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Michael Kodari
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+ About Michael Kodari

Michael Kodari is the founder of KOSEC – Kodari Securities, and one of Australia’s prominent experts in the stock market. With a strong background in funds management and stockbroking, Michael has worked with some of Australia’s most successful value investors and consulted to leading financial institutions. Michael writes for Australia’s key financial publications and is one of the nation’s most consistent, top performing investors. He has been referred to as ‘the brightest 21st century entrepreneur in wealth management' and ‘a trailblazer within the Australian stock market’, CNBC Asia.

Trump and the Rooster

Friday, February 24, 2017

By Michael Kodari

There is the old line that there are only two guarantees in life, death and taxes. In the auditions to be added as the third guarantee I would argue that change would poll pretty well, with 2017 being a pretty good demonstration of this theory. The changes are all around us, be it new restaurants, better technology or the latest fashion trend. In my line of work we make money from change, anticipating where money will flow and how to aim to be one step ahead so we can allocate capital to harness these movements. We look at new items on a balance sheet, alterations in a PE ratio and the latest dip in a moving average on a chart, all the conventional images of stockbroking. We also look at the big picture, the macroeconomic environment in which we operate, and that begins with the geopolitical terrain in which we find ourselves. Indeed it is this shifting ground that I find particularly fascinating, especially as we see relations between China and the US entering unchartered territory. This new calendar year started with the inauguration of Donald Trump in whose unorthodox take on diplomacy we have all been captivated, amused and appalled depending on your outlook. With his inclination towards bombastic social media posts it is possible to feel we are only ever 140 characters away from the next bout of intrigue. When castigating domestic firms, for example defence contractors like Lockheed Martin, companies that are beneficiaries of huge Federal contracts, Trump may or not be in his rights to let his tweets influence outcomes faster than Congress can. But when it comes to international relations, with all its nuance, delicacy and challenge of interpretation, there is a fear that Trump’s twitter account is not the perfect platform to influence the change the world wants.

Alongside the abrupt tweets, there is also an ideological change emanating from Washington. Trump has delivered on his campaign initiative to renege on the Trans Pacific Partnership as the USA increasingly looks inward and away from free trade. This has caught Australia and indeed the region in a slight bind, is it worth proceeding with the agreement without the world’s largest economy? In a neat embodiment of the increasingly insular approach from the Trump Administration was the complete boycott of the January World Economic Forum meeting at Davos this year. Under Trump’s stewardship, not one official representation was made by his team, not one White House aide nor Congressman was willing or able to appear and demonstrate their support for international understanding, cooperation and trade.

As the USA rescinds its role in international affairs, that baton will be passed onto other nations. As the saying goes, nature abhors a vacuum. That it what Xi Jinping, Communist leader of China, said making Beijing’s inaugural appearance at Davos, who most obviously replaced Trump and the USA in advocating closer economic ties is remarkable. Such has been the ascendancy of Chinese economic and diplomatic strength that it is now towards Xi Jinping that the international community looks for guidance. The message from Beijing was clear, the world is richer, literally and metaphorically, from an interlinked global marketplace and that we must work hard to protect it. The world is also a fairer and more enlightened place by communicating and trading, that an inward approach precipitates ignorance and fear.

The role reversal we are living through is perhaps the most intriguing change in Australia’s recent history. The US was once a stabilising force for peace and trade in the region, an old and trusted ally. Now the Trump administration, with its “Death by China” hawk in Navarro, Washington is tearing up trade agreements, ignoring summits and talking about currency manipulation across Berlin, Tokyo and Beijing. It is also railing against military installations in the South China Sea and fraternising with Taiwan in a fashion not seen since pre-Nixon. On the flipside, it is China that is looking to salvage a trade deal which will unite the nations on the edge of the Pacific.

Another challenge is the pace of the change we are living in is the extent to which events can move on rapidly, such that framing a narrative can be challenging. Having done so much to complicate relations with Beijing, Trump has recently moved to soothe the situation, penning a private letter to Chairman Xi, espousing the desire for a new accord. This worked wonders to calm equities markets but there is the feeling that this is far from the last instalment of the drama. Whilst Trump sent his best wishes to all in China as the New Year of the Rooster began, there was a feeling that this was a little too late, that maybe the change in the geopolitical system has already begun.

So as Trump disrupts the paradigm in the year of the Rooster, Australia must choose how to align itself in this topsy-turvy framework. Perhaps it is time for Turnbull and his team to carve out a new place for the nation so we can pre-empt rather than react to regional events. Perhaps local concerns, be they big or small, are best resolved by local participants that have a clear vested interest in workable solutions. With so many Australian exports destined for China, perhaps there is logic to the notion of finding new agreements to facilitate and promote further trade, tourism and migration. Perhaps 2017 will see unprecedented changes on these and other fronts, for increasingly it looks like change is one of life’s few guarantees! 

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Decision time in Europe

Friday, February 17, 2017

By Michael Kodari

Great investing involves a blend of insights across price action, business fundamentals and macroeconomic analysis. 2017 looks to be one of the most interesting years on a geopolitical level in quite some time. A lot of attention will be directed towards Washington and the evolving experiment that is Donald Trump as a statesman. Likewise, Sino-American relations will be of intrigue. But perhaps the most fraught international dialogue will be found in the Old World.

