For the first newsletter of 2020 we put forward five key predictions for the calendar year ahead. Each of these will definitely impact the investing world and will have an effect on the Australian economy either directly or indirectly. It is always worth considering what lies ahead.
This week we would like to begin where we ended last year, revisiting a favourite exercise of ours: making predictions. However, a slight adjustment is in order since we would like to do so at the beginning of the year as opposed to the end. So unfortunately, given that we don’t have a little thing called retrospect, they might not be as exact. So here we go…
Prediction 1 – The coronavirus will be forgotten by July
Given the rhetoric that we have all have been seeing in the media over the past month or so this might seem rather optimistic but let us make a case for it.
The novel coronavirus (2019-nCoV) surfaced in Wuhan, China in late 2019, resulting in borderline draconian measures being put in place by Beijing to stop its spread. The affected provinces were quarantined and effectively shut off from the rest of the mainland (it has since spread to most provinces to varying degrees). While many people have drawn comparisons between the current crisis and the SARS outbreak of 2002-2003, there are significant differences, both good and bad.
Check out the interactive map from Johns Hopkins CSSE (screenshot below) to see the spread.
On the positive side, the fatality rate of this coronavirus is considerably lower than SARS which, at its worst, had a fatality rate of around 8.6%. 2019-nCoV, on the other hand, is somewhere closer to 3.5%. Though to what extent these numbers can be trusted given the history of the Chinese state in being particularly creative when it comes to statistics we leave for the readers to judge. Nevertheless, based on current news flow, there does seem to be a lot more openness in terms of disclosure than in previous crises.
On the negative side however, 2019-nCoV could be a lot more contagious than SARS which at its height impacted about 8000 people and killed 800. What will be particularly telling will be to see what is referred to as the R-Naught figure which refers to the contagiousness of the disease itself. For example, if a virus has an R-Naught of 3 it means that every person that has the disease affects three other people in the community and so and so forth. So if the figures that come through are on an exponential basis, then it becomes a bigger problem. Till now the draconian measures implemented by the Chinese government, including mobilising the army to cordon off areas, have meant that the impact area has been largely contained. What is also concerning about this particular strain is the incubation period which means that once infected it takes up to two weeks to actually show symptoms, this also happens to be why the Australian government saw fit to use Christmas Island.
Coming back to the impact on global markets, at the risk of sounding rather callous given the human cost, we would suggest that it is being blown out of proportion (the common cold being rooted in a coronavirus itself). The closest thing that we find analogous is probably the flu season which impacts between 9 and 45 million people in the US alone and kills between 12 000 to 60 000 people every year without a substantive impact upon GDP. Granted, the markets are prepared for it but, given what we know of this particular problem, it hardly warrants a 9% sell-off in the Chinese indices or a 150 basis point sell-off in the ASX. Think about it like a plane crash, the actual underlying impact is rather small but it is an outlier event when compared to the thousands of car-crashes that occur every day whose death toll is substantially higher. It will make an impact in very particular niches given Wuhan’s role in automotive manufacturing or if it spreads more aggressively into other more central provinces but, if contained, it’s impact on top-line growth should be negligible, maybe 20-30 basis points. If it gets bigger sectoral dislocations could occur; for example airlines, oil prices (due to travel restrictions) and tourism. Overall it should not impact global growth all that much, especially if the Chinese government decides to intervene directly and stimulate to meet their target of doubling the economy between 2010 and 2020.
Prediction 2 – A new round of QE will take place
As we suggested last year, the Fed’s intervention in the Repo markets in September is for all intents and purposes QE (even if they refused to name it such). What we see by these actions, and after Q4 of 2018, is their unwillingness to let market corrections take place. Despite the rhetoric that Powell chooses to use about not being in the business of propping up markets, we see a deep-seated aversion to anything that might rock the boat, USS Economy.
The thing to watch in this instance is not necessarily the Fed Funds Rate but rather the balance sheet. We think the odds of trimming it to be extremely low. Rather, they are more likely to let bonds go to expiry since central banks, by their very nature, can go into negative equity and still be functioning. In essence we are emphasising the notion of the Central Bank Put which, for better or worse, is going to mean that the Federal Reserve will let the markets run hot in the absence of inflationary pressures.
That said, we are by no means suggesting that valuations at this particular point in time are reasonable on a historic basis. Indeed, one needs only look at sectors like semiconductors which are extremely procyclical by nature to realize that the current status-quo is well into bubble-like territory (i.e. valuations are no longer being driven by fundamentals). A perfect example of this would be securities like AMD (see below) or even the FAANG stocks to a certain extent, which as of January 2020 have a market capitalization of 4.1 Trillion USD.
