Heading into the end of the financial year, one of the more interesting phenomena for us has been the upward correlations in both bonds and equities. Bond markets have been predicting a downturn in economic conditions while equities, especially given the performance of growth, seemingly show expectations of the opposite. Does it make sense? Or is there something else at work?
So there we have it, we are almost at the end of our financial year and close to half-way through the calendar year. What a year it’s been, on a global front we continue to see the central banks increasingly tilt dovish, and locally the RBA increasingly likely to go zero bound. Trade tensions have continued to escalate with US sanctions or tariffs imposed upon everything from Huawei to nation states including Venezuela, China, India, Canada and Mexico to name a few. The reaction from the markets? A mere shrug. One of the more interesting phenomena for us has been the upward correlations in both bonds and equities, so while bond markets have been predicting a downturn in economic conditions, equities especially given the performance of growth seemingly show expectations of the opposite. This offers an interesting conundrum.
Hence we thought it might be pertinent to ask the following question: Does it make sense? Or is there something else at work?
In answering this, we can start with the premise that, on traditional metrics, this does seem to be a late-cycle phase. Fundamentals wise, we have seen the continual downward revisions in global growth and corporate profits (as the impact of tax cuts in the US wear off). When combined with escalating geopolitical tensions ranging from trade to the increasing potential for war (i.e. Iran) it does seem rather more prudent to go towards risk off. However, this does not seem to be happening and one of the key reasons behind this may be elsewhere from where the market is currently looking, we put forward the proposition that the reason behind this is a combination of low inflation, low interest rates and, biggest of all, changing demographics which is creating a secular bull thesis for both equities and bonds.
In essence, from our perspective markets are being driven primarily by liquidity and the search for yield at present. As the developed world’s population continues to age and the savings flow into pension and superannuation funds we could very well see the evolution of a high P/E market along with inflation across every asset class including fixed income, which continues to defy the logic of everyday market participants. So, whilst it would be easy to suggest that this latest upward trajectory is a melt-up we cannot be so certain.
Demographics & Financial Markets
Perhaps one of the most under-researched and overlooked aspects of financial markets has been the precise impact of an ageing population on the composition of the markets. While there is the odd paper that looks at the broad macro-variables and the impact of an ageing population on productivity and underlying economic growth, the same cannot be said for its impact upon financial markets as well as the investment environment. This is especially concerning given that, as the below chart shows, demographics have been an exceptionally good predictor of crises in the past.
On an intuitive basis, the relationship is easy to understand using a simple life cycle logic. A person, let’s call them X, starts work in their 20’s typically. Their expenditure tends to exceed their income. They buy a house and, as they advance into their careers, their income will eventually reach a point where it will exceed the expenditures and, while the majority of their assets might still remain non-financial (property, vehicles etc.), the excess in income is typically put towards the accumulation of assets (often growth equities). As they continue to progress and hit retirement thresholds the asset allocation tends to be translated into income, usually through the use of annuity-like instruments or bonds, at which point a phenomenon called decumulation begins to occur. Savings are no longer prioritised, the focus is now on maintaining a certain lifestyle through a certain period of time. Now imagine a scenario where the replacement levels are continually on a downward trajectory whereby a growing proportion of the population is heading towards retirement and the working age population is shrinking. The first thing that tends to happen here is an increasing demand for bonds and annuities which put downward pressure on yields naturally and also leads to a steady decline in broadline savings rates (more decumulation) which gets worse as people live longer.
From a logical perspective, what do you get when there is less saving but growing demand for bonds (hint: it’s called leverage)? So herein lies our first point, there is already a secular demand for bonds and when combined with a lack of savings rates in the country, this tends to be a self-perpetuating cycle.
So then the next logical question from there would be to ask the question would be: as the population continues to age, does that mean that there is a bear case for equities? Going back to our person X, as he retires isn’t he likely to get rid of his equity assets and go towards less risky yield-based products?
