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Weekly Investor Insights

[Small Caps] Reporting season – here we come!

Friday, February 03, 2017

By Victor Gomes

Reporting season for Australian small companies is almost upon us. Buckle up everyone as the early signs are pointing to continued volatility. But this is not the time to cut and run.

Over any reasonable investment horizon (say 5 years+) small companies should be an important contributor to most long term investors' total portfolio returns. Whilst the asset class is perceived to be higher risk (due to the greater volatility over shorter investment time-frames), an investor with the benefit of time and professional management should be able to ride out much of this volatility. Good investment returns should be what remains. This professional management has never been more important as the upcoming reporting season promises to be a little more volatile than most. For example, since the August 2016 reporting season there have already been more than 60 downgrades and weak trading updates for FY17 issued by Australian small companies.

HEALTH WARNING: The small companies asset class is a challenging one for DIY investors to manage successfully. The higher risk (and commensurate higher returns) and thus the greater ongoing due diligence required when investing in small companies is something that in most cases should be left to the professionals – such as ourselves and other proven asset managers offering sensibly managed and well diversified small company funds. Good asset managers have the luxury of time, size, systems and experience to more effectively manage the risk and volatility of the sector. It's well worth the price of entry for the lower stress and better outcomes. Unfortunately some don't take this advice.

We often see it with some investors asking us or our peers for our best picks. Some retail investors even pulling out their mobile phones at our presentations to take a photo of a slide containing our top 10 holdings. Many will then directly invest in a very narrow selection of these "best picks" – a dangerous "jackpot" mentality.

However, what these investors don’t realise is that:

1.   small companies are not a "buy and forget" asset class – things change and often change quickly. It is a full-time job managing small company investments, not something you
do after dinner one evening for a couple of hours.

2.   a sensible portfolio needs more than 3-4 top picks (often even fewer are chosen by some). A well diversified portfolio needs a sufficient number of holdings to be appropriately diversified. Our fund is one of the more concentrated funds in the market yet it still typically has 30-40 different holdings. This diversification is required so as to ride out the higher risk and volatility that is a characteristic of the smaller companies asset category.

Whilst a direct investor may get away with this type of strategy in the larger caps sector due to their lower volatility and greater business robustness (banks, telcos etc), this is usually not a plan for success when investing in small companies.

Our UBS Australian Small Companies Fund, for example, has been around since early 2004. It has delivered investors an average compound return over that period of more than 12% p.a. (after all fees)1. This compares to an index return for Australian small companies over the same period of not quite 5% p.a. (pre fees)1. Even over the past 5 years to December 2016 the fund has delivered investors an average compound return of 13.3% p.a. compared to the index return of 4.9% p.a. Very few DIY investors in Australian small companies would have had the stomach and patience to ride out the volatility seen in investment markets over the past 5 or 10 years and still deliver reasonable investment returns.

Whilst this upcoming reporting season is expected to be more challenging, it will also no doubt throw up new opportunities to buy some great businesses at below their intrinsic long term value. For us, this is not a time to be running for cover but rather to be alert to both the risks and also the opportunities that may present themselves.

[1]  UBS Australian Small Companies Fund: Mar 2004 – Dec 2016, after all fees


The year that was and is to come...

Monday, December 19, 2016

By Pat Barrett

The second half saw "The Don" win the US election and US rates rise and suddenly REITs have underperformed equities by 15%.  So what's the outlook for 2017?

The first thing to consider is the Australian economy, which is still undergoing a long and difficult structural change from mining to non-mining industries.  While there may be some 'easing pressure' in early 2017, the potential to add to high household leverage and the limited impacts on the AUD should see rates on hold.  UBS expect the RBA to stay on hold until late 2018, a record period at 'trough' cash rates.  The economics team estimate 2017 GDP growth to be 2.8% with underlying inflation at ~1.8%.  Bonds are estimated to be ~2.6% over 2017 (2.9% at present).  Other forecasters (BIS Shrapnel) have rates on hold for 2 to 3 years.  This data is not suggestive of a massive improvement in local conditions and as such, defensive assets delivering a ~9% return (5% yield plus 4% growth) would seem attractive.





Depends on sector and markets but Sydney office strongest and industrial expected to be weakest in non-core markets.  Most REITs benefit from fixed increases but underlying growth estimated to be slightly above CPI, boosted by NSW, dampened by WA. 