If you look across Europe, you see quite disparate performances and challenges, from Germany’s recent record trade surplus of 252.9bn euros, to chronic youth unemployment in Portugal and Spain. One might argue that it is this inherent heterogeneity of outcomes that makes the Eurozone project so intriguing. How do you regulate inflation, unemployment and levels of debt in structurally diverse economies under one currency and one monetary policy? One argument from a leading proponent of this – Emanuel Macron – is to forge closer links that logically culminate in fiscal harmony. The opposite approach, or the British answer, was to firstly not join the Euro and then decide it no longer wants to be a part of the EU at all. The middle path, that of a reformed EU which is more responsive to distinct national concerns, falls within the ideology of Francois Fillon. One way or another, we will see the European nations answering this riddle during a series of general elections.

Decision One: Netherlands

The first election off the blocks this year will be held on March 16 in the Kingdom of the Netherlands. Here, the Dutch electorate will choose between 31 different parties that will proportionately represent the single constituency that is the Netherlands. Such choice creates a diverse spread of results, which traditionally negates any one party holding a natural majority. So, by default, Holland tends to be governed by a series of coalitions which oscillate in their constituent members and shelf life. The current Coalition is led by Mark Rutte of the VVD, an approximate equivalent of Malcolm Turnbull’s Liberal Coalition here in Australia. The most popular party in the Netherlands, based on current polls, is the PVV: an anti-immigration, anti-Islam, anti-EU organisation led by Geert Wilders, who some might say is the Dutch Donald Trump. At present, Rutte has said he will not form a coalition with the PVV (he has tried that before and found Wilder’s views unpalatable) but there is the possibility that elements of the VVD will try to manoeuvre a new leader so they can form a government alongside the PVV. The hot themes within each campaign appear to be ‘identity’: what it means to be Dutch, and what the Dutch want from the EU, with the most popular party at present proposing that the Netherlands should leave the Union.

Decisions Two and Three: France and Germany

The biggest two nations in the EU by population and GDP are France and Germany and both nations also have elections this year. France will be first, and their electoral system tends towards an initial vote and then a subsequent runoff between the two most popular candidates. Macron, a young, dashing and inexperienced exile from the French Socialists represents his own En Marche! Party that wants greater powers for the EU. Francois Fillon, embroiled in a nepotism scandal, represents the Republicans and a reformed EU. The most controversial candidate is the National Front’s Le Pen, an anti-EU, anti-immigration populist. As with the Netherlands, the future of the EU and the Euro is likely to be the key issue, and as with Trump in the States and Brexit in the UK, it is interesting to wonder if there are silent Le Pen supporters not declaring their true intentions.

Once the populist sentiment has been gauged across the Netherlands and France, there will be the elections in Germany this September. Germany benefits a great deal from the current EU framework, not least of all the captive market for its exports, and the lower currency value the Euro represents over what a distinct German unit of currency would likely trade at.

Peter Navarro, Trump’s hawkish advisor, has already made this point, and how long it can continue will be interesting. The benefit of the Euro is manifest. The downside of the arrangement is that Germany needs to encourage other nations to stay with the Euro when they might otherwise logically want to leave, the most obvious form of influence being substantial loans. Nations such as Portugal, Italy, Greece and Spain all hold heavy debt, inclement unemployment and limited wage growth. Greek debt has reached substantial levels, 179% of GDP, and there is a real concern that they cannot make their next repayment due mid-year. The IMF are split over what annual budget surplus is possible, and might even want to leave the EU to resolve it among themselves (an outcome the Germans are treating as a political hot potato ahead of their own general election). With German unemployment at 3.8%, trade at record levels, and inflation travelling nicely at 1.9%, the only cloud on the horizon is how long the EU can limp on in its current form. 

As the member states wrestle with existential questions about the destiny and composition of the EU, across the English Channel lies the ongoing experiment with what it means to leave the EU. The UK has seen the GBP tumble, which is helping exports, making the FTSE increasingly attractive, and now sees unemployment at a palatable 4.8%. Current growth is only 0.6%, but if the UK seeks to reduce corporate tax in order to make it a hospitable environment for big firms to do business, it could lead to an increasingly bright future for the first ever country to leave the EU. 

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Pay close attention this earnings season

Friday, February 10, 2017

By Michael Kodari

In early December 2016, we penned an article for Switzer Daily called The Great Rotation, essentially covering what was a clear and discernible trend in markets away from high P/E and high growth ‘quality’ businesses, towards more cyclical and previously under-owned businesses. We had witnessed a shift in investor sentiment and indiscriminate selling pressure on high-quality names. At the time the question was posed: would that selling pressure persist?

Healthcare makes a comeback

We’re just over one month into the new year so I thought we could reflect back on what occurred and determine whether these themes have in fact persisted. At first glance, perhaps the most interesting observation to make is that the worst performing sector from that period (October 2016 to December 2016) – the healthcare sector – has had a true return to form.