Again, on an intuitive and arguably rational basis, this would be true. But consider a scenario where the central bank steps in and lowers interest rates toward the zero bound (doesn’t sound familiar at all, does it?), or even effectively crowd out private investors through QE. This would exacerbate the problem of demand and give further catalyst to bond prices, lowering yields across enough tranches that investors are forced to go towards riskier and riskier exposures (sub-investment grade) or go towards/stay in higher yielding equities. All this and the problem of leverage is exacerbated ever more seeing as there is next to no incentive to save in the system from whatever working-age population is left. On top of that, there is a further drive towards equities across all age groups again since the savings rate is zero bound.
So what does this mean for equities?
Coming back to why equities have held steady besides the perceived risks in the system. The answer is that in the current environment any slow-down in corporate profits would have to be great enough to offset a close to zero cost of capital. In other words, if the risk-free rate of return (which we accept to be the yield on government bonds or long-dated T-bills) is 0, or in Europe’s case negative, then corporate profits would have to turn true negative in order for the markets to actually correct or they will hold relatively steady. Put another way, a mere slowdown in corporate profits isn’t actually going to lead to a correction since the alternative is no-return. We believe this aspect of the market is not likely to change anytime soon given the lack of inflationary pressures in the economy. As the old saying goes ‘you cannot fight the Fed’ or any central bank for that matter.This also might answer the question of why the negative correlations between bonds and equities have been broken in recent years. In an ideal world bonds would be safe-haven assets and a diversification tool, but in a world where there is enough artificial demand created through zero bound interest rates and ageing populations they will neither be a good predictor of what is to come nor will they be a diversifier (they will be exceptionally and increasingly correlated with equities and, given the amount of demand for risk assets, will be increasingly disconnected with fundamentals and economic reality). That being said, we have always said that GDP growth never really had anything to do with equity market returns or Zimbabwe and Rwanda should have some real winners.
Does that mean we are suggesting that investors should continue to be 100% invested in equities? Definitely not. Equities as an asset class will be the best performer over the long-run but, unfortunately, most people do not think in time horizons of 100 years. So, we would like to reiterate the importance of staying dynamic in your allocations. One of the key elements to think about when structuring your portfolio should always be the concept of Net Present Value (NPV) and opportunity cost. In a world where there is no benchmark for the risk-free rate of return, our life becomes a little more complicated. What should the discount rate be in this instance? We would suggest that this will have to be an increasingly arbitrary percentage based on the calculus of someone’s age and minimum requirements (translated into yield). For example, if you require AU$50,000 and your total asset base is AU$500,000 then your discount rate would have to be 10%. Please note the example used is for illustration purposes only, using a 10% discount rate would lead to some unexceptional risk-management.
In the medium-term investors are unfortunately left with little choice but to have a risk on trade constantly and central banks have very little wiggle room, through blunt policy instruments, to unravel the distortions existing in the system (hence further increasing leverage in the system) unless we want to go through substantial pain. We all saw how that turned out in Powell’s case, we hope that he won’t be demoted anytime soon.
So a conclusion of sorts?
In essence, this is likely to mean that equities remain the largest component of any portfolio. That said, we will also likely see a greater amount of volatility in the coming months following the G20 as trade tensions continue to escalate and supply chains continue to be recalibrated. One of the most interesting developments to watch will be whether these geopolitical pressures also create inflationary pressures (we haven’t seen it yet, but consumers in the US will eventually see the cost of tariffs passed through) as these supply chains undergo changes. Closer to home, the slowdown in global growth and the double whammy of a slowing property sector is certainly a significant headwind given our reliance on commodities exports. However there is a caveat, even if you were not particularly optimistic about global growth, Australian investors have a significant advantage over their global counterparts. The nature of AUD means that it is a natural hedge against the volatility of global markets. What we mean here is that, because of the nature of our currency and its correlation with commodities, our investments should be able to significantly outperform and withstand any headwinds (especially USD based investments). In a bear scenario money tends to find itself going to safe haven currencies like the Yen and the USD. In fact, Australian investors with global exposures would’ve seen significant outperformance as a result of currency exposures which will, for the foreseeable future, continue to be the case.Closer to home, even if there are headwinds in the overall economy, the government put remains in place just as it is globally, whether you agree with it or not (thank god for 3-year election cycles?). And though Mr Lowe has ruled out QE, something in us thinks that when push comes to shove…..