Cost base

The cost cutting cycle appears near an end, all that's left is to take the bland biscuits away.  We expect costs to rise. 

Non-rental income

Funds management and development earnings will grow into 2017 with robust demand for product, largely driven by offshore capital chasing our high yields and secure legal title.


With debt costs below asset yields, acquisitions are accretive.  The big issue is competing with foreign capital that has the advantage of a lower AUD and lower hurdle rates. 


With the sector having sold-off, buybacks are a definite option for management teams.  Quite a few REITs are trading near NTA.  This is like a safety blanket for the sector which protects further downside. 


This will feature strongly in 2017.  The direct property market globally continues to power ahead and the owners of the best assets are predominantly REITs.  Another protector of downside.


There's alot of positive drivers of the sector in 2017 and if we lived in a vacuum it should be a good year for REITs.  However we are part of the global economy and once again it looks like offshore events will have dramatic impacts on the market.

The first factor is Europe and the upcoming French and German elections.  If their politicians stir up the masses like Trump did, I fear there could be turmoil in a few regions and this should spillover to the stock market.  Australia should benefit as a safe haven and REITs will be a solid home.

The big driver though is the US, particularly the speed and level of interest rate rises.  This will impact Australian bond rates and should the rate hikes be rapid, defensive assets are expected to underperform the broader equities market.  In theory it should place downward pressure on the AUD, which makes Australian property and REITs better value, but that's been the theory for most of 2016! 

The good news is that the "fast money" has sold out of the sector already, bonds have risen rapidly, the sector is much more attractive in terms of valuations (post sell-off) and news flow has been positive.  There's been no downgrades or other shananigans but rather the continued sale of non-core assets, solid operational updates and strong balance sheets. 

On balance, REITs look attractive and should deliver a solid return in 2017, estimated to be ~9% with relatively low risk.  Thankyou to all of our clients, researchers and colleagues for your continued support of the fund in 2016.

*up to 15-Dec-2016.


[LARGE CAPS]Scoring goals not breaking legs

Monday, December 05, 2016

Jakov Males is the head of equities, Australia for UBS

After over two years OPEC has finally done the economically and indeed politically rational thing. Sentiment was supportive of a deal for most of the period since the initial Algerian meeting when such a cut was proposed. However from last weekend the language from the main participants was reminiscent of the exchanges before previous failed gatherings. While OPEC members previously behaved like football teams more interested in physically hurting their opposition (taking share), they are now focused on actually winning the game (growing revenues). The outcome of yesterday's meeting was more comprehensive that even hopeful bulls could have expected, although severe action was required after the previous damaging strategy. A maximum cut, country specific quotas, independent monitoring and potential non-OPEC (mainly Russian) involvement on top, is pretty huge.

US shale will return, and besides the revenues thrown away, another unintended consequence of OPEC's share war has been forcing this emerging competitor to become more efficient and therefore sustainable. There are also projects sanctioned at US$100/b being delivered into the market. However OPEC's agreement together with Russian co-operation will send the market straight into deficit, and in late 2017 and into 2018 the three successive years of capex cuts will result in supply being further challenged.

While the portfolios are materially overweight direct oil exposure, the leverage is lower than it was for most of the last 24 months as the more speculative names were replaced with the higher quality Oil Search and Woodside. The stocks exited disappointed either around hedging strategy (which limits upside leverage) and succession, and developments around asset quality. Besides the direct energy positions, other portfolio exposures should also benefit from the flow on effects of oil normalisation.

The miners which have been bailed out by Chinese policy which stimulated demand and tightened supply and then by speculators jumping on the momentum to inflate commodity prices further, will face a sharp increase in energy expenditure which represent about 15% of total costs. Indeed this rise in the oil price should NOT be perceived as a risk-on indicator (although trading may ignore this in the short term) as it is supply not demand driven and therefore not symptomatic of a broad recovery. Rather the oil price increase is a material tax increase on activity and a headwind for all cyclicals, where we don't think valuations generally capture this risk.

Inflationary expectations that are already rising should be added to by rising energy prices. This could sustain the normalisation in interest rates and the ongoing de-rate of pure bond proxies that we believe remain overvalued and risky given their indebtedness. Genuine defensives with reliable cash flows (like AGL and Telstra) without the interest rate leverage should continue to deliver. Rising rates however should accelerate the normalisation in the insurance cycles by removing liquidity and supporting premiums, and increase investment returns. We continue to see share prices in this sector extrapolating the current cyclically weak environment.


