The Experts

Paul Rickard
+ About Paul Rickard

Paul Rickard has more than 25 years’ experience in financial services and banking, including 20 years with the Commonwealth Bank Group in senior leadership roles. Paul was the founding Managing Director and CEO of CommSec, and was named Australian ‘Stockbroker of the Year’ in 2005.

In 2012, Paul teamed up with Peter Switzer to launch the Switzer Super Report, a newsletter and website for the trustees of SMSFs. A regular commentator in the media, investment advisor and company director, he is also a Non-Executive Director of Tyro Payments Ltd and Property Exchange Australia Ltd.

Follow Paul on Twitter @PaulRickard17

Will ETFs cause the next stock market crash?

Thursday, September 19, 2019

Michael Burry, the hero of The Big Short movie, has joined the growing chorus of commentators warning about risks to the financial system due to the huge inflows into index tracking, passively managed exchange traded funds (ETFs). In fact Burry, who made a fortune correctly betting against CDOs (collateralised debt obligations) before the onset of the GFC, has gone one step further and described the inflows as a “bubble” and “like most bubbles, the longer it goes on, the worse the crash will be”.

So could ETFs cause the next stock market crash? 

I think it is very unlikely but before coming back to this and actions investors can take to mitigate this risk, let’s take a closer look at his arguments.

Burry’s thesis

Globally, there is more than US$5 trillion invested in passive, index tracking ETFs. In the US, where you can access an ETF for almost any market/sector/industry/investment thematic, equity assets being managed passively (that is, on ‘auto-pilot’ to blindly track an index) is almost the same as the value of funds being managed actively. As the following chart shows, the gap has closed remarkably over the last decade.

US Equity Fund Assets – Active (blue) vs Passive (orange)

Source: CNBC and Morningstar

Burry contends that passive investing is removing price discovery and that assets aren’t being accurately priced for risk. Because ETFs just buy securities because they are part of an  index, rather than because they are cheap or good value, this can lead to overpriced securities. Further, securities that make it into an index get an artificial boost compared to those that miss out.

This is diminishing the primary role of the marketplace, which is to establish a price for a security based on the analysis conducted by buyers and sellers. If it is just the weight of inflows or outflows that drives a stock’s price, no consideration is being given to the risk of that investment.

On a more practical level, Burry is worried about liquidity risk when it comes to ETFs exiting positions. He cites the example of the world’s most tracked index, the US S&P 500, which consists of the 500 largest US companies. But according to Burry, 266 stocks (over half) have daily trading volumes under U$150m in total. So despite there being hundreds of billions of dollars in ETFs tracking the S&P 500, the underlying liquidity of many of the component stocks is relatively poor. So if investors decided to exit the market and liquidate their ETFs, and the ETFs in turn need to liquidate their underlying holdings, there isn’t the liquidity available to make this possible. A rush to the door could trigger a very messy outcome.

He also notes that there are many derivative contracts linked to ETFs, plus buy/sell strategies used by the funds to pseudo-match flows every day. These make the situation potentially worse – it “won’t end well” according to Burry.

There are also some unusual players in the ETF game. For example, the Japanese central bank (the Bank of Japan) has amassed over the last decade, such large holdings that it now owns close to 80% of Japanese equity ETFs. This has been one of the key drivers for a huge mismatch between the valuation of large cap Japanese stocks and small cap stocks (Burry says “extreme undervaluation” in the case of some small caps). He also suggests that in a global market panic, the Japanese central bank could be a stabilizing force that leads to large cap Japanese stocks being relatively protected compared to their peers in the US, Europe and other parts of Asia.

Burry’s critics note that he is an active fund manager, the founder of Scion Asset Management, a private investment firm focussed on small cap stocks.

Should you worry?

I don’t think ETFs will cause the next crash. Firstly, stock market crashes are typically caused by external forces, such as rising inflation and interest rates in 1987; rising interest rates again for the bursting of the dot-com bubble in 2000; and the failure of debt rating agencies to assess the risk of CDOs that led to the credit crunch induced crash of 2007. Secondly, there is in effect an automatic “stabilizer” that will slow an ETF stampede  – a widening spread between bid and offer.

One of the more attractive features of ETFs is that there are market makers (investment banks) who compete by making a bid/offer spread to deal. This allows investors to enter the market and pay a price for the ETF which is very close to its underlying NTA (net tangible asset value), or exit an ETF holding at a price which is also very close to the NTA. The market makers build long or short positions, and have access to the ETF issuers to access new units or redeem units they own at the underlying NTA.

This works well in good market conditions, leading to fine bid/offer spreads (sometimes only a few basis points). But in a significant downward  move, unless the market makers have  very deep pockets, the most likely response is for the market makers to widen their spread, probably very materially. Ironically, wider spreads means that it becomes less attractive for investors to sell their ETFs, and if they are wide enough, the selling dwindles to a trickle.

A serious market correction could have a bigger impact on small cap stocks than large cap, as there will be some shrinkage in the size of ETFs (the market makers will be forced to redeem some units). Further, investors know that large cap/leading stocks recover in price  first, so they tend to steer away from small caps when the market is heading south.

If you do share Burry’s concerns and are worried about an ETF meltdown, here is how you can mitigate the risk. Importantly, focus on ETFs from the major issuers (the Vanguard’s, BlackRock’s etc). These guys have deep pockets and arguably, are in the “too big to fail” category. Next, look at ETFs that follow the major indices. Be wary of ETFs that are tracking peripheral indices (in the USA, for example, regional banks), non-standard indices or compiled indices. ETFs based on broad based indices with large caps may be more liquid than ETFs  focussed on small caps. Finally, avoid exotic or synthetic ETFs (not really a big issue in Australia). The latter are ETFs that invest in a derivative of a product, rather than the underlying product itself.