This week we take a look at what makes a business an attractive investment opportunity and examine what we look for in our search for the next opportunity.
Here are some key points to look out for:
1 – The ultimate revenue model
There is nothing like waking up in the morning and knowing exactly what you are going to earn in the next twelve months. The same applies for businesses. We do like to see companies that have the bulk of their revenue contracted or recurring in nature. We look for these types of businesses as they have great visibility on their revenue going forward and typically offer a product or a service that is essential for their customers and difficult to replace.
Sticky revenue and sticky customers are a great start when it comes to evaluating a company. These types of companies tend to have less volatility in their earnings and so investors are willing to place high multiples on them compared to other listed stocks. Software and technology platforms and payment solutions companies come to mind when thinking about companies with this kind of revenue model, even “must have” professional services firms like accounting firms. Stocks we like and own here are EML Payments (EML.ASX, 90% recurring revenue), Altium (ALU.ASX, 60% recurring) and Infomedia (IFM.ASX, 95% recurring) and CountPlus (CUP.ASX, accounting services).
2 – Cash is king
There is a saying that ‘a company’s cash flows, are its profits on a truth serum.’ We think that this sums up one of the things we try and look for in any business. There are a seemingly endless number of accounting tricks that manifest as “profit” for a company but, at the end of the day, the cash flow statement never lies. You either have cash coming in or you don’t. Ideally, what we are looking for is a company that is able to convert at least 70% of their earnings into operating cash flow.
We also look at below the operating cash flow line, and see what capital investment is required to keep the business going and, more importantly, growing. The difference between these gives us the free cash generation of a company and that should, in most cases, equate to their net profits after tax. You would be surprised to know how many well-known market darlings don’t meet this simple yet important criteria. Retailer Noni B (NBL.ASX) and recruitment firm People Infrastructure (PPE.ASX) are some examples of companies we like in this respect.
3 – Build it once and sell it many times
Great businesses have developed a product or a service that, once complete, can be sold to many customers with little to no additional investment or expenditure required. We love these types of businesses because, as they scale up and grow, the majority of sales above the break-even point tend to fall straight to the bottom line. They tend to generate strong cash flows and have high margins. Again, technology platforms, software companies and payment solution providers form the majority of this category and it is not uncommon to see these types of companies generate Gross Margins in excess of 80% and earnings margins above 30%.
4 – Avoid value traps
There are A LOT of investors out there looking for value. Typically, true value investors are searching for deeply undervalued stocks that tend to trade on very low multiples, offer high dividend yields and are sometimes trading below asset backing. Similarly, growth-oriented investors are also looking for value but in a slightly different way. Their search involves stocks that tend to have low price/earnings-to-growth (PEG) ratios and trade on multiples that are, relatively, not as high as their peer group. In both cases it is important to distinguish perceived value from a potential value trap.
Many value investors get caught out in what initially seems to be a deeply undervalued company only to later realise the business is actually in structural decline. Growth investors sometimes get caught up in what seems to be a high growth company only to find out that the growth was not of a sustainable nature or that the comparable peer group has been de-rated dramatically. In both cases, analysing the historical trends of sales and margins can give some indication as to which basket a company may belong in. Some historical examples of value traps include traditional media and printing businesses while future value traps may emerge from the disruption to the banking and financial services industry and the shift to online sales when it comes to property or retail.
5 – The art of valuations, don’t be precisely wrong…
There are many ways to value a business. Most analysts and investors tend to use a discounted cash flow model (DCF) where by forecasting future cash flows and discounting back to today at a certain discount rate yields a company’s valuation. Others like to use price earnings (PE) and enterprise value (EV) multiples by comparing to an average multiple from a peer group of companies. We personally prefer a somewhat blended method incorporating all three as, unfortunately, each method has its flaws.