The healthcare sector – with its high P/E’s and its strong multi-year performance – was the sacrificial lamb for many fund managers as they looked to free up cash that could be redistributed towards the chronically underweight materials and energy sectors. Interestingly, the healthcare sector is the best performing sector on the ASX by some way in 2017, admittedly benefiting from the strong news-flow coming from the likes of CSL and ResMed (RMD).

The Materials sector continues to outperform most of its peers as commodity prices hold up as investors clamour at the prospect for strong dividends and EPS capital management from cashed-up mining companies. Energy businesses haven’t fared as well, losing some appeal in the face of increasing US oil output and rising rig counts.

The Real Estate Investment Trust’s (REIT’s) remain under pressure, as increased prospects for higher bond yields globally have investors deserting the yield proxies that had performed so well for so long in the era of record low interest rates. Another sector with ongoing struggles is the consumer discretionary space, a sector that includes some of Australia’s most well-known retail brands. Although the sector is a rather broad church and some speciality retailers have been performing admirably, broadly speaking low wage growth and rocketing house prices appears to have constrained the consumer’s spending habits.

Outlook for earnings season: Materials sector to shine

Looking forward and the half-yearly earnings season is underway, with the number of company half-year reports ramping up from next week. It’s these reports that can assist investors with forming views on the outlook for the market and the economic sectors that make-up the index. Ultimately, it’s earnings growth that is required to underpin company and market valuations, and 2017 is expected to be a promising year on that front. The ASX is expected to deliver in excess of 15% earnings growth (EPS) for the FY17, following two consecutive years of negative growth.

It is the Materials sector that is expected to shine the brightest, turning the corner with 150% EPS growth across the sector. To avoid inflating the figures, perhaps in this instance a better measure is to look at the EPS growth of the market excluding the materials sector. Even with the exclusion of the materials sector, the market is expected to deliver impressive EPS growth of 5% plus.

On a trailing P/E basis, the market doesn’t appear ostensibly cheap, trading on a P/E of 19. However, once the expected EPS growth is accounted for the forward P/E, market falls to a more reasonable 15.5 level, not too far above the long term average.

One lesson that has been reinforced in recent times is that a disconnect between asset prices and economic fundamentals can exist and persist for a period. However, over time one of two things needs to occur:

1) Fundamentals change to reflect sentiment

2) Asset prices and sentiment shift to reflect company fundamentals

So far this earnings season, we’ve seen signs of option two occurring, particularly with some unloved and arguably harshly treated names such and CSL, Carsales.Com (CAR), Transurban Group (TCL) and Premier Investments (PMV). Sentiment towards these businesses and their sectors in general had been largely negative in the lead up to 2017. Yet, when the 1HY earnings where divulged, the true litmus test, their share prices recovered swiftly to reflect a fundamentally more attractive picture than the sentiment would’ve led you to believe.

As we lead into the bulk of reporting season, we feel that the potential disconnect between company sentiment in the lead up to reports, and the subsequent business earnings and fundamentals, will be something worth paying close attention to.

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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3 ways to be the Federer of investing

Friday, February 03, 2017

By Michael Kodari

I believe many of our readers will agree that the highlight of 2017 thus far was the glorious Australian Open, the happy tournament, which reached such a storybook ending with the dream final of Nadal vs Federer. I was lucky enough to attend the final and I’m sure many people went back to work this week inspired by it all, not least of all the performance of the hero of the hour, Roger Federer.

One of the reasons Rolex, Moet & Chandon and Gillette pay huge endorsements to the almost regal Roger is because they want to frame themselves as the “Federer of watches/champagne/razors”. His record of style, success and humility have made him a global superstar and I thought we’d have some fun and speculate as to how we could all try and be the “Federer of investing this February”.

1. Health

Winning your 18th Major at 35 years of age is testimony to not only impressive determination but also to methodical preparation, recuperation and holistic wellbeing. Not only does Federer want to be in peak condition but I’m hoping you too want that for your portfolio. Perhaps there's no better area to look for value on the ASX than the healthcare sector. The well documented sector rotation out of the space and into resources has created an opportunity to pick up a number of healthcare stocks at potentially good value.

My top recommendation in the sector is Healthscope (ASX code: HSO) – the second largest private hospital providers in the nation and an organisation with a number of new sites on the near horizon ready to augment their portfolio. Healthscope reported that they experienced a soft September in 2016, and the market dealt the share price a harsh double fault. But there is every chance that this one month was closer to being an anomaly than a trend and given the long-term thematics of the ageing population and the public sector being more expensive per bed, I would not be surprised if the report on February 22 has better news for the shareholders of this high-quality business. 

2. Consistency

One of the qualities that sets Federer apart is the extent to which he can replicate his excellence point after point, set after set, tournament after tournament. Many professionals can have good months but it takes greatness to have a good year, and only legends go on to have a good era. In your portfolio, you’ll want to have a number of stocks which you can rely on, those steady performers that produce good report after good report and produce that capital growth which can compound year after year.