13 Aussie stocks that could be hurt by BoJo’s Brexit

Thursday, September 12, 2019

The countdown for Brexit is on. On October 14, the UK Parliament is scheduled to return following the longest proroguing in history. Three days later, on October 17, European Leaders meet to consider progress on Brexit. If Prime Minister Boris Johnson (BoJo) is able to negotiate a new withdrawal agreement, this will require the approval of all 27 European leaders at this meeting. If by October 19 a withdrawal agreement is not in place, or the UK Parliament has not agreed to leave without a deal, then BoJo will be legally obliged under a new law to ask the EU to delay Brexit until 31 January 2020.

While there is no guarantee that the EU will approve a further delay, barring an emotional reaction from the French, the expectation is that they will. They may move the date forward (to keep the pressure on), but outright rejection is unlikely.

With BoJo hoping to negotiate a new withdrawal agreement, the EU seeming as intransient as ever, and no commitment from BoJo in regard to the operation of the new law, how this plays out is anyone’s  guess. It is now more than three years since the British voted by a margin of 52% to 48% to leave the EU, but Brexit looks as “far off”, or in some eyes as “close as”, at any time in that 3 year period. Uncertainty continues.

Investors are naturally nervous about the impact of Brexit. There are a number of Australian companies that have operations in the UK that could be impacted, particularly in the event of a hard Brexit. But before considering these impacts, let’s look at what Brexit could mean for markets in general.

Brexit hasn’t been that bad for stocks

UK’s leading share index, the FTSE100 has risen by 15% since the vote on 23 June 2016 to leave the EU. In fact, it is up by more than 25% from the low of around 5,800 points achieved a few hours after the market opened for business on 24 June. The following chart shows that it has been a fairly orderly climb.

FTSE 100 – Sept 14 to Sept 19 (source: LSE)

Like other global markets, it has been tracking the US markets higher. This year, it has put on around 7% compared to the Dow Jones 20%, notwithstanding the Brexit uncertainty from Theresa May’s botched withdrawal agreement and now under BoJo.

Dow Jones (black) vs FTSE 100 (orange) – 2019 YTD (source: Bloomberg)


The performance of the UK stock exchange suggests that markets aren’t that fazed about Brexit, thinking that the impact is more likely to be short term rather than long term.

Certainly, Brexit is not the crisis that Grexit proved to be in 2015. While the Greece economy is only a fraction of the size of the UK, Grexit carried with it far more significant risks. Firstly, the threat of contagion and that the EU might start to disintegrate with fellow PIGS (Portugal, Ireland and Spain) seen to be at risk. But perhaps more importantly, a European banking and debt crisis brought on by Greece defaulting on loans largely provided by German banks. None of these conditions exist with Brexit, particularly as the EU has proved to be very united and a tough negotiator regarding the terms of Britain’s exit.

A hard Brexit (that is without a negotiated withdrawal agreement) will hit both the UK and European economies as trade and the supply of services is disrupted. Bank of England Governor Mark Carney recently warned that a “disorganised Brexit” would see UK GDP decline by about 5.5%. Joblessness would increase, taking the unemployment rate to more than twice its current level to about 7%. Inflation would also more than double to 5.5%.

This would no doubt add to the fears of a pending global recession, sending bond yields lower, gold higher and equity markets down. But the good news is that his estimate of a 5.5% hit to GDP is down from an earlier forecast of an 8.0% hit made in November 2018.

A hard Brexit is also likely to see the pound plunge. However, a sharp fall in the pound will make leading UK companies, particularly those operating across multiple geographies, significantly cheaper to offshore buyers, potentially leading to a boost for the UK stock  market. And we have seen this over the last few weeks as the debate about Brexit in the House of Commons has dragged on. Whenever there has been talk of a hard Brexit, the pound has fallen and the UK share market has rallied. Conversely, when it has looked like deferral is more likely, the pound has rallied and the stock market has fallen.

There is no doubt that markets will welcome (in the very short term) a further deferral, but this just kicks the can down the road. The uncertainty will continue.

My best guess about Brexit is that the impact on markets will be fairly muted. Not only is arguably already built into the price (although very hard to know by how much), markets know that the disruption will be short term. In the long term, both the UK and European economies will recover as natural boosters like a weaker pound kick in.

Which Aussie stocks will be impacted?

Of course, the overall impact on markets and the impact on individual stocks can be quite different. Despite my prognosis of a more muted response with the former, the Australian market has a habit of “shooting first and asking questions later”. So, don’t be surprised that in the event of a hard Brexit, Aussie stocks with UK exposures come under a bit of short term pressure.

Listed below are13 ASX listed companies with exposure to the UK. They are broken down into two camps. The first group, where the potential is for more impact, because revenue from UK operations is material or they have warned about Brexit disrupting business flows. The second group, potentially less impacted, earn some revenue in the UK (between 5% and 20% of total revenue).

ASX listed companies that could be impacted by Brexit.

But if prices get hit hard, many of these stocks might become good buying opportunities.


My 3 top stocks from reporting season

Thursday, September 05, 2019

August company reporting season has just wrapped up. This is the time when those ASX companies that have a June or December balance date (about 80% of listed  companies) report their full year or half year earnings. It is a critical time, as they also share with the market an outlook of how they are faring and likely to fare. Here are my three top picks from reporting season.

1. CSL

CSL gets a gong because it is probably Australia’s best company. When the government owned Commonwealth Serum Laboratories was privatised and floated in 1994, investors paid the princely sum of $2.30 per share. A few years’ later, the shares were split into three which reduced the effective cost price to $0.77. Yesterday, the shares closed at $236.45,  meaning that investors in the original float have enjoyed a gain of over 30,000%.

Year-after-year, CSL has met or exceeded profit guidance, delivering sales growth in excess of 10% and profit growth even higher. Financial year 2019 was no different, with a profit of US$1,919m up 11.0% on FY18 and towards the higher end of earlier guidance of US$1,880m to US$1,950m. Adjusting for the impact of exchange rates, profit rose by 17% to US$2,015m. This came on the back of an increase in sales of 11%.