DCFs are easily manipulated by the chosen discount rates and trying to predict cash flows out into perpetuity is an almost impossible task. Comparing a company to a group of its peers is also risky. You may find the entire group of peers, or a few outliers, to be overvalued in nature thus distorting the average you are comparing it against. Additionally, these peers may have different fundamentals in play than the company you’re looking in to. Either way, it is important that investors do not get fixated on any one valuation method and learn to adapt and apply each to each company based on its own merits. We have always been advocates of the saying ‘We’d rather be approximately right, than precisely wrong!’
This week the TAMIM Australian Equity Small Cap team review some of the more interesting take aways from the November AGM season as it relates to their portfolio.
Konekt Limited (KKT.ASX)
Market cap: $52m AGM date: 16 November 2017
Workplace services provider Konekt (KKT) held its AGM during November. At the AGM, KKT confirmed forecast revenue growth of more than 70% and underlying EBITDA growth (excluding one-off items) of greater than 70%.
A key focus of the AGM was therefore on updating the market on its recent Mission Providence acquisition – pleasingly, KKT noted that there have been no surprises following completion and that the business was tracking to expectations. The acquisition diversifies KKT’s existing revenue streams, and enhances its ability to provide return-to-work (RTW) employment services, to complement its existing core offering of delivering RTW injury management programs (essentially managing the process of rehabilitating injured workers and getting them back into jobs – and where it is the current national market leader).
KKT noted the acquisition also provides KKT the capacity to enter new or underserviced markets. The logical potential new market here is providing RTW disability employment services – an attractive opportunity with the Federal Government’s 2017 budget highlighting an additional investment of over $3 billion in disability employment services to help people with disabilities get and keep long-term jobs.
A private equity fund has recently bought a majority shareholding in one of KKT’s key competitors – APM, the largest provider of disability employment services to the Federal Government (see here). Apart from this transaction, there has been growing private equity interest in the sector – possibly driven by the potential to capture some of the increasing amount of government funding committed to the disability sector.
KKT continues to trade on a PE multiple of less than 10x, with EPS growth (excluding amortization, abnormals and potential cost synergies) of 15% – 20% forecast over the next two years – a powerful combination of value and growth.
There would also appear to be little upside priced into KKT’s current share price to reflect the further growth available to KKT from the larger scale opportunities it is looking to capture, as the business transitions from its injury management focus to a larger, diverse, more integrated employment services company, operating in multi-billion dollar markets.
Joyce Corporation Limited (JYC.ASX)
Market cap: $48m AGM date: 30 November 2017
Diversified investment company Joyce Corporation reported a strong trading update at its AGM in respect of each of its businesses lines:
Lloyds online auctions – revenue growth for Q1 of FY18 of 61%
KWB Kitchens – revenue growth for Q1 of FY18 of 13%
Bedshed network – revenue growth for Q1 of FY18 of 5%
Investment properties – both now generating external rent with revaluation gains expected.
JYC continues to invest in the intellectual property and development of each business unit to ensure long term sustainable growth. JYC reiterated that on the whole, its businesses are resilient to economic cycles and are unlikely to face any significant threat from Amazon.
To summarise our investment case here, JYC has interests in:
The fastest growing, and one of the largest, online auction sites in Australia (FY17 revenue growth of 56%, and YTD growth of 61%);
The largest specialist kitchen renovation business in Australia;
A large bedding and furniture franchise business; and
Approximately $20m of recently refurbished real estate.
We view the sum of each of these equity interests to be significantly higher than JYC’s current $48m market cap.
Blackwall Limited (BWF.ASX)
Market cap: $52m AGM date: 17 November 2017
Blackwall Limited (BWF) – fund manager, property manager and manager/developer of the Wotso shared workspace business, held its AGM during November. BWF highlighted that by locating its Wotso workspaces in city fringe and suburban sites, it is able to achieve industry leading margins of 25% to 30%. This is because it incurs significantly lower rental expenses but is still able to charge similar rates for its spaces as city-based co-working spaces.