Source: Google FInance
Nevertheless, we fundamentally believe that in the absence of any changes to current, seemingly consensus, monetary policy stance around the world, we are unlikely to stop a continued melt-up in the coming twelve months. This comes with the caveat that current valuations also have the flipside of being priced for perfection and, as a result, any negative news is likely to see a disproportionate response in terms of price movements. In other words, volatility will be back again this year and if severe enough on the downside, which is almost certainly going to happen in the lead up to 2020 elections, the Federal Reserve will be forced to intervene directly and with the certainty that they won’t have the opportunity to even disguise it as was the case in September.
Prediction 3 – RBA cuts rates to 0.25%
So Wednesday came and went with the RBA holding rates steady at 0.75% as was expected by the market given better than expected employment figures. However, we do not, unfortunately perhaps, see this holding steady throughout the year. RBA Governor Lowe has already made veiled comments targeted at Canberra about the extent of firepower left on the monetary side of the equation. Perhaps he might be right on this front, since monetary policy can only go so far in impacting the underlying economy. In other words more needs to be done on the fiscal side of the equation, whether it be a more flexible approach to the obsession with getting back to surplus or spending on things like infrastructure. However and perhaps unfortunately, we are cynical that this might be the case given the political equations of our time.
In the absence of any substantial movements on the political front, any perceived weakness in the underlying economy, including a cooling off in the property market, will be met with more rate cuts and, given the headwinds we seem to be facing in the form of health (the coronavirus, granted blown out of proportion) and environmental/rural (bushfires) crises, we can expect that there will be hurdles along the way. Undoubtedly these hurdles will be met with rate cuts going towards the zero-bound. Maybe even our very own QE dare we say?
Again, despite the gloominess that all this might suggest, it is not necessarily all negative for equity markets depending of course on sectoral allocations. Infrastructure, utilities and the like are likely to be beneficiaries to this given their highly leveraged nature. Any government expenditure on longer-term projects going forward should also bode well for these sectors despite the regulatory mess that they seem to be facing in terms of policy clarity. In addition, finding companies with clear catalysts in terms of earnings growth should also allow us to be disproportionately rewarded by the market.
Prediction 4 – Trump wins re-election against either Joe Biden or Bernie Sanders
Funnily enough the sign James Carville famously hung in Bill Clinton’s Little Rock campaign headquarters in order to keep the campaign on message in 1992 is still rather relevant today. It read:
Change vs. more of the same.
The economy, stupid
Don’t forget health care.
It is point number two we would like to focus on here.
Let the circus begin. At the time of this writing, the Iowa caucuses are in progress and New Hampshire is soon to follow with approximately USD 40m spent on the campaigns already. The lead contenders as of the 5th of February are Pete Buttigieg closely followed by Bernie Sanders, Elizabeth Warren and Joe Biden. The caucuses, while remnants of the past and probably outdated in their function, are still fundamental to the American political process. For those of you who are not well-versed in the essential difference between a caucus and a primary, a caucus requires the registered party members to physically go to a meeting at a designated place to nominate their nominees whereas a primary is conducted in a similar manner to an election where the voter goes to polls to cast their ballot. The caucuses are often determined by the loudest and most active party, clearly benefiting candidates like Sanders over more establishment candidates such as Joe Biden.
That said, only six states still use the Caucus format to select their nominees with the rest being primaries. Iowa being a swing state has always been exceptionally adept at choosing the winning candidate and thus is seen as essential to the nominating process, though many have questioned the priority this particular state takes. Nevertheless, it is still a rather good representation of the mid-west which was essential for Trump to take the White House during the 2016 elections, Iowa going to Trump 51% vs. Clinton’s 41%.
One thing is for sure, the top three candidates during the initial primaries will have the momentum behind them in a rather crowded field to go on to national primaries including the all important California and New York. Currently, we would bet that Bernie Sanders and Elizabeth Warren will come out in the lead in early stages but Joe Biden will close the gap following deals with drop-outs or those that don’t have the requisite numbers. Bernie Sanders would appear to be the clear favourite within the party, especially with younger voters, with Joe Biden being seen as the man most likely to be able to beat Trump. Elizabeth Warren would, we assume, still be on the ticket as a running mate for either of those candidates.
All in all and returning to Carville’s second point, whoever the candidate might be, we find it exceptionally hard to believe that a contender could dislodge a sitting President with the economy going so well, even if he doesn’t actually understand how it works. Despite what your opinions about the man himself are, the dynamics of the previous elections mostly remain standing. While Joe Biden as a nominee would have the baggage in the form of his son Hunter and the Ukraine fiasco (depending on which way you lean, the Ukraine situation is baggage for Trump too), Bernie Sanders might be too progressive for most of moderate America unfortunately.
Just as last time, we see an electoral college win for the Tweeter-in-Chief and another loss when it comes to the popular vote.