A highlight was CSL’s fairly bullish forecast for FY20 which was better than the market had been anticipating. Notwithstanding a change to its distribution arrangements of albumin in China (which will see CSL move to a direct distribution model rather than deal through third parties), CSL has guided for total sales growth of 6% (up 10% when adjusted for the change in China) and profit growth in the range of 7% to 10%. This translates to a NPAT for FY20 of US$2,050m to US$2,110m.

As befits a stock of this calibre, CSL is not cheap, particularly in relation to some of its global healthcare peers, trading on a forecast multiple of around 35 times FY20 earnings and 31 times forecast FY21 earnings. But it is Australia’s third largest stock by market capitalisation, the global leader in blood plasma products and one of the few large cap Aussie stocks with consistent double digit top line growth. The brokers, according to FN Arena, have a target price of $241.98 for CSL, about 2.3% higher than last night’s close of $236.45.

A core stock for portfolios. Buy in market weakness.

2. WiseTech Global (WTC)

Logistics software solutions provider, WiseTech Global (WTC) is now capitalized at over $11.0bn and is heading towards the top 50. WiseTech develops, sells and implements software solutions that enable logistics service providers to facilitate the movement and storage of goods and information, domestically and internationally.

With its CargoWise One software platform and other products, it provides solutions to more than 12,000 logistics organisations from 150 countries. 25 of the top 25 global freight forwarders use WiseTech’s solutions, as do 43 out of the top 50 global third party logistics providers.

Revenue for the year to 30 June surged by 57% to $348.3 million, well above the guidance range it had given in March of 47%–53% growth. EBITDA (earnings before interest, tax, depreciation and amortisation) rose 39% to $108.1m, while net profit rose by 32.7% to $54.1 million.

Looking ahead to FY20, WiseTech said that it expected revenue growth of 26% to 32% ($440m to $460m) and EBITDA growth of 34% to 42% ($145m to $153m).

WiseTech’s growth strategy is built on multiple drivers   greater usage by existing customer (more transactions, users and modules), new customers to the platform, stimulating the network effect, innovation and expansion of the global platform, and accelerating organic growth through acquisitions. It says that it can benefit from trade wars, Brexit and other geo-political uncertainties, as these just increase complexity in moving freight between borders and potentially drive the uptake of CargoWise.

The problem for investors is that WiseTech is super, super expensive. According to FN Arena, it is trading on a multiple of 126 times forecast FY20 earnings and 92 times forecast FY21 earnings. The consensus broker target price is $30.00 (individual broker targets range from a low of $26.69 to a high of $36.00), some 20% lower than last night’s close of $37.41.

As much as I would like to say it is a “buy”, I just can’t get there to pay these sort of multiples.

3. Nanosonics (NAN)

Shares in medical equipment company Nanosonics surged on the day it released its profit result, jumping from $4.90 to $6.50. Its major product is Trophon, automated technology for the disinfection of ultrasound probes. Nanosonics reported revenue growth of 39% to $84.3m and profit before tax of $16.1m, up 208% on the prior period.

The global installed base of Trophon grew by 18% to 20,930 units. North America accounts for about 90% of these, which Nanosonics estimates gives it a 46% market penetration. Potentially, this mean that there is an enormous opportunity for Nanosonics outside North America in Europe, the Middle East and Asia Pacific where their penetration is around 2% to 4%.

Nanosonics strategy is to establish Trophon as the “standard of care” for all semi-critical probes across hospital departments and private clinics, enter new markets (in FY20 Japan,  Denmark, Finland, Spain, Portugal and Switzerland) and an expanded product portfolio. In this regard, Nanosonics announced that it was targeting the “introduction of the next significant new product towards the end of FY20, subject to regulatory approval”. Nanosonics didn’t release any details about the product, but its description as “significant” got everyone quite excited.

The company says that the FY20 profit will be heavily weighted towards the second half as it accelerates its investment in growth (sales and marketing, new product launch readiness, corporate infrastructure expansion, business development and new product development).  Operating expenses are expected to jump from $49.2m in FY19 to $67m in FY20.

This hasn’t stopped the market from putting a “sky high” valuation on the company. According to FN Arena, the brokers have Nanosonics trading on a multipole of 130 times FY20 earnings and 84 times forecast FY21 earnings. Overall, valuations are a bit mixed, with Citi down at $4.40 a share and UBS at $7.25. The consensus target price is $5.93, about 10% lower than yesterday’s closing price of $6.57.

For the speculative part of the portfolio. High risk given the market’s current valuation, but on track record, a stock to consider buying.


Wesfarmers, brought to you by Bunnings

Thursday, August 29, 2019

Australia’s largest conglomerate, Wesfarmers, should probably consider changing its name to Bunnings. Following the divestiture of Coles, Bunnings accounts for 55% of Wesfarmers group EBIT and is driving earnings growth. As a standalone investment, it returns a staggering 50.5% on the capital Wesfarmers has invested.

On the back of total sales growth of 5.2% and store-on-store sales growth of 3.9%, Bunnings EBIT for the 2019 financial year rose by 8.1% from $1,504m to $1,626m. This helped Wesfarmers post EBIT from continuing operations of $2,974m, up 12.2% on 2018’s $2,650m. After tax, and including $3,171m of extraordinary gains realised on the sale of Coles and other assets, Wesfarmers reported a net profit of $5,510m for the full year.

Officeworks also starred, with sales up 7.6% and EBIT 7.1% to $167m. The Chemicals, Energy and Fertiliser division delivered an improved performance, due to higher sales and more favourable external conditions. EBIT rose by 14.2% to $438m.