Wotso is a very fast growing business – during FY17, Wotso grew its revenue by 84% and operating profit by 93%. It manages the largest number of coworking sites in Australia, together with a Singaporean business, and is currently looking at New Zealand opportunities.
At the end of November, BWF confirmed that following the uplift in value of a fund that it manages, it had generated performance fees of approximately $11m. This fee will be converted into units in the fund – providing BWF with an ongoing income stream and the potential to benefit from further capital gains in the fund. This is an $11m asset that BWF did not have this time last year – and is quite material in the context of a $52m market cap company.
In addition to this ‘new’ asset, BWF has a number of other ‘surplus’ investment assets on its balance sheet – we estimate BWF’s net assets to be worth approximately $35m in total.
Deducting the value of these net assets from BWF’s market cap of $52m implies that BWF’s three operating businesses (the fast growing Wotso business, and BWF’s fund and property management businesses) are being valued at just $17m. The fund management business has generated performance fees of $14m in the last 6 months alone! To provide an indication of sector values for larger co-working companies, we note that WeWork, the world’s largest co-working company and Wotso’s largest Australian competitor, is currently valued at an incredible 20x its forecast
annual sales. (Wotso’s annual sales are currently tracking at approximately
$8m).
Paragon Care Limited (PGC.ASX)
Market cap: $138m AGM date: 22 November 2017
Healthcare equipment and consumables supplier, Paragon provided revenue and EBITDA guidance at its AGM which was in-line with market expectations and translates to ~10% organic EPS growth for the year (pre any acquisitions).
A number of growth drivers for PGC were articulated in the AGM
presentation:
– A growing demand for the provision of preventative equipment service and maintenance throughout the medical, scientific and allied health industries, with these recurring service revenues now expected to contribute ~10% of PGC’s FY18 revenues;
– Extending PGC’s geographic footprint – i.e. the rolling out of a new South Australian warehouse and logistics site in January 2018. Queensland and New Zealand are areas that remain underserviced
by PGC;
– PGC continues to benefit from increasing demand in the aged care sector with these revenues increasing 20% to $14m for FY17
– PGC’s e-health offering Midas, a web reporting software platform, is making strong progress towards contributing profit; and
– Strong pipeline of value accretive M&A to add to PGC’s product range, service and maintenance offering and geographical footprint are being reviewed.
Despite these positive developments the PGC share price continues to be weak. We believe the weakness can be explained by the following:
An upcoming CEO transition – short term in nature;
The market expecting a capital raise at some point to fund a potential large acquisition – again short term in nature if it happens;
Seasonality of the business becoming more pronounced as hospitals buying increasingly trends to the third and fourth quarters of the financial year (structural – but can be mitigated through increased service and maintenance and consumable revenues).
Whilst the current share price is disappointing, we expect the PGC share price to be materially higher this time next year. PGC have stated some aggressive financial targets (revenue of $250m and EBITDA of $37.5m) – and have an excellent track record in achieving its targets.
Robert Swift takes a look at the electric vehicle phenomenon and takes a look at how his TAMIM individually managed account strategy is looking to take advantage of this increasingly potent thematic.
Our one source of energy
The ultimate discovery
Electric blue for me
Never more to be free
Electricity
Nuclear and HEP
Carbon fuels from the sea
Wasted electricityOur one source of energy
Electricity
All we need to live today
A gift for man to throw away
The chance to change has nearly gone
The alternative is only one
The final source of energy
Solar electricity
Electricity, Orchestral Manoeuvres in the Dark, 1979
Aside from showing that our musical tastes are firmly mired in the late 1970s, this is an article on the apparent inexorable rise of electric powered vehicles, and the concomitant decreasing importance of humans in driving them. We seem to be in the midst of a number of significant technological changes including the prospect of a mass, government mandated, move towards Electric Vehicles (EVs).