[FIXED INCOME] Politics, policy and market developments

Friday, November 18, 2016

By Anne Anderson

Our current thoughts

  • The combination of a Republican congress and senate increase the likelihood of a fiscal stimulus package being passed;
  • Trump will be highly motivated to deliver on some of his election promises relatively early in his term – including policies around immigration, trade and regulatory policies, tax cuts and infrastructure spending;
  • At this stage the sequence of policy changes is unclear – and this matters a lot – in terms of what it means for growth and inflation over the next few quarters and beyond. Infrastructure spending has a high growth multiplier, whilst trade barriers will restrict near term growth;
  • What we can conclude though is that the market expectations on growth and inflation is likely is to be higher than previously forecast. But there is a high degree of uncertainty around the actual policy package and whether the current fillip to optimism and wealth effects will be temporary or sustained;
  • Comments from Fed Chair Janet Yellen on Thursday US time acknowledged that the package is net expansionary for fiscal policy and this will be incorporated into their policy deliberations. Indirectly, she interpreted the market’s response in terms of increasing long term interest rates by about 40 basis points and the USD by 3.5% as being appropriate. Fed Chair noted that it is all incredibly uncertain but they will watch and react. We see no obvious impediment to a further tightening of 0.25% in Fed funds by December;
  • Chair Yellen affirmed that it is ‘fully my intention to serve out that term’ that ends January 2018. Importantly, she affirmed that the independence of a central bank together with pursuit of goals established by Congress – (in the case of the Fed) was crucial. There is strong evidence that in cases of political interference the result was sub-optimal economic outcomes. In our view, affirmation of Central Bank credibility is significant for the longer term stability of markets and anchoring of inflation expectations;
  • Near term, we think that bond markets will remain choppy – buffeted by announcements from the US, the flow of economic data, politics and the actions of other global central banks;
  • A reminder of the latter point presented yesterday as the Bank of Japan reappeared as a buyer in the Japanese bond market – acting on their ‘yield curve control policy’ that undertakes to keep the JGB 10-year yield close to zero;
  • A theme of divergence in global central bank policy is one certainty and an emergent theme is the degree to which fiscal policy will feature as part of the mix with the US leading the way;
  • Within our portfolios, post the Trump election, they have benefited from a range of bearish US interest rate strategies and expectations for higher market pricing of inflation and steeper yield curves. We have taken profits on most of these positions following the significant market moves with a view to re-entering these types of strategies as markets move back towards more attractive levels.


[FIXED INCOME] Why are Australian bank ratings under pressure and what are the investment implications?

Friday, November 04, 2016

By Earl San Juan

Earlier this week, Standard & Poor's (S&P) placed the entire Australian banking system on Negative Outlook. This implies that there is a one-in-three chance 25 Australian Banks' credit ratings may be downgraded within the next 2 years. S&P cited the continuing strength in property prices increases the risk of a sharp correction. This combined with record household debt could lead to widespread credit losses in the banking system. But it’s worth putting into perspective these risks in the context of the strength in bank balance sheets and trends in lending indicators where owner-occupier and investor credit growth has moderated as a result of tighter lending standards and macro-prudential policies. We also note the following:

  • Bank capital levels are solid and are likely to be further strengthened;
  • Non-performing loans and arrears – despite increasing moderately in the last 18 months – are still below historical averages and compared to global peers;
  • The risk profile of new borrowers has improved materially where the share of new high loan-to-valuation (LVR) lending and interest-only loans has fallen, 80%+ LVR lending is now at its lowest share in almost a decade
  • Dynamic LVR is now around 50% and mortgagees are reported to be around 2.5 years ahead on mortgage repayments on average.

House price growth nation-wide has slowed compared to last year and although Sydney and Melbourne have bucked the trend recently, new apartment supply is projected to catch up to demand over coming years. On the other hand, anecdotally there is still a sense of 'fear of missing out', particularly with the younger generation where housing affordability will remain a significant challenge. Investor lending, now subject to an APRA imposed 10% growth limit, had initially weakened but is now seeing a bit of an uptick. This would make sense with Net Interest Margins and equity returns under pressure and NAB and ANZ refocussing efforts back into the domestic market, creating an intensely competitive environment.