Offsetting these performances were Industrials and Safety (EBIT down 27.1% to $86m due to challenges with Blackwoods) and the discount department store businesses, which have been consolidated into the Kmart group. Earnings decreased by 13.7% from $626m in FY18 to $540m in FY19.

Wesfarmers has stopped itemising the losses of the troubled Target business, the other part of the Kmart group. It did note that sales in Target stores continued to fall, down 1.5% for the year. Meanwhile, sales in Kmart branded stores rose by 1.5% but were flat on a comparable store basis.

Since taking over two years’ ago, Wesfarmers Managing Director Rob Scott has been repositioning the conglomerate. He has divested Homebase, the chain of UK home improvement stores that Wesfarmers tried to “Bunningsise” and failed. He has demerged the Coles supermarket, convenience store and liquor business, creating a separately listed ASX entity that Wesfarmers maintains a minority 15% stake in.

Other sales have included:

·      Wesfarmers 40% interest in the Bengalla JV thermal coal mine in the Hunter Valley for $860m. This completed Wesfarmers exit from coal mining (the sale of the Curragh mine was finalised in March 2018);

·      The Kmart Tyre and Autoservice business for $350m; and

·      A 13.2% indirect interest in Quadrant Energy for US$170m.

But as if wanting to lend support to the adage that it is “harder to acquire a business than sell a business”, Scott has struggled to find replacement assets. He dabbled with plans to buy troubled rare earths producer Lynas before launching a $776m bid for lithium miner Kidman Resources and spending $230m on buying online retailer Catch Group.

Catch is allegedly profitable and cash generative (Wesfarmers hasn’t provided details), while the market is starting to say that Scott has overpaid with his bid for Kidman. The deal is expected to be endorsed by Kidman’s shareholders when they meet next Thursday.

Organic growth has also alluded Scott, with gross capital expenditure decreasing by $80m in FY19 to $860m as Bunnings get close to saturation coverage in the Australian market, weak consumer spending hurts the discount department stores, and the industrials division battles a less favourable trading environment.

Scott’s investing in data and digital, including (according to Wesfarmers) a “step-change digital offer”. But translating this to material revenue growth could prove to be challenging.

So far, his report card reads something like: “easy to sell, hard to buy, and even harder to grow organically”.

What do the brokers say?

The brokers see Wesfarmers shares as being overvalued. “Rich” is the word Morgan Stanley uses to describe the current market valuation. According to FN Arena, the broker consensus target price is $35.08, some 10.7% lower than yesterday’s closing price of $39.28. Morgan Stanley is the most bearish at $32.00, while Macquarie is the most bullish at $37.50. There are 4 neutral recommendations and 3 sell recommendations, and no buy recommendation.

Following the profit result on Tuesday, several brokers revised upwards their target price, with the consensus rising from $33.11 to $35.08. This didn’t translate to an increase in forecast earnings, which brokers now expect to fall marginally to 166.1c per share for FY20 compared to an adjusted 171.5c in FY19. Ord Minnett (JP Morgan) described the earnings trajectory as “weak”. Others noted the lack of organic growth.

At the current price, Wesfarmers is trading on a multiple of 23.7 times forecast FY20 earnings and 22.7 times forecast FY21 earnings. The dividend is expected to drop to around $1.52 per share (the $2.78 paid in FY19 included a special dividend of $1.00 and five months of earnings from Coles), putting Wesfarmers on a prospective yield of 3.9% (fully franked).

The bottom line 

In the current climate, Wesfarmers is viewed as a relatively low risk stock with reasonably predictable earnings. While not typically labelled a “defensive”, it is starting to demonstrate some of these characteristics. This goes some way to explaining why it is trading on such a high multiple.

Take away Bunnings however, the conglomerate’s other business are considered by many to be in the “take it or leave it” category. Purchases of Kidman Resources and Catch are unlikely to change this assessment.

With Wesfarmers struggling to grow revenue and earnings, and the jury still out on Scott, the stock is expensive. Definitely not a buy, more a long term sell near $40, but at the same time, unlikely to fall away too far in the short term.


Is BHP the new yield stock?

Thursday, August 22, 2019

There is a very old saying in markets that goes never buy a resources company for yield. The wisdom of this was proved again just a few years back when BHP was forced by shareholders to abandon a hopelessly flawed “progressive dividend” policy established and championed by former Chairman Jac Nasser. Jac might have known something about motor cars but proved he knew nothing about running a mining company.

But under CEO Andrew Mackenzie’s tight and very disciplined reign, BHP has resumed paying very attractive dividends. This year, it has returned to shareholders US$17.1bn in cash through an off-market share buyback, special dividend of US$1.02 per share and higher ordinary dividends. In regard to the ordinary dividend, it announced on Tuesday a final dividend of US$0.78 per share, which took the full-year dividend to US$1.33 per share. This is approximately A$1.96 per share.

The ordinary dividend payout ratio this year is 74% of underlying attributable profit, well above BHP’s stated policy of a “minimum payout ratio of 50%”. For shareholders, BHP was yielding around 5.6% based on last night’s closing price of $35.25. This is fully franked, so it grosses up to a pretty attractive 7.9%.

BHP has been able to sustain a higher payout ratio than its target because it has become very disciplined on cash flow generation and expenditure. Net debt is down to US$9.2bn (from US$10.9bn a year earlier) giving BHP a gearing ratio of 15.1%, while capex is being tightly controlled at US$7.6bn. BHP says that its major growth projects are “on time and on budget”.

While BHP has avoided the temptation that many mining companies succumb to when the cash rolls in – making acquisitions at the top of the cycle at inflated prices – cash flow is still ultimately dependent on the commodity price cycle, the volume of production and the cost of production. BHP has absolutely no control over the former – it is a price-taker, and limited control over the latter.

Despite times being good in the iron ore market, thanks mainly to the disruption in supply following the tragic collapse of a tailings dam operated by Brazilian competitor Vale and Chinese demand for steel remaining robust, cash flow from operations actually fell marginally from US$17.6bn to US$17.4bn. Softness in copper prices, and “negative productivity” of US$1.0bn from “weather, resource headwinds and unplanned outages”  impacted cash flow.