Initially spurred on by environmental concerns, battery technology is likely to advance so rapidly that it will prove cost advantageous to switch to EVs as vehicle prices, running and maintenance costs come down, and recharging facilities become ubiquitous. For example, battery prices were around US$1300 KWh in 2007 falling to US$500 KWh in 2012, US$145 KWh in 2016 and General Motors estimates US$100 KWh in 2021.
At the moment, under 0.5% of all global vehicles are fully electric. Several governments, such as France and UK, have already mandated a date for the outlawing of combustion engine sales! Additionally, the UK has seen a price put on diesel emissions by a charge now levied on diesel vehicles, in addition to the congestion charge already levied, to enter capital cities. This has had an immediate impact on the resale value of diesel cars and the incentives are clearly being put in place to introduce fully or partially electric cars.
However, are electric cars feasible currently; are they truly less polluting, and how can we make money as investors, from this trend?
We don’t think EVs are currently feasible for a number of reasons, BUT will be when some other necessary changes take place – many of which are already underway such as ride sharing in cities.
Here are the obstacles which need to be overcome for EVs to be feasible and for a mass uptake possible:
1) Range.
EVs currently look good, especially the sports varieties, but do not have sufficient driving range to be viable, especially when there is the problem of…
2) Inadequate recharging infrastructure.
The USA has over 125000 gas filling stations and currently fewer than 15000 electric recharging stations. Not only that but the home voltage of 110V in the USA is inadequate to charge a battery in an acceptable time frame. Even at 220V, the standard elsewhere, the car battery would take over 8 hours to recharge. Check out the Nissan charge website here for details.
What about people who live in apartments or houses with no driveway? Are we to see wires hanging out of windows in streets tightly packed with terraced houses? It’s unlikely. In short, a lot of infrastructure spending is needed.
In countries where there has been some uptake of EVs like USA and China, auto manufacturers like Tesla and VW have built parking bays for re-charging so it’s possible. Local authorities in conjunction with electricity companies, have plans to provide further facilities in streets. Oil companies with existing fuel stations will also gradually convert these to electric charging as take up increases.
It is also likely that car dealerships will become marque aligned charge points. These businesses are already under pressure since there is really no reason for their existence. They are tied to the manufacturers for historical reasons, but the success of the direct selling model, piloted by Tesla, has illustrated their obsolescence. Qualcomm, the USA based technology company, is even discussing how charging can take place wirelessly from the road surface – effectively producing a limitless range vehicle – as you charge on the move.
The infrastructure will be built but capital expenditure requirements will be high, and experience has taught us that to invest during a period of high capital investment is not optimal – better to wait until we see who is winning and then enjoy the momentum.
3) Initial outlay cost for EVs is too high.
Savings from lower fuel costs will take most of the expected holding period of the car to materialise. Additionally, the EV technology is likely to get better and thus the resale value of even a three year old EV is likely to plummet at an ever faster rate. In short, a strictly logical buyer would still opt for a combustion engine or hybrid car over a fully electric powered vehicle.
4) Current technology.
The combustion engine will continue to improve both in terms of mileage and emissions. It is also not readily apparent that EVs are LESS polluting than the combustion engine, simply because the source of the electricity may be producing high carbon emissions? Additionally, the EV batteries tend to contain a lot of heavy metals which are hard to dispose and are polluting to mine. Put another way, when the fight is really on, the traditional technology has many more aces to play and the benefits of the switch may become LESS obvious not more.
Our conclusions?
1) EVs will become synonymous with driverless cars.
There will more incentives offered, and penalties imposed, from governments to aid the adoption of EVs and driverless vehicles. Higher gasoline or diesel taxes and additional taxes on low MPG cars and ‘congestion charges” are always good revenue raisers, and are consequently probable!This is very likely to result in the greater use of Electric Vehicles for short distances where the range limitations are irrelevant and probably as a ride sharing format. City commutes less than 15km by single passenger occupancy combustion engine cars may become a thing of the past.