One stock code I feel fits this bill and is well worth your attention is CGF, that of Challenger Limited. Operating in the retail annuity market, Challenger is the outright market leader with close to 70% market share. As Australia’s fit and healthy baby boomers approach retirement, they are increasingly attracted to the benefits of holding an annuity, especially given the possibility that they might enjoy a particularly long retirement by historical standards. While capital growth assets such as property are very popular as a means to prepare for retirement, there is no guarantee that this boom will go on forever and increasingly a number of financial planners are taking heed of the Murray Financial Services Inquiry to flag the virtue of a good income play like annuities.

Like Federer’s forehand, a number of domestic retirees will want an income that is steady, reliable and that can last for a couple of decades. In that event, Challenger are set to serve up the highest number of annuities in the market and with its modest dividend and prohibitive PE ratio, perhaps adding CGF to your portfolio before February 14 could be an ace decision!

3. Innovation

When Federer first broke onto the circuit, he was an aggressive serve-and-volley specialist who used power to unsettle his opponents. As he matured, he adapted his game by creating his own hybrid understanding of a baseline game that stills allows room for the odd net charge. No-one else plays the game in quite the same way as Roger and it is, in part, this progression which has allowed him to dominate his sport for so long. In order to potentially outperform the market, the professional stock picker is looking to harness the timely acquisition of growth stocks that have something innovative and clever to add to the market.

The stock I think is most likely to match this requirement this month is software disruptor Altium (stock code: ALU). With leading product ‘Altium Designer’, ALU produce the software that technology firms use to design plastic circuit boards. Given that plastic circuit boards (PCBS) are found in everything from smartphones to TVs to the modern sports car, you can readily imagine that there is significant demand for Altium’s services. Not only are these goods naturally in short product life cycles with fast turnaround of the latest models, they are also increasingly likely to be impacted by the advent of the ‘Internet of Things’. This trend is likely to see a number of household items and white goods talking to one another (e.g. your thermostat synchronising with your smartphone and your car to seamlessly adjust the heat when you are nearly home) so we feel Altium is likely to add even greater numbers of customers over the medium term.

With their report due on February 15, we feel they are an agile innovator just like our Swiss tennis hero and we hope these recommendations will help you smash reporting season!

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Taking the pulse of the healthcare sector

Friday, January 27, 2017

By Michael Kodari

After reaching an all-time high of 23,008 in June, the healthcare sector was subject to a vicious sell off in the second half of 2016, declining in the vicinity of 18% from its high. To give the declines some perspective, the healthcare sector declined 25% during the 2008-09 GFC period.

In recent weeks, we’ve seen the healthcare sector bounce back strongly, albeit still a long way from previous highs. Off the back of strong earnings upgrades and results from CSL and ResMed, the sector has actually been the best performing sector on the ASX since Christmas 2016. We remain confident that over the medium term, the healthcare sector will not only rebound strongly, but will continue to grow based on underlying structural shifts that will see the number of people over 65 years old double over the next 15 years.

Australia has an aging population which will provide tailwinds for decades to come. The combination of low fertility rates and increasing life expectancy is growing the proportion of those who are aged 65 and over. Naturally, as we age as a population, we require greater care, fuelling the demand for surgeries, hospital beds and pathology services contributing a disproportionate amount to healthcare spending.

With the population demographic aging, demand and reliance on the healthcare sector will continue to grow in the coming years. The healthcare industry encompasses two broad subgroups:

1) Healthcare equipment and services

2) Pharmaceuticals, biotechnology and life sciences

Think Ramsay Healthcare and CSL Limited respectively. The healthcare industry is evolving, once an industry dominated by the cumbersome bureaucracy of government, the industry has modernised with the advent of modern enterprises into the sector. To prove the point, Commonwealth Serum Laboratories, or CSL Limited, was privatised in 1994 for great success, while a company of the likes of Ramsay Healthcare has emerged as a leading private hospital operator in a field once the domain of governments.

Other broad trends that stand to benefit investors in the sector include greater doctor-patient interaction and exponentially increasing healthcare spending globally. Annual doctor visits are increasing, along with awareness for many diseases and medical disorders. In many instances, doctors are now able to diagnose a greater portion of suffers. Take sleep apnoea for example. It is believed the condition affects 12 million Americans, while to date, fewer than four million have actually been diagnosed. With greater awareness and increasing diagnosis, this stands to benefit those businesses aligned to the space immensely, provided they are well run and high quality organisations such as a ResMed (RMD) or Fisher & Paykel Healthcare (FPH).

When it comes to healthcare, the macroeconomic benefits aren’t limited to the developed world. While developed nations manage aging populations, emerging nations with their burgeoning middle classes and improving living standards offer an additional tailwind. Research by Hear-It AISL has estimated that over 250 million people worldwide suffer from a hearing loss that a Cochlear hearing implant has the capacity to treat. Of these people, it’s believed that only 20-30 million people can actually afford the hearing systems, with less than 5% of those having received an implant. Once again, the enormity of the market is evident.

Healthcare typically accounts for greater than 10% of government GDP in developed nations, with the figure increasing. For example, US spending is pushing 20%. Generally speaking, populations with established middle classes, poor health habits and hopes of living forever have the monetary means to spur on the health sector for many years to come. 