Looking ahead to 2020, BHP seems reasonably optimistic. Noting that global growth is expected to slow from 3.75% to around 3.25% and the trade headwinds, they expect the iron ore price to normalise, but with differentiation for higher quality product. They are a little more optimistic on copper, saying the underlying fundamentals remain sound and that “copper demand should grow steadily”.

What do the brokers say?

The brokers thought that Tuesday’s profit result was largely in line, although the underlying  profit of US$9.1bn was a touch less than some had forecast. Others were also disappointed that BHP didn’t declare a special dividend.

In the main, the brokers think that BHP is in pretty good financial shape. Mackenzie and his team are progressing a manageable set of growth options, there is a strong focus on capital returns, and BHP is working hard to drive down the cost of production and improve efficiency.

For FY20, the brokers currently see the dividend rising to US$1.54 per share (A$2.26), before falling back to US$1.26 (A$1.86) in FY21.

According to FN Arena, there is 1 buy recommendation and 6 neutral recommendations. The consensus target price sits at $38.69, 9.8% higher than the current price. While this is a reasonable gap, broker target prices for resource companies are notoriously unreliable as they are largely driven by the broker’s  forecast for commodity prices. It turns out that brokers aren’t much better than anyone else at forecasting commodity prices.

Individual recommendations and target prices are set out in the table below.

Bottom line

The adage about never buying resource companies for yield has stood the test of time and should be respected. That said, BHP is very well positioned to keep spinning off a heap of cash and the likelihood is that BHP will pay some handsome dividends in the years ahead. 

While I don’t think that this is the time in the cycle to be loading up on BHP, I also don’t think this is the time to be bailing out. My track record on forecasting commodity prices is as good as the next persons’ (pretty hopeless), so I am putting this to one side. Rather, I think BHP is doing most things right and for that reason, will remain a core stock in my portfolio.


Is CSL Australia’s best ever company?

Thursday, August 15, 2019

When the government-owned Commonwealth Serum Laboratories was privatised and floated in 1994, investors paid the princely sum of $2.30 per share. A few years’ later, the shares were split into three, which reduced the effective cost price to $0.77. Yesterday, after the release of its full year profit report, CSL shares closed at $234.00. For investors in the original float, they have enjoyed a gain of 30,000%!

I can’t think of any other ASX-listed company that can boast that sort of performance for its shareholders. Maybe Mike Cannon-Brookes and Scott Farquhar’s NASDAQ listed Atlassian has matched it in recent years, but locally at least, CSL is the clear stand-out.

Year after year, CSL has met or exceeded profit guidance, delivering sales growth in excess of 10% and profit growth even higher. And for an Australian company where more than 91% of its revenue is earned outside Australia, that is a pretty remarkable story.

The other interesting think about CSL is that it makes so little “noise” in the community. The ultimate “quiet Australian”, the fact that it is Australia’s third largest company by market capitalisation, bigger than the ANZ, NAB or Westpac, is a surprise to many. Few have heard of the CEO, Paul Perreault, who keeps a low profile with the media.

CSL employs 25,000 people globally, with females representing 57% of the total employee base. It has been named in the Thompson Reuters Top 100 Global Diversity and Inclusion Index.

These are some of the factors that make CSL Australia’s best company, and some might say, best ever company. And as befits a great company, it delivered for shareholders again yesterday.

CSL’s full year profit of US$1,919m was up 11% on FY18 and towards the higher end of earlier guidance of US$1,880m to $1,950m. Adjusting for the impact of exchange rates, profit rose by 17% to $2,015m. This came on the back of an increase in sales of 11%.

The result reflected continued strong growth in CSL’s core immunoglobulin and albumin  therapies, high patient demand for specialty products Haegarda (sales up 61%) and Kcentra (sales up 14%) and strong profit growth from CSL’s influenza vaccine business Seqirus. CSL opened 30 new US blood plasma collection centres, a new research facility in Melbourne, and progressed phase III trials for CSL112 (a therapy that helps remove cholesterol from the arteries of patients following a cardiovascular event).

Profit was assisted by a lower corporate tax rate, and cashflow from operations was down 14% to US$1,644m as expenses and inventory rose. The final dividend of US$1 per share (approximately A$1.48) was also slightly lower than expected.

A highlight was CSL’s fairly bullish forecast for FY20, which was better than the market had been anticipating. Notwithstanding a change to its distribution arrangements of albumin in China (which will see CSL move to a direct distribution model rather than deal through third parties), CSL has guided for total sales growth of 6% (up 10% when adjusted for the change in China) and profit growth in the range of 7% to 10%. This translates to a NPAT for FY20 of $2,050m to $2,110m.

What do the brokers say?

Going into the result, the brokers were largely neutral on the stock. While all acknowledge the undoubted strength of the company and its fantastic track record, the stock is seen as expensive (particularly in comparison to its global healthcare peers), trading on a multiple of around 37.5 times FY19 earnings and 34 times prospective FY20 earnings. Additional concerns include CSL’s ability to continue to win market share in immunoglobulins, plus the impact of the distribution change in China.

According to FN Arena, there were 3 buy recommendation and 4 neutral recommendations.   The following table shows the recommendations and target prices for the major brokers.

On the back of CSL’s better than expected profit guidance for FY20, brokers are expected to revise their earnings estimates and target prices modestly higher in the coming days. However, CSL will most likely trade at a premium to the new consensus price.

Bottom line

There is nothing in this result that would give a shareholder in CSL a cause for concern and apart from profit taking, there is no reason to sell. Stick with the trend.

Despite the earnings multiple, CSL should be a core stock in investors’ portfolio. It is the best company in Australia, and in the listed environment, has no peer. If you don’t own it and are scared about the price, mark it down on the watchlist to buy next time the market has a blip down.