Prediction 5 – Gold will break above 1700 USD but equities continue to melt-up
As mentioned a number of times last year, we are firm believers in the notion that gold should be looked upon as a hedge to a broader portfolio rather than a growth play. That said, we continue to believe that it has a long trajectory in terms of upward momentum. While we did not see it as particularly attractive then, this year the trends are indicating otherwise.
For one, the key will be a sustained break above 1500 USD and a resistance at that level. We are increasingly seeing a bullish pattern developing in combination with the other relevant factor: the USD. Again, as previously mentioned, the precious metal has an inverse correlation with the USD both for historic and practical reasons. As the Fed continues to lower rates and undertake unconventional policy tools we might see this correlation break. The USD might still have upward momentum given its reserve currency to the world status and weaknesses in the Euro as well as emerging markets but recent trends, including various moves by central banks around the world including the PBOC (China), RBI (India) and Russia, are suggesting that there is going to be increased demand. We predict that by the end of the year gold will reach 1700 USD.
Though the one downside could once again be the coronavirus since Chinese and Lunar New Years have historically created demand for gold since it is a common gift during these events.
Kevin Smith, of Delft Partners and portfolio manager of the TAMIM Asia Small Companies Fund, addresses Japan in the wake of some of the negative news associated with the market. Japan forms an integral part of both the Asia Small Companies and Global High Conviction portfolios and it is important to stay abreast of what is happening in one of the world’s largest economies.
Our October article highlighted that the Japanese equity market is changing with:
Improved governance of companies
Investors reducing exposure to cash in favour of equities
Recent “safe haven” status in the face of global volatility
We would like to reiterate our positive view of Japanese equities with this follow up article and address some of the negative news associated with proposed amendments to the Foreign Exchange and Foreign Trade Act (FEFTA) which are designed to control foreign investments that could threaten Japan’s national security. If the Bill is passed before the end of the extraordinary session of the Diet this month, the new rules would come into force in the first half of 2020. The main source of concern is the proposed 1% threshold (reduced from 10%) above which prior notification is needed for international investors to hold an equity stake in Japanese listed companies in key industries.
By way of background, the listed equity market in Japan has a relatively low percentage owned by foreign investors, currently 29% up from 18% in the year 2000. Some international comparisons are shown in Table One, each country has higher percentages of foreign ownership, the United States having changed dramatically in the past two decades while France and the UK have always maintained relatively high levels.
Table One: International Ownership of Equity Markets in Japan, US, France and UK
Sources: S&P500, ONS, Banque de France, Euronext and Bank of Japan
An example closer to home would be Taiwan that currently stands at 40% foreign ownership which has increased from zero in 1990. Taiwan suffered from a very similar financial bubble to Japan in the same timeframe of late 1980s to early 1990s. Taiwan responded to their financial crisis by allowing direct foreign participation in the equity market for the first time in 1991 when foreign ownership of the Japanese market was at 10%. The opening of the market has seen much larger foreign participation in Taiwan than that of Japan, although the latter is now at least showing signs of catching up.
A key factor in the opening up of Japan has been the reduction of defensive cross shareholdings. During the 1990s cross shareholdings accounted for more than 30% of the market capitalisation and today that number is less than 10%. Excessive cross shareholdings were associated with poor capital efficiency and complacent management in protected companies who were not motivated to deliver strong returns to their shareholders. There was a strong negative correlation between the number of cross shareholdings held in a company and return on equity achieved by that company. Aggregate return on equity for the market in Japan wallowed in low single figures for more than two decades and has only started to approach the double figure level in the past two years.
The Corporate Governance Code of 2015 has seen a dramatic reform in corporate leadership, ensuring transparent and fair procedures are used in the appointment and dismissal of senior management. The job for life culture has been eliminated in Japan. The Code recommends that companies appoint at least two independent directors, you can see in Table Two that more than 70% of companies have complied with that requirement, a dramatic change from 2014 when only 12% of companies had two or more independent directors.
Table Two: The Rise of Independent Directors in Japan
Source: Tokyo Stock Exchange
We expect to see big steps taken towards Boards with majority independent directors in the next five to ten years. Medical technology business Hoya Corporation is an example of a company that has made the transition to a majority of independent directors. Hoya Corporation has a structure that should be a model for other companies in Japan with 5 independent directors plus the CEO comprising the Board and all sub-committees are controlled by the five independent directors, see Table Three. Hoya Corporation therefore scores well on our assessment of corporate governance and is included in our concentrated portfolio of global equities. We like their rule that directors must attend at least 75% of meetings in order to qualify for re-election. The Board conducts an annual survey of effectiveness, operates clear rules regarding conflicts of interest and has a strong disclosure policy. Hoya Corporation specifically has a policy of not maintaining cross shareholdings and employs no anti-takeover measures.