This week’s announcement nonetheless adds to the increasing threats to the major banks’ credit ratings as there are now three potential sources for downgrades:

  • Stand-Alone Credit Profile (SACP) downgrade: this refers to bank ratings without upward notches for government support. Strictly speaking, the announcement this week relates to a negative outlook on the banks’ SACP’s;
  • Sovereign downgrade: we think this is the most immediate and likely catalyst for a downgrade, though largely still uncertain and predicated on the Commonwealth budget being placed on a 'sustainable' path to balance; and
  • Reassessment of government support: there is the potential for S&P to reassess the assumption from ‘highly likely’ to just ‘moderately likely’ in the next couple of years. This could arise if APRA introduces a Total Loss-Absorbing Capacity (TLAC) framework*, similar to that of other jurisdictions, where certain classes of creditors can be bailed-in, reducing the need for a government bail-out.

We can arrive at different S&P rating outcomes for the major banks depending on which combination of events are triggered:

A sovereign downgrade will result in a downgrade of the major banks' senior unsecured ratings. According to S&P's ratings methodology, a downgrade of the major banks’ SACP’s will not by itself result in a downgrade of senior unsecured ratings, but a combination of this and a sovereign downgrade will. If all three events are triggered, the result will be a two-notch downgrade. Clearly this is the worst case and most uncertain scenario, and whilst we currently assign a low probability of it happening, there are numerous moving parts, including how the Australian TLAC framework takes shape and the amount and type of capital the banks raise in response to it and how quickly they raise it.
In summary, we are of the view that a one-notch downgrade in itself should not cause credit spreads to widen materially and importantly Australia’s banking system still ranks amongst the lowest risk and highest quality in the world.
* TLAC relates to Recommendation 3 of the 2014 Financial Systems Inquiry, which states that 'ADIs should maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution while mitigating the risk to taxpayer funds — in line with emerging international practice.'


[SMALL CAPS] Australian Shares

Friday, October 14, 2016

By Victor Gomes

Last week we began this series with Episode 1, being a review of the first two of eight factors of successful businesses, namely that;

1.    Management are owners/founders or otherwise act as if they are.

2.    High returns on capital will often dispense with the need for high debt.

Today we move on to Episode 2 with an analysis of factors #3 and #4.

3.    Re-invest profits – don't perpetually raise new equity.

Let's again look at Technology One (TNE) a position our fund has held for about 5 years. As previously discussed, it meets both factors #1 (Managers are owners/founders or otherwise act as if they are) and #2 (High returns on capital dispense with the need for high debt).

Unsurprisingly, TNE also meets many of the other factors of successful businesses including #3. It has not issued any material new capital (other than minor issues as part of employee incentive plans) in the 16 years or so of its listed life. In 2000 it had 303m shares on issue. Today it has barely 3% more, at 310m shares on issue.

The power of a business with high returns on invested capital (factor #2) combined with low capital needs translates into a stable share count and high total shareholder returns (+ 800% over 16 years for TNE). Furthermore, TNE's high returns allow it to fund itself without the need for debt. The end result is a company with no debt and no need for new equity issues. This is truly a unique business franchise.

Sirtex (SRX) is another example of the power of compounding shareholder returns on a stable shareholder equity base. Similarly to TNE, it also listed in 2000 and at the time had a share count of about 54m shares. Today it has a share count of 57m shares, a rise of about 5% over 16 years. This lack of dilution from new equity issuance over the period combined with growth and high returns on capital has delivered shareholder total returns of about +1100% or around 12 times its share price in 2000.

On the other side of the coin, there are many companies that don't sufficiently re-invest profits or otherwise have such low returns on capital that they are unable to internally fund growth without debt. These businesses are typically the serial offenders in blowing out their share count and also have high levels of debt.

As any long term investor in airlines will well know, the globally aviation sector has a very poor industry structure. Industry returns on capital are low and profits are volatile. Contrast then the share count increase for businesses like Qantas (+67% over 16 years) and Virgin Australia (+210% over 15 years). No surprises that both have high debt levels and poor total shareholder returns (Qantas +48% over 16 yrs – around +2.4% pa , Virgin Aust -86% over 13yrs).

We could go on and on….with the resources sector in particular having a very poor history of equity capital stewardship. Some of the worst offenders include Beach Energy (+715% share issues over 16yrs) and Cockatoo Coal with an eye-watering +6100% increase in shares on issue over the 10 years since listing.

4.    Stable management who often promote from within.

If there is one over-riding factor that is critical when investing in small caps, it is management quality (honesty, integrity and competence).