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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5 leadership lessons from Sir Alex Ferguson

Friday, January 20, 2017

By Michael Kodari

As we look ahead to an eventful 2017 with its French elections, Brexit, the Dow pushing for 20,000 points, and of course, Donald Trump, there are lots of exogenous events which have the capacity to influence the ASX. When it comes to endogenous change, perhaps the first theme to emerge in 2017 might be that of management overhauls across the index.

I gather my friend Peter Switzer has been reading up on Sir Alex Ferguson, the Scottish soccer coach who established 26 years of success at Manchester United, and I too would wholeheartedly recommend his collaboration “Leading” with Michael Moritz, the Chairman of Sequoia Capital.

Having dominated his sport for a generation, Sir Alex is now using his experiences as a sounding board for leaders around the world, including his link-up with Harvard Business School, so let's explore if there are any pointers he would have for the business community here in Australia.

1. Be consistent in imposing discipline

Sir Alex felt it was essential that any organisation had faultless discipline and that this culture must come from the top. We live in an age of transparency and increasing media scrutiny, so any CEO with their salt will need to act with a lot of integrity in 2017 and beyond. It simply won’t do to blindly hope that the Board, the media and ASIC will overlook anything questionable, and in that vein, one of the first casualties of the new year was Gilman Wong, former CEO of Sirtex (SRX). The Sirtex Board conducted an investigation into the sale of personal shares in his own company by their former CEO, and elected to immediately terminate Mr Wong’s employment on 13 January. 

2. Embrace your entire team

Manchester United are a global brand within soccer, employing a catholic spectrum of coaches, sports scientists, millionaire sportsmen and tea ladies. Sir Alex took the view that you should treat everyone the same: “You must recognise that people are working for you. Knowing their names, saying good morning in the morning is critical”. Such similar counsel might be of value to new Crown Resorts (CWN) Chairman, John Alexander, who this year steps up to replace Rob Rankin. This well-diversified business will refocus their attentions within Australia this year and will hope that, with the right morale across the organisation, they can succeed domestically where they struggled in places like Macau.

3. Firing is hard

Sport, like business, has highs and lows, winners and losers and even the top performers find it hard to stay at the top of their game forever. Sir Alex Ferguson had to move on legends of the game like Roy Keane, David Beckham and even Mark Bosnich, and always had to juggle the emotional challenge with business needs. Perhaps for Bellamys (BAL) there was this dilemma of replacing the CEO, Laura McBain, who had done so much to put this formerly small business on the map. After a long period of self-imposed halted trading, Bellamys returned to the ASX this year and replaced McBain with former Bain & Co consultant, Andrew Cohen, among a raft of news and changes. As a business, Bellamys faces a testing 2017 with limited cash reserves and a large inventory, so we wish Mr Cohen well and hope for their beleaguered shareholders that firing Laura McBain was the right move. 

4. Think long term

As a sports manager, your performance is constantly in the public domain, and in many ways, very similar to a CEO that can choose to follow their share price on a daily basis. In this area, Ferguson took the view that if he worried about each result, he would never buy himself the time to implement the changes he felt were necessary. So, taking a long term approach has its merits, and in this sense, perhaps a good example of a firm managing its management changes can be found at Carsales.com (CAR). After 20 years at the business, Greg Roebuck has decided to step down in march 2017 and is going to spend his last eight weeks helping with the transition for new CEO, Cameron McIntyre. Cameron McIntyre is himself a Carsales.com veteran having joined in 2007, and most recently held the position of COO. 

5. Ask good questions

Finally, leaders need to ask good questions of the people they employ. Sir Alex is quoted as saying “I often get a measure of someone by listening to the questions they pose. It shows how they think, offers a sense of their level of experience and degree of maturity.” In this domain, a classic example of interviewing comes from the appointment of Peter Gregg by Primary Healthcare back in February 2015 (PRY). At this juncture, Mr Gregg alerted the Board to the notion that there investigations into his period of employment with Leighton (now CIMIC). Primary Healthcare were happy to proceed with his appointment at this juncture, but some 20 months or so on from this, time ASIC have decided to prosecute Mr Gregg on two charges of falsifying documents. With this court case looming over him, the inevitable decision to resign was triggered and now PRY will be looking for a new CEO. Perhaps Primary Healthcare will look back and wonder of they asked all the right questions before that appointment. 

So, as 2017 unfolds, it already looks possible that the role of the CEO will be a key theme in share price performance, and to that end, perhaps we can all learn a little from leadership innovators like Sir Alex Ferguson. 

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The US economic outlook

Friday, January 13, 2017

By Michael Kodari

The US employment market delivered another strong performance to finish 2016 on a high. According to Bloomberg, it was the sixth year in succession where the economy added in excess of 2 million jobs. The economy added 156,000 jobs in December, below the forecast 175,000, while the unemployment rate rose to 4.7%.

On the face of it, the headline figures appeared to underwhelm, nevertheless, it was pleasing to see the figures for November revised higher. At 4.7% unemployment, many would argue that the US is very close to full employment – a state of affairs that may be contributing to the softness in the payrolls data.