Table Three: Board Structure of Hoya Corporation
Source: Hoya Corporation Annual Report 2019
We have seen strong international buying of Japanese equities in recent months, Table Four shows the weekly flows in 2019 with positive numbers apparent in April/May and October/November.
Table Four: International Participation in the Japanese Equity Market
The average level of weekly net buying of Japanese equities by international investors since 2005 is just ¥37 billion which is equivalent to USD 18 billion per annum. In the past two years we have seen weekly outflows as high as USD 20 billion (March 2018) and annual outflows of more than USD 50 billion.
In our October article, we highlighted that a key change in Japan is the rise of activist shareholders, buying significant stakes in companies then demanding changes in strategy, structure and management. A survey by Nikkei found that 139 new stock purchases in the first eight months of 2019 were made with the intent to encourage companies to change how they do business. We suspect that the pace of change has caught the Japanese authorities and companies by surprise, perceived domestically as too much pressure to change too quickly. The existing disclosure rules leave companies wide open to unexpected changes in the shareholder registers which historically didn’t happen in the era of defensive cross shareholdings.
The scale of recent inflows has been impacted by the news surrounding the proposed amendments to FEFTA. We have seen industry bodies challenging the Ministry of Finance regarding the consequences of the changes to FEFTA and the response has been to start to modify and moderate the impact of the Bill. For example, international pension funds and sovereign wealth funds are excluded from the prior notification requirements together with international investors who do not intend to seek board seats. The Ministry of Finance will publish a list of companies to be included in these rules, that list is likely to be limited in scope and not the restraint on investment that was initially feared by industry participants.
In conclusion, we believe that Japan has adopted the correct path of improved corporate governance in recent years, significant progress has been made in a short space of time which has helped to increase the extent of international participation in the Japanese equity market. The proposed amendments to FEFTA are a short-term step backwards, a reaction to rapid change and not a change in the overall direction which should see international ownership of the Japanese equity market rise to the 35-40% level in the next decade.
We’ve been hearing more and more about it in the media, it’s time to take a closer look. Huawei’s meteoric rise globally is coming to a head as the US/China Trade Kerfuffle drags on and we thought it was time to take a closer look at what they are trying to do. Have we seen this type of empire building before? What does it mean for the average investor at the bottom of the world?
We have previously stated that we view the trade war as not necessarily a question of simple economics or ongoing Current Account Deficits. In fact, we are of the opinion that as long as the USD remains the global reserve currency, the artificial demand created by global trade effectively ensures that the US could at least theoretically maintain such deficits for an indefinite period of time without being too adversely impacted (hopefully we don’t have any workers from the American Midwest or Rust Belt reading this). Quite on the contrary, we view this current adversarial environment as a longer-term trend that will take us slowly but surely towards a new equilibrium in the global economic order. One outcome of this is that the two major players (the US & China) increasingly look at disentangling their supply chains and carving up spheres of influence. All this in preparation for an era where the very essence of political and economic survival will be contingent upon leadership in the next generation of technological advances broadly characterised as the fourth industrial revolution. The clearest and most obvious representation of this process has been the curious story of Huawei.
The recent headlines surrounding this rather opaque company made us want to take a closer look at it. It has certainly been a busy time for them on all fronts and we think their PR teams might be having a more interesting time than those in the White House in terms of putting out fires on an almost daily basis. From mere accusations by the US administration to the State Department making it official policy to intentionally go out of their way in convincing governments around the world to view them as a threat, lobbying heavily to block their usage in the rollout of 5G in the UK and across the EU.
Closer to home, state and intelligence officials continue to persuade our own government to view Huawei increasingly as a proxy for the Chinese State. Whatever the truth of the matter is, and we feel somewhat disposed to believe that there may be an element of truth in the accusations, we might then ask ourselves the question, just why is it that there has been such a furor created about this one company? To the point where individuals are being caught in the crossfire, the most immediately obvious case being the arrest of Meng Wanzhou, CFO and daughter of the companies founder, in Canada for breaking US sanctions against Iran. Officially the US Attorney’s office where the warrant originated is nominally independent, we remain unconvinced that the White House would not be at least given a heads up before the US Attorney for the Southern District went ahead and issued it though. We get the feeling that, if not for the fact that she was the daughter of the founder of Huawei and the granddaughter (on her mother’s side) of a Deputy Governor of Sichuan (her father having married particularly well), things might’ve been rather different in ages gone by. A slap on the wrist, a few outraged interviews and the world would’ve moved on. We’re not legal professionals but a slight bureaucratic delay in the issuance of the extradition request until Ms. Meng was back on Chinese soil would’ve done it. After all, when there is a will there is a bureaucratic hurdle in the way.