Intel’s purchase of Mobileye looks increasingly clever since cars will become more intelligent if they are to be both driverless and use an infrastructure which is not yet fully ready.
2) For car makers, bigger will be better since some of the bigger car companies have deep pockets, but all the smaller ones don’t.
Existing auto manufacturers face both an opportunity and a threat from the transition to EV; they also have to grapple with other new technologies too – driving automation and artificial intelligence. This is already leading to vast investment expenditure by all the major players. Some will invest well and be winners, while others lose out. At this stage it is just too early to call but they will all share a need to deploy a lot of capital on new technologies.
Bigger may be better because they have deeper pockets. Our fund currently holds Daimler – the owner of Mercedes Cars and Trucks. They are rarely first to market with anything, but, they do have the size and financial resources to make the necessary investment scale. They have already developed an electric truck, and this is being trialed with various customers. EVs will become viable in short haul ride sharing format but longer distance driving and heavy payload will remain combustion engine dependent (at least in the short term).
Right now, it is just too early to know who the definite winners and losers will be from the auto manufacturers, but the picture will start to get clearer as time evolves. Newcomers like Tesla may be early, but they may not ultimately be successful – they may have made the initial technological leap – but ultimately vehicles need to be made to a consistent and reliable standard, and profitably. This can only happen with high volume capacity. This challenge may yet defeat Tesla.
3) Invest in the auto component suppliers since the capex burden will necessitate devolving more production and R&D to autoparts companies.
A way for the car makers to free up necessary cash flow is to outsource more of their existing work in the manufacture of parts, and their R&D functions. We like Lear Corp, Borg Warner, and Magna. Battery companies too will continue to be theme stocks. Battery technology is improving rapidly right now having been fairly static for decades, so we can’t be sure precisely what will finally win out. At present the focus is on lithium, cobalt and magnesium.
Toyota and Panasonic are cooperating on battery technology to provide a ‘Japan Inc’ solution and VW has committed over US$10bn with JAC Motors which is based in Anhui Province, China and listed on the Shanghai Exchange.
Mining companies with significant exposure to these materials may continue to do well – Albermarle, FMC Corp, SQM (NYSE), Tianqi Lithium Corp (China) have all been names in the headlines.
4) Invest in the shovel makers not the prospectors?
We’ve all heard the old saying from the California gold rush in 1849 – the ones who were sure to make money were the shovel suppliers – few actual prospectors got rich; many died.
This may not be a bad approach in this new gold rush? So, what are the “shovels” in the electric and/or autonomous vehicle market? Well electricity for one!
Of course, it will be some time before consumption by electric vehicles becomes meaningful for electricity utilities and the distributors, but it will eventually lead to significant growth for them from about 2025 and beyond. Many countries simply don’t have the capacity right now to meet this demand, so this will require more electricity infrastructure. This will have to be renewable energy such as nuclear, wind, solar or bio fuels. This will create demand for the likes of Siemens, Vestas, and solar panel manufacturers,
Another reason to like electric utility and transmission companies? The surge in crypto currency interest and its mining is incredibly power hungry. Power demand from Bitcoin mining operations has surged along with the Bitcoin price, and miners now consume as much power as Denmark! Bitcoin mining will consume 1.5-3% of global power.
These utility companies have suffered from poor performance in the growth driven stock market of the last few years and are now priced for zero revenue growth and profit declines. With growing power consumption per capita as living standards rise, and growing populations, this looks unlikely.
The following companies are ones we think interesting:
China Resources Power
ENEL in Italy
First Energy Corp in the USA
RWE in Germany (majority owner of listed Innogy, the renewable energy company)
We have been right in having zero exposure to utilities but as interest rate increases become increasingly discounted, and as electricity consumption continues to rise, the attractions of owning the shovel makers in this new gold rush are becoming increasingly tempting. We follow about 2,000 global companies of which about 120 are classified as utilities. Of these 120, over one quarter are in the top 10% rank by valuation. Put another way – many of these stocks are very, and disproportionately, cheap.