CommBank: get the razor gang to cut costs

Thursday, August 08, 2019

The market voted with its feet yesterday on Commonwealth Bank when on an otherwise up day, its shares fell by 1.4% to $78.70. This followed the release of a disappointing full-year profit report. The clear message from the investor community was that the bank needs to work harder, smarter and faster to take out cost.

The Bank missed at a headline level with cash NPAT of $8.5bn coming in $300m short of expectations and down 4.7% on FY18. More worryingly, the second half profit of $3.8bn was down 18% on the first half result of $4.7bn.

The second half contains three fewer days than the first half for the Bank to earn interest on loans, so it is always a more challenging half year. And there are other extenuating circumstances, including the cost of customer fee removals, the cost of customer remediation and the extra risk and compliance staff the Bank has hired. But even allowing for these items, revenue fell and costs rose - “negative jaws”! This is the antitheses of the Bank’s much championed “positive jaws” (revenue growing at a faster rate than expenses), which it has delivered year after year and is one of the key reasons that it has been able to command a premium price relative to its major bank competitors.

Last February, CommBank CEO Matt Comyn said that the bank was targeting “no absolute cost growth” and a cost to income ratio of 40%. But this half, costs soared by 13% and the cost to income ratio blew out to an incredible 49.8%.

In a world of flat lending volumes, compressed interest margins, and no willingness or ability to increase fees (in fact the opposite, fee refunds or rebates), it is very difficult for a bank to grow revenue. The only avenue to improve shareholder returns is to reduce costs or return capital. Until very recently, CommBank hasn’t been in a position to do the latter.

On its own productivity measures, the Bank is falling short. Operating income per employee fell from $591,876 in 2018 to $568,644 in 2019, a fall of 4.0%. Employment costs as a proportion of operating revenue hit a five year high at 24.2%. The harsh reality is that CommBank has too many staff, too many managers and some of them are getting paid too much. It is time for a razor gang to bring out the axe.

Some positives

There were some positives in the result. After falling by 0.05% in the first half, the net interest margin (NIM) remained stable in the second half at 2.10%. Looking ahead, the Bank said that the impact of the two rate cuts announced by the RBA in May and July, plus a technical accounting change, would reduce NIM by a further 0.05% . This is a little less than the market expected. Further, Comyn acknowledged that there was now a NIM “tailwind” arising from a fall in the spread between the 90 day bank bill rate and the RBA cash rate.

The Bank was able to make headway in the home loan market, growing at a rate 1.3 times the system growth rate. It put this down to its speed of decisioning and turnaround times. There was also a gain in transaction deposit balances, the latter up 9% over the year.

With the dividend, CommBank maintained its second half dividend of a fully franked $2.31 per share for a full year payment of $4.31, unchanged on 2018. The second half dividend will be fully “neutralised”, with the Bank buying back on market any shares issued through the dividend re-investment plan.

CommBank’s capital position is strong, with the CET1 (common equity tier 1) capital ratio of 10.7% above APRA’s “unquestionably strong” target of 10.5%. Post the completion of the sale of the asset management business CFSGAM in August and CommInsure later this year,  the CET1 ratio rises to 11.8%. With the changes mooted by the Reserve Bank of New Zealand expected to consume up to NZ$3.0bn of capital, this means that CommBank will have around $4bn to $6bn of surplus capital.

The Bank is explicitly flagging the return of the surplus capital to shareholders. Interestingly, an “off-market” buyback, which is particularly tax effective for SMSFs and other low rate taxpayers, looks to be on the cards. The Bank said: “potential future capital management initiatives……..could include forms of a capital return including an off-market share buyback”.

What do the brokers say?

Going into the result, the major brokers were negative on CommBank, viewing it as expensive compared to its major bank peers. They had CommBank trading on a multiple of around 16 times forecast earnings, compared to around 13 times for Westpac and the NAB and 12 times for the ANZ. According to FN Arena (see table below), there were 3 neutral recommendations and 4 sell recommendations from the major brokers, with no buy recommendations. The consensus target price was $73.11, 7.1% below yesterday’s closing price of $78.70.

There is nothing in this profit report to suggest that there will be material changes to the broker recommendations, with the earnings profile a little weaker than expected and the  capital position a little stronger. CommBank will continue to be viewed as expensive relative to its peers.

Bottom Line

Until CommBank gets its act together on costs, the market will struggle to ascribe it too much of a pricing premium. The prospect of a capital return will provide support, and with the dividend of $4.31 secure and delivering a yield of almost 5.5%, CommBank will remain attractive to yield buyers. But don’t expect it to outperform in a bull market.


Is there value in small and mid-caps?

Thursday, August 01, 2019

The share market might be hitting all-time highs, but investors in small and mid-cap stocks aren’t popping champagne corks. For the 12 months to 30 June, the market has returned 11.6%, including dividends. But for small caps, it is only a measly 1.9%. Midcaps are doing marginally better, with the Midcap 50 index (which covers the performance of stocks ranked 51st to 100th  in market capitalisation) up by 3.7%.

Normally, strong rallies on the share market are led by the cyclical stocks that get an earnings boost as economic conditions improve, turnover rises, and profits grow. These tend to be concentrated in the small and mid-cap parts of the market.

But the rally in calendar 2019, which sees the market up by 21% in price terms and almost 24% when dividends are included, has been driven by interest rates, iron ore and technology. The first two factors have played strongly to the fortunes of the top stocks.

Lower interest rates has been the most important factor. This started when the US Federal Reserve used the word “patience” on 20 December last year and expectations of three US interest rate increases turned into talk of two or three interest rate decreases. And our local Reserve Bank followed suit and cut interest rates in May and July due to concerns about the economy and unemployment. So called “bond proxy” or “interest defensive” stocks soared. These are stocks that have reasonably predictable and reliable earnings, usually independent of the economic cycle, and offer attractive yields in comparison to cash. These  include the likes of Transurban, Sydney Airport, Medibank, Woolworths, Coles, property trusts such as Dexus and Goodman and utilities such as APA.