Cynical? Remember Jamal Kashoggi? Sadly, probably not. Popular conscience seems to have the memory of a goldfish.
The very fact that there seems to be an increased propensity by both parties to dig themselves in quite hard tells you all you need to know, at the very least, about the importance of control over 5G and the global communications landscape/infrastructure for both governments.
The argument over Huawei’s opaque ownership structure and extraordinary closeness to Party officials are certainly red flags. This in itself shouldn’t be an issue altogether based on past behaviour though. If it were, it would essentially preclude us doing business with a large chunk of Chinese corporates. As we have previously written about, opaque structures and closeness to government officials is a norm rather than an exception in China. In addition, Huawei’s ability to garner local government contracts and scale operations on a rapid scale was actually what attracted US companies like 3Com and Symantec to partner with them in China in the first place. We have also previously elaborated on the eventual issues that foreign partners have had in sectors ranging from automotive to financial services (for further reference please look to the case of SAIC and GM in Shanghai). What is the distinguishing feature here is the sheer amount of friction this has caused on both a geopolitical and international front.
We think this might have more to do with how much of a threat the company itself, and the new economic footprint that the CCP has undertaken, poses to US commercial interests. The argument we make is that, as Huawei and other Chinese companies move further up the value chain (as opposed to basic manufacturing), this is inevitable. We have seen this story play out in the past, just look to Japan in the late 20th century. Similar rhetoric was used in pointing out the opaqueness of Japanese Keiretsu firms and the unfair advantages that said companies had in trade. Initially, in the US, governments and regulators alike were happy to see what was essentially labor arbitrage. They can no longer do so now as the Chinese economy has transitioned to middle income. In order to sustain growth levels and avoid the middle income trap/secular stagnation, the economy can no longer rely on cheap labor as the primary driver of corporate investment. The Chinese state’s solution to this conundrum poses a direct threat to high-tech US firms and Silicon Valley’s almost hegemony-like status.
Ironically, the vitriolic rhetoric of the Trump administration may have had the benefit of giving the Communist Party its catalyst to make some rather painful transitions domestically as the issue is now one intrinsically tied to issues of national pride. As we like to say, nationalism goes both ways. It gives the excuse that Beijing needed in order to build consensus and undertake the rather painful reforms. The inevitable slow-down and short term pain that comes from a rapid shift in policy settings as they make the transition towards consumption led growth and higher value add services/manufacturing can always be blamed on external forces (for example, quiet factory floors in places like Shenzhen and a ticking up of unemployment). The most obvious sign of this has been the increased tendency of Chinese consumers, especially in the younger generation, to dispense with buying iPhones in favour of local brands such as Huawei. The latest trend has been to build an app store that is a viable alternative to the Android or iOS based platforms.
So where is this going?
We do not claim to have a crystal ball that predicts who might end up winning in this race. But from Huawei’s perspective we think they have a marked advantage in many ways. For one thing, they are not driven by the same motivations as listed companies in the US or notions of shorter term profitability, not to mention the significant amount of cash that Huawei has retained on the balance sheet.The global communications supply chain is very interlinked as companies have increasingly looked to specialise. So, in essence, companies that might compete in one market might act as customers and suppliers in others. The blockage of US companies from doing business with Huawei will make consumers worse off in the short run at least. For one, Huawei has a proven record of efficiently and effectively building out network infrastructure, though they do rely on certain components from US companies for this. The ban will have the short term impact of slowing down the process of 5G rollout around the world and increase the associated costs. For telco providers such as Optus (Singtel), this will make things increasingly complicated, being caught in the crossfire, since they have to work around relationships with their US partners while still maintaining pre-existing strategic partnerships with Huawei (including things like their joint research center).
On a longer term basis, this will effectively create two distinct opportunities to benefit from. First, the creation of artificial regulatory barriers can actually be beneficial for incumbents as it can insulate them from competition. That being said, the increased competition from new greenfield markets might put downward pressure on margins over the long term but we think the insulation might be good for margins in the medium term. Rather than product segmentation our view is geographic segmentation will become increasingly important. So then the true target and playing field will be greenfield territories especially emerging markets across South America, South East Asia and Europe. These areas will be where Huawei and its American counterparts go head to head in a battle for dominance. With some insulation in terms of their existing foothold in domestic markets.
Source: telecoms.com
Huawei the Company: Potential Trajectory – How do we play this?