It appears that there’s insufficient supply of labour for jobs requiring managerial and specialised skillsets and as such, particular rolls are difficult to fill. It is our view that this theme is being illustrated in the divergence between wage growth and employment growth.

Wage growth

In December, overall wage growth hit the highest level since 2009, rising by 2.9%. That could support consumer spending, stoke inflationary pressures and ultimately lead the Federal Reserve to tighten monetary conditions and increase interest rates faster than expected. It was therefore unsurprising to see US treasuries and the US dollar respond in kind, rallying strongly on the back of the data.

Americans aged 25-34

Also of note was the ongoing decline in the number of Americans aged 25 to 34 not working, a figure that fell below 22% for the first time since 2008. This is encouraging given it’s an age bracket that’s particularly supportive of household formation, which, in turn, could lead to positive developments for residential markets, credit growth and auto sales.

An interesting observation made by Goldman Sachs is the recent uptick in the prime-age rate of employment, driven by improvements in the number of disabled workers now more able to work, and many wilfully unemployed persons reassessing their vocational status.

To put it politely, such changes of heart come in light of improved job prospects, work tasks and remuneration where the “overall” benefits begin to outweigh those offered by welfare and disability services.

Areas for concern

Despite the positive indicators, there are a number of areas of concern. Headline wage growth is being impacted by the fact that retiring workers tend to be older and more highly paid workers, whom are typically replaced by younger and less highly paid workers. This is a structural trend that is unlikely to subside anytime soon in an economy with an aging work force.

From a longer term perspective, the ratio of active to retired workers in the US continues to fall indicating a greater number of retirees reliant on less workers which is of particular concern in a environment where debt to GDP is rising. Despite sentiments to the contrary, it is evident from this that the US will need to look at an effective immigration policy to avoid following a similar path taken by Japan.

Optimism over the short term

Refocusing on the shorter term and there are a number of indicators that leave us optimistic for ongoing strength in the US economy. Despite a strong employment market and improving wages, the US economy has remained fairly subdued. Part of the reason for the fairly slow recovery can be put down to the deleveraging of the US consumer which has seen consumers pay down household debts and increase their savings rate.

Additionally, the wealth effect brought about by rising asset prices, whether it be property or equities, places the consumer in a strong position. As it stands, the increase in the savings rate has been pronounced. As confidence builds, it’s conceivable that those savings will be deployed, leading to a pick in household consumption where its significance can’t be understated for an economy that relies on household consumption for close to 70% of its GDP growth.

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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3 important investment lessons from 2016

Friday, December 16, 2016

By Michael Kodari

If I were to picture our readers in this last fortnight of 2016, I would conjure up an image of festive cheer and good times with family friends. Whether it be on the golf course, at the beach, or on the yacht, now is a time for relaxation, enjoyment and perhaps a touch of recalibration. Whether we are taking stock of our personal achievements, family endeavours, or our investment portfolios, the end of one year and the dawn of the next is always a logical time to review, analyse and evaluate. And on the global economic front, what a year 2016 has been.

Domestically, we have seen the election of Malcolm Turnbull by the most slender of margins. Australia has moved away somewhat from a two party duopoly, and now has a number of minor parties that hold considerable sway in influencing decisions at a federal level. Turnbull will need to use his persuasive powers to good effect if he is to navigate the terrain to pass the legislation required to develop on the nation's outstanding 25-year record of economic growth. So far, the Liberal Party have also been successful in avoiding any infighting, but there are lingering underachievements such as the gay marriage plebiscite, corporate tax plan and ‘jobs but not so much growth’.

Brexit blues and Trump's triumph

When Nassim Taleb wrote the 2007 classic The Black Swan, he argued from a position of years of statistical and risk analysis that we are all reasonably poor at anticipating difficult-to-predict events. This hypothesis was perfectly captured with the UK’s decision in June to vote to leave the European Union. All the polling analysts had doubted that scenario would ever come to pass, so it was a major shock with the reverberations felt as far away as on the ASX. 

A further, and perhaps more dramatic political upset occurred with Donald Trump’s triumph in the US election this November. Again, the media, influenced by a series of polling metrics, had failed to envisage the probability, and you, just like all of us, were left enthralled, amazed or appalled (depending on allegiance) with the final outcome. Despite losing most of all the major urban areas along the two coasts, Trump was able to capture huge swathes of southern and midwestern USA in a political outcome that will be studied for generations.

Indeed, 2016 closes with Trump yet to be inaugurated and he is already making headlines on a virtually daily basis. He is the first President-elect to be an avid disseminator of ideology and rhetoric through social media and his outspoken tweets are rocking the stock market as different sectors and businesses come under his 140 character radar.

Second guessing what will transpire across the next 12 months is an almost impossible task. 2017 will see Trump in power and it will be fascinating to see how he fares with Congress, international leaders and unforeseen political events obstructing him week after week. For instance, will Trump be able to soothe US-Chinese relations having decided that attack was the best form of defence following the uproar surrounding his calls from Taiwan? Another issue will be what leadership Trump can impart on the European continent as the EU faces one of its most challenging years since inception.