BHP, Rio and Fortescue have also performed strongly following a surge in the iron ore price.  The latter hasn’t been on the back of an improving outlook for world growth and steel production, but rather due to a supply disruption to the world’s largest producer (the Brazilian miner Vale) after the collapse of a tailings dam in January.

And then there has been a huge rally in our local tech darlings – WiseTech, Appen, Afterpay, Altium and Xero (the so called WAAAX stocks). As our local market looks to reward growth and prices stocks on multiples of revenue, rather than multiples of earnings, some of these stocks are up by more than 100% in 2019. Our tech sector is now amongst the most expensive in the world, pushed by the relative paucity of local IT companies available to Australian fund managers to invest in.

2019 is proving to be a very strange year!

However, the longer term data shows that many years are “strange” and that “mean reversion” is the norm. This suggests that if one component or sector of the market does really well for a while, it will eventually have a period where it does poorly so that over the longer term, performance will cluster closely (i.e. revert to the mean).

The following table shows the performances of the different components and industry sectors that make up the ASX over the last 1 year, 3 years, 5 years and 10 years. The top 20 stocks, for example, have outperformed over the last 12 months, but underperformed over the last 5 years. As a group, they  did well in the first half of the decade, but not so well in the second half, meaning that the 10 year return (an average of 9.7%) is very close to the overall market’s 10.0% pa. The midcap 50, while having an off year in 18/19, is still the best performing component over 10 years at 11.0% pa.

Australian Sharemarket Total Returns to 30 June 19

Source: S&P Dow Jones

The same story with the industry sectors. With the exception of the energy sector, the returns over 10 years are clustered around 10% pa. There is more variability over the shorter periods, suggesting that mean reversion tends to apply.

It would be wrong to draw the conclusion that mean reversion will necessarily apply to the performances of the small caps and mid-caps.  However, there has been an improvement in the month of July relative to the top 20 stocks, and if the interest rate cuts and other stimulus measures work as the Reserve Bank hopes they will (boosting consumer confidence, consumer spending and in turn economic growth), some of our smaller companies will witness an improvement in trading conditions. If the market expects earnings to improve, share prices should rise.

Standing in the way of this could be Donald Trump and his trade war. But with a lower dollar, fiscal and monetary stimulus measures in place, and other parts of the market starting to look really expensive, a scenario that favours small and mid-cap stocks could be developing.

How can you play small or mid-caps?

It is hard for a private investor to play without a “managed position” due the challenges of building a diversified portfolio. An easy option is to consider index tracking exchange traded funds. Blackrock’s iShares has ISO, an ETF that tracks the Small Ordinaries Index (stocks ranked 101st to 300th by market capitalisation). Betashares has SMLL. There is also an ETF from VanEck which tracks the Midcap 50 index (MVE).

Theoretically, an active manager should be able to do well in this space because  companies are less well analysed and researched, and their buying or selling can have a bigger impact on the price. There is a plethora of managed funds in this area, as well as several listed investment companies. Two that aren’t trading at a significant premium to their NTA (net tangible asset value) are Mirrabooka (MIR) and WAM Microcap (WMI).   


BHP’s action on climate change

Thursday, July 25, 2019

Call me a cynic, but it is hard not to think that BHP’s investment to “address climate change”  isn’t much more than a carefully orchestrated public relations (PR) exercise. My antennae were immediately raised when the first thing I saw on BHP’s website was a slick, beautifully filmed 45 second video. They were raised further when I read the 400 word press release.

On Tuesday in London, BHP CEO Andrew Mackenzie announced a US$400m ‘Climate Investment Program’. To be spent over 5 years, the program will “scale up low carbon technologies critical to the decarbonisation of our operations. It will drive investment in nature based solutions and encourage further collective action on scope three emissions”. Scope three emissions are indirect and are generated by BHP’s customers as they transport, transform and use BHP’s coal, iron ore, copper and petroleum, and are 40 times higher than emissions from BHP’s own operations.

While US$400m sounds like a lot, over 5 years, it averages out at US$80m a year. In FY19, BHP spent around US$8,000m in capital expenditure on new mining projects and expansion of existing projects – so this investment in “climate” is about 1% of capex.

Mackenzie pointed to the work BHP is doing to drive action on the capture of carbon from industrial processes. They have been working with Peking University on carbon capture and storage technologies within the steel industry, joined Responsible Steel, a group of steelmakers aiming to reduce emissions from the sourcing and production of steel, and  invested in direct air capture through a US$6m equity investment in Carbon Engineering Limited. Yes, the Big Australian is playing in the big league!

To be fair to BHP, I have no doubt that Mackenzie (and I am sure many of his staff, management team and Board) are very, very concerned about the threat of global warming caused by an increase in CO2. As a producer of fossil fuels, BHP is indirectly responsible for the emission of millions of tonnes of CO2. They see the problem as a global challenge, requiring global action across several dimensions and involving multiple solutions. They want to help and play their part

And while this is a positive commitment and a step in the right direction, it really isn’t much that much more. Short on detail, lacking any specifics, and interestingly, not considered to be “material” by BHP itself. It chose to release the announcement as a press release, rather than to the ASX as a market announcement. Under its ASX continuing disclosure obligations, BHP is required to tell the market first of anything that could be considered to have a “material” impact on its share price.

If BHP was serious about taking action on climate change, the first action it would take would be to close or sell its energy coal businesses. While the BHP PR machine likes to pretend that it is just involved in the production of metallurgical coal (that is the coal used in  the production of iron and steel), BHP produces around 27.5m tonnes of energy or thermal coal (that’s the coal used by “big polluting” power stations) at its Mt Arthur open-cut coal mine in the Hunter Valley and at Cerrejón in Columbia.