From a corporate perspective we will start by saying that we doubt Huawei will ever go public. Even the legendary founder Ren Zenghfei officially only owns 1.5% of the actual company, the rest of the ownership held through a series of opaque structures that give some credence to the suspicion of effective control by the Party. However what will be interesting for investors will be the implications that the regulatory environment creates for others across southeast Asia, including Taiwan. Said players will be beneficiaries through Huawei’s largess and their need to source alternatives in terms of hardware and supply chain replacements (some profitable opportunities to be had thanks to an acquisitive giant mayhaps?).Another strategy being touted is the potential for Huawei to open its software architecture and turn it into open source. They may also find themselves giving away certain technologies to partners that might be able to roll out in the US thus circumventing any sanctions. This will, we hope, be an interesting longer term trend and something they might look to achieve in pursuit of both positive synergies from an ideation perspective as well as a competitive ploy.
On the flip-side, Huawei’s closed and rather opaque governance mechanisms will also be a hurdle to further scalability in the wholesale market. This will be where politics will certainly come to play, with increased lobbying on an intergovernmental playing the prominent role. For example, the Chinese government might give certain incentives or parcel certain projects as part of the OBOR initiative in Central Asia.
We however doubt that the governance structure is going to change though even if it is profitable in the short-run and allay concerns from global regulators. This isn’t all about money after all, as any person who has followed Mr Zhengfei can attest. With his obsession for Napoleon and a penchant for European military art, we think this might not just be about profit. After all, here is a man who from humble beginnings as a researcher in the PLA (People’s Liberation Army) has built a global behemoth. For those of you unaware, he started very much as the perennial outsider, his family coming from a Koumintong background and being distrusted by Party Officials (which precluded him from joining its apparatus for a significant period of his life). He grew leaps and bounds by managing the officials in mutually beneficial manner as well as making himself useful by building up the nations capabilities in strategic sectors. With the new generation of Party Leadership being dominated by previously untouchable outsiders we think things will get a lot more conducive for him and he will play a vital role in the future of China’s commercial policy. This is mere speculation, but we somehow doubt his interests might be driven by purely commercial motives, in him we see a pragmatic individual intent on building a legacy. This aspect of his personality would certainly explain his hobbies and fascination for that other upstart conqueror in history.
But who are we to judge, we have our very own conquering types. The longest standing of these would be the infamous Rupert Murdoch brigade. In this instance all we can do is figure out places where we might pick up some profits in the fringes as they go about their process of Empire Building.
Huawei’s new campus in China (as we said, that penchant and fascination with European conquerers/imperial era styles is very real judging from the campuses alone)
Ron Shamgar takes a look at a selection of stocks – some good, some bad – following reporting season. Highlighting the important numbers and what to look for going forward, this is a must read for keen Aussie investors
This week we once again highlight some of our holdings that reported during August. The TAMIM All Cap IMA portfolios delivered a very strong performance of +4.55% during August. Calendar year to date the portfolios are up +28.21%. The TAMIM Small Cap Income Fund also delivered a strong performance of +4.13% during the month, calendar year to date the fund is up +23.92%. We discuss a selection of holdings from both portfolios below, including ISD, NEC, FXL, JIN, BBN, MNF.
Isentia (ISD.ASX)
Isentia is the leading media intelligence company in Australia and Asia Pacific. We previously highlighted the turnaround story within ISD under a new management team. FY19 results were in line with guidance at revenue of $123m and EBITDA of $23m. Cash EPS came in at 4.7 cents and operating cash flows were quite strong, benefitting from some favourable balance date movements. Overall, the balance sheet now has the lowest amount of debt since 2015 at $28m net debt. The business is finally benefiting from lower negotiated copyright costs and a focused and incremental investment into the product suite.
Management has done a good job of taking out costs by automating several aspects of media reporting. Guidance for FY20 is for $20-$23m EBITDA and we estimate net debt to reduce further to approximately 1x earnings. This is a level that we believe will enable the board to consider reinstating dividends. Management believes from FY20 onwards both revenue and earnings will return to growth (10-20% growth) and we see FY21 Cash EPS of 5.5 cents as a realistic outcome. Right now, we value the company at ~65 cents and we believe it is highly likely that ISD will get taken over in the next 2-3 years for over $1 a share.
Nine Entertainment (NEC.ASX)
Nine has done an excellent job of diversifying their revenue base away from the traditional broadcast TV business with only 47% of group revenue coming from TV. The business is now less susceptible to the structural headwinds and cyclicality of TV advertising spend. The company has new and emerging growth businesses to help boost long-term growth.Nine’s subscription streaming service, Stan, turned profitable in 2H19 and should add to profits in FY20. Stan has over 1.7m subscribers and should generate $200m+ of revenue this year. We believe Stan alone is worth a good portion of the current NEC valuation. Online property classifieds business, Domain (DHG), is recovering from one of the worst real estate listing environments in twenty years, and the acquisition of the remainder of Macquarie Media (MRN) should also be incremental next year.