Some of the good things we like about investing small companies include being in the earlier and faster growth stage of their development, being more focused by typically operating in only one industry sector and being better able than larger companies to exploit disruption, innovation and change. However all these positives can quickly become negatives without good management there to exploit them. And a good management team will often grow their own successors.

Contrast this to poorly performing companies who are constantly changing management and tend to appoint from external candidates. These outcomes occur because of thin resourcing or otherwise as a way of bringing in an external change agent to fix existing problems.

Domino's Pizza (DMP) and Flexigroup (FXL) are examples of the good and not-so-good of factor #4.

Domino's senior management team are all long serving and, like their pizzas, are internally grown. The CEO, Don Meij started in 1987 as a pizza delivery driver at the Redcliffe store in Brisbane. CEO of Europe, Andrew Rennie, started in 1994 as a Darwin store franchisee, ultimately owning 13 franchised stores before moving into the corporate team as CEO Australia. Nick Knight, the recently appointed CEO of Australia & NZ also started as a single store franchise owner, ultimately owning the largest network of franchised stores by 2012. Even CFO, Richard Coney, has been with the company for 20 years. Domino's is the ultimate textbook example of the stable, high performing and internally grown management team.

Flexigroup on the other hand is onto their third CEO in 5 years. An initially successful strategy of growing in point-of-sale finance in Australia, led by prior CEO John DeLano, has found the going tough in recent years. After DeLano left in 2012 to return to the USA, the company appointed an ex-Telstra executive as the new CEO. Not only was he an external appointment and thus did not fully understand the unique culture built up by DeLano, he also had neither a sales nor finance sector background. Soon enough, other senior management (who should have been the internal candidates for CEO) also left the firm. Some like ex-CFO Garry McLennan and ex-head of Global Operations, Doc Klotz went on to greater success in the same industry with
Eclipx Group.

The problems just kept mounting for FXL with stalled growth due to failed new initiatives and increased competition in existing divisions. Another change of CEO saw the appointment of an ex-CBA executive as the current CEO. This time around it's a case of the right industry background but the wrong culture (they need
a CEO with a challenger mindset, not incumbent's mentality).

Next is Episode 3, where we examine key factors #5 and #6:

5.    Do not needlessly diversify a good core business.

6.    Earnings are all-inclusive, not "underlying".


[SMALL CAPS] Australian Shares

Friday, October 07, 2016

By Victor Gomes

This process has served our investors very well with our fund returning them more than 13% pa (after all fees) since inception*. This compares to an index return of about 5.5% pa over the same period.

Fundamental message: Don't buy index in Australian small companies.

Consequently we thought a review of the key lessons learned from the fund's journey of investing in good businesses over that period was in order. We have found that there are eight key factors that time and again consistently distinguish a truly successful business from the also-rans. Today we will start with the first two factors.

1.      Management are owners/founders or otherwise act as if they are

The fund has owned ARB (a global leader in 4WD accessories) for more than five years. The company was founded in 1975 by Roger Brown, his brother Andrew and his best mate John Forsyth. It was listed on the ASX in 1987. Today the company is still run by the same three men and they remain large shareholders. Whilst the company may occasionally transgress the current-day politically correct corporate governance standards of a small board and an executive chairman (Roger), shareholders are not complaining having seen earnings grow by 13% pa over the past 10 years. As owners, it's not surprising that the senior management pay also themselves very modestly by industry standards ($250k-$380k each).

Another and more recent example is our fund's investment in Wisetech Global (WTC), an IPO from earlier this year. Not only did we like the high growth and recurring revenue basis of their cloud based logistics software business, we also really liked the fact that the founder and CEO, Richard White, sold very few shares into the IPO (about 2.5m of his 151m shares). Today he still owns more than 51% of the company.

2.      High returns on capital will often dispense with the need for high debt

High returns on invested capital (ROIC) are an investor's best measure as to the quality of a company's business franchise. TechnologyOne (TNE), a now cloud-based enterprise software business based in Brisbane is another long term holding of our fund. Its ROIC is a not-too-shabby +200% pa. Partly due to the fact that as a software business it does not require much capital, nevertheless, by giving Adrian di Marco, its CEO and founder, your $1 of new capital (should he need it), he can then earn more than $2 annually from that original $1. Unfortunately the (quality) problem for us as investors is that because of his very high ROIC Adrian's business is more than self-funding and doesn't require any new equity capital from us. Consequently, TNE is not only debt free (as are ARB and WTC from #1 above), it periodically pays out a special dividend in addition to its normal dividends to return cash and franking credits to its shareholders.