Not only is there the Brexit timetable and framework to work on, but the European Union will also be further rocked by issues emanating from at the very least Italy, Spain and France. Italy faces a new election for their next Prime Minister and further concerns about the liquidity of their domestic banks, while Spain has serious challenges with structural unemployment, especially among under 25s. There are suggestions in Italy that one-way European countries might return to better growth rates if Germany were to leave the Euro, allowing the currency to depreciate and provide better value for exporters. Most intriguingly of all, there is a French general election to come and there is widespread concern that Marie Le Pen, the National Front leader, will poll well. The National Front have a long-standing reputation for socially conservative and profoundly nationalist policies which will not sit well with the broader European, liberal project. 

Source: ABS, AMP Capital, Switzer

So it is perfectly possible to envisage 2017 as being another highly eventful year. Whatever does transpire, there are perhaps three lessons you can take to harness the advantages. The first is that change is inevitable, and that with technological developments, the pace of change is increasing month by month, tweet by tweet. The stock market will react with a degree of volatility because unforeseen changes have not been priced in yet and the process towards a fresh equilibrium takes time.

So for the stock market, the second lesson is that it pays to be active when monitoring the portfolio. This year has seen dramatic movements in the prices of businesses across the materials, energy and healthcare spaces. Financially sound businesses have been sold off aggressively as sentiment shifts, so simply setting and forgetting might be an unnecessary risk to take. 

The final, and perhaps most important lesson of 2016, indeed any year, is that no matter what has happened or will happen in the future, investing in equities can be the fastest way to grow your wealth. The above graphic shows the performance of the ASX as an index over the last 90 years. In that time, we have seen events like World Wars, famines, the rise of Communism, Oil price shocks, the advent of the internet and now, Donald Trump. Whether these events have been for humanity's better or detriment, whether these events have been anticipated or not, the ultimate lesson is that shares remain the highest returning asset class over the long term, and in our opinion, a wise investment no matter what 2017 has in-store.

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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The great rotation

Friday, December 09, 2016

By Michael Kodari

The sector rotation in the broader market continues for now. Basically, since the start of October, we’ve had indiscriminate selling pressure on very high quality businesses, but the question is whether that pressure can be expected to persist?

We think this phase has come to pass. As always, we only look to invest in businesses with growing Revenue and Net Profit, high Return on Equity, stable and growing NPAT margins, low Net Gearing and positive Free Cash Flows. For now, the market seems to be disregarding such qualities however in time, we feel that those positive traits will again become very difficult to resist.

A good example of the market irrationality at present is the recent 1HY result from Fisher & Paykel Healthcare (FPH). FPH delivered 26% net profit growth and 12% revenue growth for the half. These results exceeded market expectations, yet drew price target downgrades from numerous brokers, despite those figures exceeding their own forecasts. To us, that doesn’t seem logical, but after all markets aren’t necessarily rational.

To give you some perspective of the market divergence, the table below outlines each sectors performance since the start of October.

 

What we can see is that there are only four sectors in positive territory, while the remaining seven are in negative territory. The three sectors doing the best are financials, mining and energy - a complete reversal of what had occurred in recent years. If the ASX 200 was an equal-weighted index where each sector contributed the same weighting, the ASX would have fallen 3.65%, but as it turns out, the index was only 1.50% lower (as at 05/12/2016) given the ASX greater weighting towards banks and mining companies. To break things down even further, the average return of those sectors in the red is a significant -8.50% signifying the scale of the sector divergence that‘s been occurring.

Many investors would be at home scratching their heads and staring at their investment returns wondering where it all went so wrong. Cold comfort can be taken from the fact that some of the best performing fund managers from the last three years have lost in the vicinity of 8-9% for the month of October alone.

After a tremendous period for the healthcare sector, the space finds itself as the worst performing sector. After reaching all-times highs as a sector in July 2016, the sector has now retreated approximately 17% from those levels. To give some perspective, the healthcare sector only declined 24% during the GFC. I suppose the natural question to ask is, why has this occurred?

The answer is rarely a single factor and this case is no different. The healthcare sector has been under enormous pressure in the United States, with neither Hillary Clinton nor Donald Trump seen as sympathetic to the biotechnology or pharmaceuticals space, and as such, Australian Healthcare businesses have borne the brunt of those sentiments. However, beneath the surface there are other factors at play that apply not only to the healthcare sector, but other sectors as well. 

I promise not to get too technical, but I think there's an important point to make as it goes a long way to partly explaining the recent sectorial shift on the market. Consider the fact that the Australian 10-year government bond has increased from 2% at the start of October to approximately 2.80% now.

When analysts value businesses, a key input used to discount future cash flows is the companies weighted average cost of capital, or WACC. As bond yields rise, as they have, so does a company’s cost of debt. This, in turn, leads to the WACC increasing as well. What this invariably means is that future cash flows are discounted by a larger value, resulting in a lower valuations for all businesses to which the higher rates are applied. However, the important distinction must be made that not all businesses are affected proportionately. Essentially higher growth businesses, often trading on higher P/E ratios, experience larger percentage declines in value, than those businesses with lower growth prospects. 