Management can now focus on extracting revenue and cost upside on top of cross-selling opportunities from Nine’s full suite of media assets they have acquired in the last two years. Guidance for FY20 is for 10%+ growth on FY19 EBITDA of $424M. We estimate EBITDA to exceed $500M and EPS of 14 cents. We see the 5% ff dividend yield as quite attractive. We value NEC at ~$2.50.
Flexi Group (FXL.ASX)
FXL is a new holding, we initiated this position at $1.50. The company is a consumer and commercial/business lender and has recently appointed a new CEO, Rebecca James, who has finally pivoted and focused the business to target millennial customers in the Buy Now Pay Later (BNPL) sector. Under her stewardship, FXL has consolidated many different and confusing brands to a handful that are clearly resonating with their target market. We believe the company is on the cusp of not just lending volume growth but also a valuation re-rate.
FY19 results came in at guidance of $76m Cash NPAT after an impairment. The company is forecasting volume growth of 15% in loans for FY20 and has also seen strong traction for their newly launched BNPL brands. In addition to being profitable, FXL also pays a dividend of 7.5 cents fully franked. Both these metrics compare well to other listed BNPL stocks that not only don’t make a profit but won’t be paying dividends anytime soon. We feel that further evidence of customer and lending traction will see FXL re-rate materially. We value the company at about 100% upside to our buy in price. Our valuation is $3.00+.
Jumbo Interactive (JIN.ASX)
Jumbo is the largest online reseller of lotteries for Lottery license holder Tabcorp (TAH.ASX). We have known the business and the Managing Director for many years now. JIN reported strong growth in FY19 and exceeded guidance. Revenue was up 62% to $65m on ticket sales (TTV) of $320m and 776k active customers. Active customer growth and the number of large jackpots are the key drivers of revenue growth.
Management has also, for the first time, given a 2022 TTV target of $1bn. This will be a mixture of lottery sales and the new and emerging vertical of charity lottery. The company has over $70m in net cash and we expect acquisitions to help drive international expansion of charity lotteries. Based on the 2022 target, we estimate that JIN can earn $70-$80m of EBIT. We value the company at $30.00+.
Baby Bunting (BBN.ASX)
Baby Bunting was probably the standout retail result for the year. Net profit came in 12% above market consensus with sales up 20% to $362m with like for like sales up 8.7%. Online sales grew 46% to 12% of group sales. The balance sheet is strong with net cash and dividends also up 60% to 8.4 cents ff. Guidance for FY20 is 30% growth and further margin expansion.
BBN is benefiting from dominating its baby goods category. In fact, there’s no direct competitor left with more than a handful of stores. We see BBN as a “category killer” and will continue to take share away from competitors. The company is forecasting as many as five new stores to open this year. Private label brands are now 28% of sales and the long term target is 50%. This should see group EBITDA margins lift to 10%+. We bought BBN for the growth/dividend component of the Fund at $2.15. Our valuation is $3.00 and since the shares now exceed this level we have been trimming our position.
MNF Group (MNF.ASX)
MNF is a telco software provider of managed services to businesses and other telco wholesalers. The company specialises in cloud based hosted phone numbers (Voice Over IP or VOIP calls) and other applications to help businesses manage all their communication needs in the cloud. The increase of cloud based technology adoption and the rollout of services such as the NBN are benefitting the company in growing its user base. A key leading indicator for MNF is phone numbers hosted. This has grown 18% last year to 3.8m numbers. We like the large proportion of recurring revenue within the business with $50m of recurring gross margins within a total of $83m in FY19 (up 20%).FY19 results were a bit messy due to one off costs and acquisitions. More importantly 2H19 underlying numbers are showing strong momentum in the business and, on an annualised basis, are already within the mid-point range of the $33-$36M EBITDA guidance given for FY20. We expect the company to slightly exceed guidance, with a full year contribution from acquisitions and further organic growth, as they expand into Singapore and other parts of South East Asia. MNF is experiencing strong industry tailwinds as their small business and large customers – Google, Uber and the like – all require their services and innovation due to technology trends for the use of in-app and online communication technology. We value MNF at approximately $5.80.
Ron Shamgar takes a look at a selection of stocks – some good, some bad – following reporting season. Highlighting the important numbers and what to look for going forward, this is a must read for keen Aussie investors.
This week we highlight some of our holdings that reported during August. The TAMIM All Cap IMA portfolios delivered a very strong performance of +4.55% during August. Calendar year to date the portfolios are up +28.21%. The TAMIM Small Cap Income Fund also delivered a strong performance of +4.13% during the month, calendar year to date the fund is up +23.92%. We discuss a selection of holdings from both portfolios below, including EML, NBL, RMC, PPE, CLH.
EML Payments (EML.ASX)
EML was one of the standout results of reporting season. The company exceeded guidance at both the revenue and profit line. Key take aways included:
Revenue was up 37% to $97m and underlying EBTDA was up 43% to $30.2m (excluding one off costs).
