europe without having a central Fiscal policy and a central Government is likely to result in the EU disintegrating at some time. That time does not appear to be now as Germany and France have invested heavily in the EU concept and been major beneficiaries of it. Their growth has continued a pace, whilst the poorer cousins in Italy, Spain and Greece have languished, one reason being that their currencies can’t devalue and interest rates cannot reset to give monetary stimulus.
The UK has not suffered this major flaw. Rather the two key issues in favour of BREXIT are control of immigration and sovereignty. The EU has as a separate tenet not only the free movement of goods and services, but the free movement of labour and it is this free flow of immigrants that has been the focus of a negative reaction in the UK. France and Germany would argue that you can’t take the good i.e. the free flow of goods and services without also accepting the responsibilities of free movement of labour. France and Germany have given indications they will seek to punish the UK should it seek to exit. There is every incentive on them to do so, because they will be keen to teach the UK a lesson and discourage other members such as Italy from holding a vote.
The sovereignty argument relates to the gradual assumption of power in Brussels as EU representatives are now elected separately e.g. in the UK and so increasingly some in the UK Parliament feel that their sovereignty is being impinged.
The indications are that the vote is finally balanced. However whether the threats from Germany and France are helpful in scaring UK voters away from the BREXIT case remains to be seen. The almost unanimous view of the business community is that the possible interruption to trade and the likely lowering of UK GPD growth to zero are too high a price to pay for the benefits espoused by the pro BREXIT case.
Around this uncertainty it is instructive to look at the prices of Commonwealth Bank (CBA) shares during the same period. On the 31st of May 2016 CBA were trading at $78 and again on the 7th of June 2016. Falling in sync with the index, CBA shares fell under $72 in the 3 days to last Friday, 17th of June 2016. This example illustrates how important it is for investors to be focused on value rather the sentiment. CBA net profit after tax (NPAT) is forecast to increase from $8.7B in June 2014 to $9.5B two years later in June 2016 and $10.1B for the June 2017 year. This places the stock on a PE of around 13 and a forecast yield of 5.7%. Analysts’ intrinsic values are mostly above $85. In short the research would indicate that not only for CBA, but NAB and several other strong yield stocks that the negative sentiment around BREXIT has created a value buying opportunity.
In the Burrell dealing room there was a view last week that BREXIT may be a “sell the rumour, buy the fact” event i.e. that the nervousness in the market for BREXIT was reflected in the prices which bottomed last Friday and that as the BREXIT event approaches, a more realistic assessment has occurred. Certainly if the BREXIT vote has a majority in the negative, it would be anticipated that the markets in the UK and globally would likely firm. What might happen in the event of a positive vote to exit is more difficult to predict. Some of the bearish news articles have suggested Armageddon, but in fact little will change in the short term and it’s unlikely an Armageddon will result. Whilst Britain would experience difficulty for a period in negotiating a free trade agreement, during the two year exit window, it would be expected in a free trade world that permanent barriers would be negotiated away. In an Australian market context, it is difficult to see that the outcome of the vote has material impact on the value of CBA.
What of other possible Xfactors? In January 2016, three Xfactors were considered. The possibility of $20 oil may now be discounted, with oil recovering to US$50 and supply/demand heading towards rebalance. The second factor being the reasonably full valuation of the USA stock market has been your diarist’s main concern. While reasonable GDP growth in the USA has so far protected the US stock market from a much needed correction, growth has fallen and earnings per share (EPS) growth in the past 6 months has been negative, setting the scene for some vulnerability in USA stock prices. The USA stock market is by no means uniform with some areas trading at high PEs e.g. Facebook, Amazon & Netflix whilst others trade at quite low PEs e.g. selected quality technology stock such as Cisco and industrials such as Borg-Warner. We recommend clients lighten exposure to the USA, particularly to indices and the highly valued sectors. The third possible Xfactor discussed in January were debt levels in China. These debt levels have continued to grow with some commentators seeing debt in China at 250% of GDP. China has high levels of foreign exchange reserves and a deal of the debt from state owned enterprises (SOE’S) are internal debts within the public sector which it may be argued contra on consolidation. Nevertheless, there appears to be an ability for non-performing loans to be transferred by the Chinese banks to off balance sheet trusts and several commentators have seen the level of balance sheet trusts as being material in the context of banks total balance sheets. While China has been responsible in the management of its services economy and ongoing infrastructure in areas such as replacing major pipe works in China, the calls for China to take proactive action in respect of its debt levels are growing louder by the day.
These possible Xfactors are a back drop to low rates of GDP growth globally and some faltering in earnings per share growth.
Actions from a value investor would include sale of stocks on high valuation multiples e.g. high PE ratios above 20 where the companies are without material growth, a favouring of companies with maintainable dividends at levels materially above term deposit rates and a sprinkling of selected stocks which do have good growth, because by dint of their scarcity, such stocks are likely to be sought after by market investors and trade at premium. Certainly, stocks with stronger growth were the ones that traded at a premium in Japan during its long period of stagflation and low economic growth.
To summarise, BREXIT whilst a serious issue for the UK, is unlikely to be an Xfactor for Australia in the medium term. The negative sentiment provides a value opportunity for some companies which have been sold below intrinsic value. The possible Xfactors of a fully valued USA stock market against the back drop of low GDP and EPS growth are of more concern, with a lightening of exposure and the transfer of funds to $US account useful strategies for the next 6 months. China debt levels are also a possible Xfactor, but the Chinese Government have so far shown itself capable of meeting its economic challenges and your diarist would not be surprised to see some action on this front from the Chinese authorities.
Taking risk off the table by the sale of stocks with high valuation multiples is proven both overseas and in Australia. Value stocks with strong dividends and low multiples are likely to be preferred, except for those increasingly sparse number of stocks which are showing good growth, which will trade at premiums in the market.
Lastly, be wary as an investor of succumbing to the negative sentiment. Negative sentiment is a friend of the value investor as it provides opportunity.
The other themes for 2016 are also a helpful guide post and are listed below.
Themes for 2016
↗ Dividend yield driver
↗ Interest rate cycle headwind
o Central banks in different parts of the cycle
↗ Segment stocks in Burrell Universe into four segments
o Other high yield, but steady/lower growth
o High growth & sound business model, management, Balance Sheet, ROE > 10%
↗ Adopt a realistic view on China, not a sentiment view
o Markets wholly reactive to China as a proxy to demand growth for energy & mineral resources. There is relatively well developed themes so looking for inflection points in calendar 2016.
↗ US economy and the USD
↗ Digital disruption and competition
↗ Australia innovation stocks: medical appliances; global champions
↗ Weaker resources sector = lower A$ = 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
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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.