Sirtex Medical is another long term holder for the fund (>5 years). Sirtex has a ROIC of >80%, has no debt (net cash) and pays a fully franked dividend. Although in a higher risk industry of medical technology, its net cash position and stable yet fast growing existing business (treating liver cancer using an internal radiation therapy in “salvage” patients) mitigates some of the inherent industry risk that high debt levels would simply magnify further.

We know of many examples of poor businesses masquerading as quality franchises through the use of high debt. One in particular (who shall remain nameless to protect the guilty – you know who you are!) is a recently re-floated “old” business. After departing the listed scene for a period whilst its private equity buyers worked their special magic to polish up an average business with the usual tricks of doing a “pro-forma” on the historical numbers, stripping out hard assets and then adding high debt to paying themselves a large pre-IPO dividend, it is now back listed on the ASX and pretending to be a better and reformed business. Fortunately for us, having been around the block a few times, just like with Dick Smith, we still remember what it looked like in its “pre-polished” days. The underlying business franchise remains average at best as reflected in its return on assets (ROA) of less than 6% pa. However with the magic of a lot of debt, this sub-par franchise indicator transforms into an surprisingly strong return on equity (ROE) of almost 15%. Debt is (currently) cheap and tax deductible so it can mathematically enhance poor returns easily. This is no more than a case of good ol’ fashioned financial engineering and is not a sign of a good business. Caveat emptor!

Stay tune for the next episode featuring #3 and 4 key factors of successful businesses:

3.      Re-invest profits – don't perpetually raise new equity.

4.      Stable management who often promote from within.

*ASCF returns to 30 September 2016


[SMALL CAPS] Has the horse bolted

Tuesday, September 13, 2016

By Stephen Wood

The FY16 reporting season has passed. Most results passed without fanfare. We did however receive a few positive surprises and a few negative ones. Positive surprises included Motorcycle Holdings, Baby Bunting, iSentia and Sirtex Medical. We received a negative surprise from Gateway Lifestyle (GTY-AU). In particular the company guided to 5% earnings growth in FY17 when the consensus of analysts expectations pre result was for 26% growth. The stock fell 17% the day the result was released. The analyst consensus for pretax earnings for FY17 has now been revised down from $57m to $48m. The Gateway share price a week or so later is still sitting at the lower level although it has not, so far, fallen further.

We have not sold any of our Gateway shares. Why not? We remain very positive on the long term outlook for low cost, manufactured retirement living that Gateway provide. Ingenia Communities (INA-AU) and Lifestyle Communities (LIC-AU) both provide a similar product and both have had benign, in line reporting season outcomes. We are confident that the model is not broken. So what happened to Gateway. We believe that it is a combination of growing pains and the equity market expecting too much too quickly. Gateway has grown its assets very quickly and the market expected earnings results from this asset base quickly. The Company, who only listed a little over a year ago have also been scaling up their management and development and selling capability since the IPO but these things take time.

We have met management of Gateway post the result and are confident in the medium and long term strategy. We believe we can also see how the market's expectations and the company's short term execution had become mis-aligned. These things happen. We do not believe there is anything fundamentally wrong and at this stage are sticking with our investment in this company and the sector.


Feedback from China: no high level hope

Monday, June 20, 2016

By Jakov Maleš

Despite trying desperately to be optimistic, after numerous company and industry meetings and presentations, we left China last week with no confidence that top-down management of the economy will deliver the kind of sustained stimulus or structural growth required by the cyclical parts of the Australian equity market.

As expected, the authorities are struggling to balance reform and the shift away from their traditional capex/fixed investment heavy industries towards consumption, with the labour redundancies from exiting industries everyone agrees are in massive overcapacity. The term ‘kicking a can‘, which has been overused over recent years, regrettably absolutely applies here. Beyond the management challenge of the abovementioned shift, the political issue of executing strategies across over 30 administrative divisions with various degrees of autonomy and power is huge. While the central government may very well desire to reduce capacity in certain industries for both economic and environmental reasons, local governments take every opportunity to defy them. Even within the federal government, disputes are occurring as evident by the article in May from the ‘authoritative person‘ highlighting the risk of adding to already high leverage through the credit release as occurred in the first quarter. This conflict raises the risk of a policy mistake in an economy that is already stressed out.