Operating cash flow conversion of 75% met expectations.
Balance sheet finished the period at approximately $20m net cash.
More importantly the 2H19 annualized run rate provides a starting base of $33m EBTDA for FY20. Based on minimal organic growth, benefit of acquisitions and contract wins we expect $45m of EBTDA this year on revenues of around $130m.
EML is at an inflection point. Business momentum is accelerating and Gross Debit Volume (GDV) monthly numbers for June/July 2019 provide a strong start to the new financial year. As an example, in FY18 GDV processed was $7bn, in FY19 it was $9.3bn and we estimate FY20 GDV of $14.5bn. All divisions are growing strongly. With market consensus sitting at $40.5m EBTDA this year we feel that EML is due an upgrade. The AGM and EMLcon investor days in November should provide a further share price catalyst, with guidance and a potential announcement of a dividend policy. EML is our largest holding and we value it at about $5.50.
Noni B (NBL.ASX)
The Noni B result was solid and as expected. Sales came in at $864m with EBITDA of $45m. Guidance of $75m EBITDA this financial year was also reiterated. The positive surprise from the result was the balance sheet sitting in a net cash position ($7m) and the higher dividend which brings FY19 to 14.5 cents fully franked (ff). Online sales are now 10% of group sales and should continue to increase. The company has confirmed that they expect profit growth in FY21.
A new store opening strategy was also announced and should mean 100 new stores annually for the next three years. Management has also indicated that, with a huge database of customers, they are trying to capture additional share of wallet by launching new online stores in beauty, luggage and other accessories. These stores will white label other online retailers which means no risk or working capital drag for NBL. We expect any positive like for like (LFL) sales growth or improved gross margin updates for FY20 to help prompt a re-rating of the stock. We are expecting $80m EBITDA this year with dividends of 25-30 cents ff which bodes well when the shares are at $2.90. NBL is worth closer to $4.50 by our maths.
Resimac (RMC.ASX)
Resimac is one of the largest non-bank mortgage originators in Australia. From the results, points of note include:
FY19 saw strong asset growth of 19% with principally funded loans growing to $10.2bn;
Interest income was up 15% to $118m; and
NPAT was up 19% to $31m.
With cost to income continuing to reduce, RMC is leading to margin expansion. More importantly half on half growth in earnings has now continued for six consecutive halves. This is a key metric for any growth company. Management has also indicated that it is looking to expand into other lending segments.
Due to the recurring interest income from the loan book, most of the growth came in Q4 which did not fully benefit FY19 income but should provide a strong start to FY20. In addition, funding costs have decreased significantly in 2H19 and we expect this to also benefit earnings this year. Overall, we expect 30-40% earnings growth this year, taking it to 10-11 cents EPS. RMC’s share price has rewarded us since buying in at 50 cents but is still undervalued. For a company growing at 20-30% p.a., it is trading on an undemanding 9x PE with a 3% fully franked dividend yield. The sector is trading on 13x and we see RMC’s multiple catching up over time, most likely quite quickly. We now value the business at approximately $1.35.
People Infrastructure (PPE.ASX)
PPE reported a quality result and is experiencing strong industry tailwinds. Worth noting was:
Revenue was up 27% to $278m and NPATA was up 55% to $12m;
Cash flow conversion was strong and dividends for full year were well up to 9 cents ff;
EBITDA margin at 6.4% is tracking upwards to company target of 8% over the long term. These are world best margins for a staffing business.
Health and Community services is now 50% of revenues and management is targeting 70% over the next few years. This provides the company with higher margins, better pricing power as the current market leader, and a defensive earnings stream. FY20 guidance is for 25 cents cash EPS and we see further acquisitions coming in 2H20. The balance sheet has capacity for $20M+ of deals before needing to come back to investors for more equity. We value PPE at ~$4.50.
Collection House (CLH.ASX)
Collection House was sold off heading into reporting season as the company received some negative publicity in August due to the escalation in bankruptcy proceedings against some of their customers. In addition, their listed peer, Pioneer Credit (PNC), is currently suspended for accounting audit issues. Combine that with their largest shareholder selling out and a stretched balance sheet, and there is not a lot to get excited about here.
CLH’s results basically met company guidance but the quality of the result wasn’t great with many one offs and accounting adjustments to get there. Cash collections did not improve in 2H19 as expected although FY20 forecast is for substantial improvement. The company will need that improvement as capacity to borrow further is quite limited. We question management’s rationale for increasing dividends and some of their investments this year. Heading into the reporting season we had sold down our holding on these concerns and completely exited the stock in the wake of their results. Past mistakes have taught us to be more risk averse in these situations.