Invest in electric utilities and you can tell your friends that you are also investing in the future of electric vehicles.
This week Guy Carson takes a look at the Australian GDP figure and digs in to how it impacts the everyday share portfolio.
Last week the Australian Bureau of Statistics (ABS) released the GDP data for the September quarter. The headline result saw an economy that grew at 0.6% for the quarter and 2.8% for the last 12 months, both slightly below expectations. The annual rate increased from 1.9% year on year rate achieved in June as the negative September 2016 quarter dropped out. Beneath the hood, there were some interesting trends within the data with strong fixed investment (infrastructure) offsetting weakness in household consumption.
The chart below from the ABS splits out the different components of GDP for the latest quarter. As you can see the standout from the last quarter was GFCF – Private (Gross Fixed Capital Formation – Private) which represents private investment. This added 0.9% to the final number despite residential investment falling with infrastructure taking up the slack.
Source: ABS
On the other side is the Australia consumer. Household Final Consumption Expenditure (HFCE) added just 0.1% which was the weakest result since 2008. This shouldn’t come as a major surprise and is something we have talked about for some time (see here).
The trend of increased infrastructure investment, lower residential investment and subdued household spending are in our opinion likely to continue (again we wrote about this here). In order to see the economy transition away from the mining boom, the Reserve Bank of Australia cut interest rates to spur economic transition. With the worst of the mining decline now behind us, the RBA is reluctant for the interest rate cuts to continue (and at 1.5% there is a little scope for further cuts anyway). The interest rate cuts spurred a residential boom through both prices and (more importantly for the economy) construction.
Further interest rates cuts are most likely off the table now and that means no further boosts for the household. It also means house price growth will slow (and potentially reverse). With no sugar hits left for households, consumption is set to be weak and has been slowing for some time. We can see this trend in the chart below looks at retail sales growth by state. The decline has been led by the mining states with Western Australian and Queensland in negative territory whilst the other states are trending downwards as well after a strong bounce in 2012 as the interest rate cuts started.
Retail sales were particularly weak with two key drivers. On July 1, households were hit with two price increases. Firstly, the large amount of household debt got hit with APRA induced interest rate increases. These rate rises were for interest only and investor mortgages. This did see a significant amount of switching from Interest only to Principal and Interest but the overall impact remains capacity taken out of the household budget. Secondly, electricity prices went up 17% across the board. The combined impact is that heavily indebted households have less to spend. Whilst the media has focused on the entrance of Amazon to Australia, it is our opinion that the weakness in household balance sheets has been the major source of weakness for retail companies to date.
We do have to note thought that both of the price rises mentioned above are one off in nature. We do see households as the major risk to the Australian economy; however a stabilisation rather than a capitulation is the most likely scenario in the near term without further external cost increases.
The major question for households therefore becomes how much impact does the wealth effect have? The wealth effect is the theory that when household wealth rises, people will feel richer and spend more. On the flipside, when prices soften, spending will suffer. With a majority of household wealth held in property and prices potentially starting to soften, there is the potential that household confidence will weaken and spending will follow.
For us, the retail and residential sectors (as well as 2nd order derivatives) remain difficult to invest in. There may be specific opportunities but “Green Shoots” remain a distant thought.
On the flip side, infrastructure investment continues to be the most likely driver of economic growth going forward. The chart below shows the range of projects and the spike in activity set to come. The projects are focused on road work and along the East Coast.
Source: Cimic
Over the course of this year we have added positions across companies focused across the likes of Bridge building, surveying and scaffolding. These companies tend to be leading players in niche industries and as a result are typically ignored by larger institutions. We have been able to acquire these positions at what we believe to be attractive valuations and all cases believe the prospect for earnings growth over the coming years.
Timing the cycle is always difficult so whilst we do have an exposure to infrastructure, our major sector exposures continue to be Information Technology and Healthcare. These are two sectors that have structural tailwinds and contain quality niche companies that we believe will continue perform strongly regardless of the economic cycle.