The issue of leverage in the system was indeed the focus of the week. While bulls argue China's relatively closed economy can absorb what is traditionally massive debt as Japan has, the authorities remain very concerned. Corporate debt is about 70% of the total which is almost 250% of GDP. While SOEs remain the main culprits and have implicit government backing, several senior economic figures expressed fears about continuing to fund this group when returns are near zero. The risk to capital outflows and the currency were emphasised. The message delivered was that the government is already uncomfortable with the level of leverage, and will not continue to fund marginally more growth with increasingly more debt.

Most banks we spoke to denied funding the SOEs in the credit boom in the first quarter, suggesting, at least for now, they are being kept afloat by the government. That much of this new credit is being used to pay existing interest given many Chinese companies can't afford to pay these expenses, was also confirmed. The likelihood is that non-performing loans are closer to markets estimates of over 10% than the official figure of about 2%. These conversations highlighted the lack of progress in even shifting financial support from the over geared and poor returning SOEs in industries suffering overcapacity, towards the relatively healthy private sector. As in many countries, there is almost a consensus that the property market is a bubble, but little desire to address it or to hop off the momentum train.

There is just no chance the demand growth required to meet the oversupply in bulk and metal commodities, will be delivered by the Chinese market. While our portfolios are comfortably underweight the metals and mining sector, our overall resources position is near neutral due to the large energy overweight. While this energy position is supported by huge undervaluation in the more leveraged names and an unequivocally constructive supply and demand outlook, we are conscious that the sector will be hurt by automatic risk off trading if there is a shock out of China. However, given our underweight to almost all other things cyclical (equity market leverage, discretionary, property leverage) and all other things overvalued bubble style (growth and bond proxies), we remain committed to the current holdings.


[SMALL CAPS] Time to re-visit small cap resources

Friday, May 27, 2016

By Stephen Wood

We are feeling increasingly comfortable with our decision to re-weight into small cap resources after the gyrations in these stocks in February and early March this year. While the combination of the trend in the US$, A$ and commodity prices remain very volatile and skittish on a day to day basis we believe that there is selective value in small cap resources.

We are of the opinion that the small cap miners who have survived the downturn over the last 4–5 years are now reaping the benefit of a decline in labour costs, significantly improved infrastructure and the demise of competitors.

Whitehaven Coal is a company that has quietly made significant progress while the small cap market has been focused on high growth industrial companies. While Whitehaven is still carrying a debt load that is too high we believe that it is likely to now make progress on reducing debt with surplus cash-flow. During the last few years the company have well and truly optimised the performance of the Narrabri Long-wall and the new open cut Maules Creek mine. While this has been occurring new efficient coal loading capacity at Newcastle has opened and the excessive demand for labour and engineering services, which was in part caused by the infrastructure investment, has abated. While the US$ price of thermal coal has fallen from over US$70/t two years ago to $US52/t (-26%) now it is worth reflecting that in A$ this price decline is a much more modest A$79/t to A$71/t (-10%). Over the last six months both the US$ price and A$ price has been relatively stable at around $US50/t.

We accept that over the very long term that the global demand for coal will be subject to pressure from new technology that will continue to focus on making renewable energy more viable. However we also believe that the world will continue to rely on fossil fuels for a very long time. In order to balance this long term exposure we have also recently increased our investment in lithium production. Lithium batteries are likely to be a key technology used in the storage of renewable energy and electric cars. We have held an investment in Orocobre for a while but we have more recently added smaller positions in aspiring lithium miners Galaxy Resources and Pilbara Minerals.

Stephen Wood is a Portfolio Manager at UBS


[FIXED INCOME] Heed the Doves, but beware the Hawks…

[FIXED INCOME] Australian dis-inflation

[LARGE CAPS] Another bank reporting season

[LARGE CAPS] Safe as houses?

[SMALL CAPS] The 'cloud'

[FIXED INCOME] Mixed signals from the Australian economy

[LARGE CAPS] R.I.P blue chip stocks


[SMALL CAPS] Some early results from reporting season

[SMALL CAPS] Avoiding land mines in small caps


[SMALL CAPS] A win on the trifecta

[SMALL CAPS] The magic pizza revisted

[FIXED INCOME] Looking through the volatility — thoughts on economies, markets and portfolio positioning

[SMALL CAPS] Capital in the 21st Century

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