One interesting aspect of the announcement was about strengthening the link between  emissions performance with executive remuneration. From 2021, BHP says that this link will be “clarified” to reinforce the strategic importance and responsibility of reducing emissions as a business. If done meaningfully, such that progress on emissions reduction impacts executive pay, this could play out well in the investor world where an increasing number of institutional fund managers are placing ESG (environmental, social and governance) issues at the top of their investment filter. For example, the world’s largest sovereign wealth fund, Norway’s Government Pension Fund Global, recently announced it will divest from a slew of coal companies and oil explorers and producers .

BHP’s announcement to address climate change received widespread coverage in the media, including the “climate change friendly” ABC, Fairfax and The Guardian. It will play well in the cities and will be a positive BHP’s brand and standing in the investor community. But unless there are some hard actions that follow, and meaningful investment dollars behind these actions, it will go the way of most PR announcements.


AMP: a falling knife or bargain buy?

Thursday, July 18, 2019

Two of the investment “truisms” are “every dog stock has its day” and “don’t catch a falling knife”. Investors are now looking at AMP, Australia’s once great and largest financial institution and asking which of these apply. Is it a buy or just leave it alone?

There is no doubt that AMP has been a “dog” of a stock. Right from its very first day as a listed company in 1998 following demutualisation – probably the most chaotic trading day in the ASX’s history – when AMP shares opened at an astonishing $36 (about $20 higher than anyone had expected), traded up to a high of $45, before closing at $23, it has been in this category. Failed investments in the UK (the purchase of Henderson and National Provident Insurance), the attempted takeover of GIO and then the merger with its once fierce rival, AXA Insurance (formerly National Mutual), before the final humiliation and disgrace at the Banking Royal Commission. A litany of mistakes, poor decisions and underperformance over the last two decades – an absolute dog (with due apologies to dogs).

And this continued on Monday when the AMP announced that the sale of its life insurance business to Resolute Life, a “buyer of last resort”, was unlikely to proceed. The regulator in New Zealand, the Reserve Bank of New Zealand, wouldn’t sign off on the deal unless Resolute agreed to hold separate “ringfenced” New Zealand assets against the New Zealand insurance liabilities. This made the deal unattractive to Resolute and they bailed on the transaction.

This means that AMP will either have to keep the capital intensive life business, increasing the likelihood of a capital raising and diverting management’s focus from AMP’s new strategy, or do another deal with Resolute. This would come at a much lower price, partly because of the cost of the ring-fencing, but also because AMP says that since the deal was done, valuation changes and the Government’s Protecting Your Super legislation (which bans insurance on inactive super accounts) have wiped about $700m from the value of the life business.

The irony is that prior to the announcement, a handful of fund managers had criticised the Resolute deal and were arguing that it shouldn’t go ahead without shareholder approval. They were silenced by the market reaction, with AMP’s share price tumbling to $1.80.

AMP also announced that it was abandoning any plans to pay an interim dividend.

What’s AMP worth?

That’s the $64 question. Looking at the brokers, they have a consensus target price of $1.97 (range of a low of $1.50 to a high of $2.35). See Table below.

Source: FNArena, as at 17 July 2020

That’s of course a 12-month share price target and is based on earnings from continuing operations. However, another scenario is that AMP is broken-up and key business units are sold.

These would include AMP Bank, with its 110,000 customers and $20bn in assets. In FY18, AMP Bank made a net profit after tax of $148m. Valuing this on a multiple of say 10 times earnings, this gives it a valuation of around $1.5bn or approx. $0.50 per share.

Then there is the investment management business, AMP Capital. As at 31 December 2018, it managed assets of $187bn and contributed $167m in after tax profit. Although it is being impacted by investor outflows due to “AMP brand damage”, the AMP Capital team is widely respected. This business could be worth another $0.50 to $1.00 per share.  

The sale of the legacy life business to Resolute was originally priced at $3.3bn. Only $1.9bn of this was in cash, with Resolute making a $300m capital contribution and providing a further $1.1bn in non-cash consideration (mainly an upside for AMP of future earnings). Taking away the $700m diminution in value and other factors, the life business is possibly worth around $2bn – about $0.70 per share.

AMP has a NZ wealth management and advice business (which boast operating earnings of A$40m) that is slated to be sold via an IPO, and of course, the Australian wealth management and advice business with its thousands of financial planners, affiliated licensees and hundreds of thousands of clients. Who knows what this is worth, or what parts are even saleable?

Putting these together, a “break-up” of the parts valuation is north of $2.

Importantly, AMP hasn’t made any decision to go down this path (apart from the sale of the life business). But it is not hard to foresee a scenario where through growing market pressure, the Board is forced to confront this option. If the share price stays under $2, the calls will get louder.

What do the brokers say?

The major brokers aren’t enthusiastic about AMP, with only ‘neutral’ and ‘sell’ recommendations (see Table above). A number see risks “tilted to the downside”.

The main concerns centre around the possibility of a capital raising, increased advice remediation provisions, further delays to the “turnaround story” and a capital intensive and less agile life business diverting management’s focus from re-shaping the wealth division.

There aren’t too many upsides mentioned.

My view

I would like to say that the AMP is a “buy”, but I am not convinced the knife has stopped falling. Firstly, AMP hasn’t bounced quickly away from $1.80, which suggests there is institutional selling meeting retail bargain hunters. Secondly, I just don’t buy the story that AMP’s Australian wealth management business can be readily “turned-around”. Unless AMP can develop a market leading customer proposition or pricing offer, the crisis caused by “loss of trust” could be irreversible and terminal. Finally, I just have a sneaky feeling that we might see $1.50 before we get back to $2.

If the market starts to talk about a break-up and the AMP Board embraces the thought, it could be a different story.



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