The table below illustrates that point. We have two companies, one high-growth business, and one low-growth business. The change in value assumes a 1% increase in each companies WACC from 9% to 10%. In reality, there are numerous variables which determine a company’s WACC, and certain variables have greater influence than others depending on the business. However, for this exercise, we’ll keep it simple and use standardised WACC for each business. As we can see, the decline in value for the high growth business is far greater than for the lower growth business.

Now consider the following traits associated with the healthcare sector: high growth and high price to earnings (P/E). The same qualities can be associated with another poor performing sector in recent months, the technology sector. What this shows in our opinion is that rising bond yields have affected not only the high dividend yielding and highly indebted business, but the higher growth companies as well. Therefore, bond yields have certainly been one of the factors accentuating the enormity of the sector rotation we’ve witnessed in recent months.  

Another factor undeniably driving markets at present is that we seem to have reached the capitulation phase for commodity bears. Year to date, the materials sector has returned 40%, unwinding some of the underperformance in recent years and masking the underperformance of the broader market. For those overweight, these materials businesses have achieved performance far better relative to those who’ve been underweight, but we feel that this trend cannot persist for much longer. The coal price has increased 200%, while iron ore jumped to a two-year high despite little changing with the long term fundamental picture. It is as if we are returning to the glory days of break-neck industrialisation in China which certainly isn’t the case.

Looking back over recent decades, many would be surprised to find that despite the commodity super cycle, the broader market has had less years of negative returns, with a superior total cumulative return than the materials space. Interestingly, the materials sector has had significantly greater volatility over that period, as well as inferior returns. We therefore hold the view that investors can improve their returns and reduce their volatility and risk by remaining underweight the materials space over the medium- to longer-term.

Moving forward, we implore investors focused on quality to remain undeterred, and over time, such sectorial shifts shouldn’t affect or change their investment philosophy. As always, investors should remain focused on delivering strong returns in excess of the index and we feel investors have good chance of doing so as long as they ignore the short-term noise and remain focused on high-quality businesses with growing earnings and high-quality balance sheets.

Disclaimer: This is a sponsored article by KOSEC. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Headed for another interest rate cut?

Friday, June 17, 2016

by Michael Kodari

The March quarter GDP was released this month and came in substantially higher than market expectations. Over the period, the Australian economy expanded by 1.1%, greater than economists’ estimates for a 0.8% increase, and contributed to a 3.1% annualised figure, versus the forecast 2.8% gain.

The primary driver of growth continues to be net exports, which jumped 4.4% to contribute 1% to growth as resource export volumes continued to grow. Household spending and government expenditure were the other main contributors increasing 0.7% and 0.9% respectively. That means final consumption expenditure added 0.5% to GDP. Household demand for services such as financial services, retail, food services and arts and recreation all helped propel household spending.

graph

Equally encouraging for the services sector was the pickup in business lending, which rose at the fastest pace in seven years. A slight lift in CAPEX intentions signalled that the transition from a mining led economy to a services based economy is not only ongoing, but gathering momentum.

The strong performance in net exports was more than enough to offset the ongoing weakness in the domestic economy, which is presently being inhibited by subdued investment in the mining and non-mining sectors. Fundamentally, the underlying issues holding back the economy at this stage remain subdued corporate income and weak household income growth, and the RBA is conscious of that fact.

Gross fixed capital formation declined by 1.7%, subtracting 0.4 percentage points from GDP growth. Private investment fell 4.2%, mainly due to a decrease in new engineering construction, new building and machinery and equipment.

graph Source: ABS

It is important to understand that the sizable boost from resource exports is uncommon in nature and cannot be relied upon on a consistent basis, with more 'normal' increases likely to contribute 1% p.a. to GDP growth, not 1% per quarter.

The terms of trade declined by another 1.9% for the March quarter, meaning that while GDP has been stronger than expected, Gross Domestic Income (GDI) growth for the economy is subdued. In recent months, the market has seen commodity prices stabilise and relative strength in the AUD. If this situation was to persist then it will become an issue for the RBA.

During the March quarter, trend real net national disposable income was flat at 0.0%. Through the year, real net national disposable income fell 1.1% compared with an increase of 3.2% for GDP, highlighting the constraints on domestic demand.

In order for the domestic economy to return to anywhere near ‘trend’ levels, improvement in the domestic economy is required to incentivise non-mining sector investment. Interest rates are low, labour is cheap, and the exchange rate has come down. These three things should all be positive incentives for businesses to invest for the future but so far hasn’t happened. The reality is, until downward pressure on the domestic income abates, a sustained pickup in economic activity and inflation is unlikely.

For now, the stronger than expected GDP figures have kept the RBA at bay, who decided to leave rates at 1.75% in early June. We believe the RBA will cut rates again before 2017, but choose to wait for the June quarter CPI data, as well as overseas events such as the Brexit vote next week. That leaves August as the likely month for the next 0.25% cut.

graph Source: ABS

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