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Being early is the same as being wrong… or is it?

by | Jul 18, 2017 | Market Insight

This week Robert Swift examines one of the more costly mistakes of the TAMIM Global Equity High Conviction portfolio so far this year. We still believe the investment thesis for Macy’s to hold but this experience underlines the significance of timing on short-term returns in investing.
Macy’s – too early or just plain wrong?
Robert Swift
Contrarian investing is a great approach as long as you don’t forget that other investors are selling the stock because they think they know more than you. Sometimes they do. A stock you think attractive is cheap for a good reason and the cheapness is an illusion. You’re the ‘patsy at the table’ that other investors want to offload their stock on. Consequently, since we don’t want to be wrong too often, we try to identify cheap stocks with a catalyst – “cheapness AND change”.

Anyone can see that a stock is cheap by using publicly available information on P/E, Price to Sales, or Price to Book. This is not really forward looking analysis at all but a simple exercise in sifting stocks based on historical data. What is harder is to identify the reason for the earnings, the price earnings multiples, and the share price to rise. Cheapness alone is not enough for us. There has to be some change to attract other buyers and for the company’s management to convince us and other investors that they can deploy capital into more profitable projects and return the company to even modest growth. It’s the combination of cheapness and change that works well in a value approach.

We categorise the catalysts in 3 dimensions:

  1. Management change,
  2. Strategic change often with balance sheet change, (disposals and/or acquisitions) &
  3. External/Regulatory change.

Most often one or more of these is the catalyst that drives a share back to favour and the share price higher. It is a well-known ‘problem’ to be too early when you buy cheap stocks. It is a ‘problem’ because the investment can take time to come to fruition since other investors have to change their mind and start to buy the stock. Having seen it underperform for so long it is often hard for them to do so rapidly. This time delay is an opportunity cost (there may be much more fun going on in other stocks elsewhere where the crowd is gathered) and it is important to be paid to wait in the form of an above average dividend yield. Timing the entry point perfectly is hard, but even if we invest a little ahead of the catalyst being evident, we don’t mind waiting a while partly because the dividend yield pays us to be patient. Never forget that a significant part of the total return from equity investing is the dividend yield and not just the share price appreciation!

A stock which possessed cheapness and, we thought, catalysts for change was (and still is) Macy’s (M.NYSE). This is a department store which trades under the brand Macy’s and Saks 5th Avenue. It has not been easy for the company but we see both internal and external catalysts.

Unfortunately, we invested both at a higher price and sometime ago at the beginning of 2017. Six months later the price is lower and while we have collected some dividends, we are ‘underwater’.

So what has gone ‘wrong’ and why are we holding on?
This retail industry is certainly a tricky place to invest right now. You’re either forced to pay sky-high valuations for the stocks like Amazon (>1860 earnings) or Ulta Beauty (35x earnings) that are working on momentum alone or to take chances with potential value traps like Macy’s, Target, or Kroger, all of which have near single-digit valuations, but also don’t seem to have many growth prospects in the near term. Some former glamour retail stocks are at the brink – such as Sears, Abercrombie & Fitch,

What do we see in Macy’s?
The retail ecosystem (landlords and retailers) is now, finally, responding to the Amazon and Alibaba category killers. The weaker players such as Sears have been driven to the precipice but survivors will have more market share available, less competition, and the benefits of having managed against a tough backdrop which means a tight cost structure.

Macy’s will survive and should prosper – at these stock prices we are now getting paid 7% in the form of a dividend yield to wait for the changes made by new management to have an effect on profitability, business strategy and the share price. We also anticipate mall owners to respond to the internet by driving more foot traffic through their doors. This morning we saw this story about a Shanghai mall from the local press.

We are generally underweight consumer cyclicals and believe that the consumer is over-leveraged in the UK, the USA and Australia and doesn’t have much spare income at all. We also watched Amazon and Alibaba roll out their business on the internet; saw the demise of Barnes and Noble the USA bookseller which was the first to be hit by Amazon’s internet book sales, and so waited for the retail carnage to continue driving down stock prices everywhere.

Then early this year we decided to enter the retail industry and purchased Macy’s for the model gobal high conviction portfolio.

Why will Macy’s survive and prosper? What on earth were we thinking?!
Asset value – about half of retail space is freehold and worth considerably more than stated in the report and accounts. The credit card business alone is possibly worth several billion $ since it generates about $700m pa. The value of the company in the stock market is currently about $7bn. It is very likely that the net asset value of the real estate is 3x that.

We think the market is effectively ascribing negative value to the retail and credit card operations and has a jaundiced view of the real estate value. It is a classic contrarian value opportunity and we anticipate that even a stabilisation in store sales will see a rapid reappraisal of the company.

Sales and cash generation – sales per quarter are equivalent to almost the market capitalisation of the business. Put another way the company is valued at about 25% of its annual sales. Cost reductions will flow through to the net income line as long as management can stabilise the revenue numbers once the store disposals are completed. We think they can.

Change is evident in Management action:
Cost cutting and refocusing – New management is cutting unprofitable or marginally profitable stores. Real estate disposals generated over $650m last year which is equivalent to 10% of the market capitalisation. A venture with Brookfield (albeit on a small portion of the asset base) has been signed to optimise the real estate portfolio. Meanwhile total sales fell only about 3%. It’s not the sales at any price margin that are important but making profitable sales that matter. We think it obvious that total sales will fall as the company rolls out a closure programme and news flow on this does not concern us.

New management has a positive attitude to shareholders and has continued with share purchases from the considerable free cash flow.

Reinvesting to grow again – The company is driving foot traffic to stores with new formats such as Spas (Blue Mercury) and discount offerings (Backstage) and digitising (belatedly) their retail offering (check out www.macys.com).

Macy’s online sales are growing in double digits so it’s not like Amazon is the only successful online destination! We believe that general retailers have forgotten that impulse buying is important as is the consequent need to bring foot traffic through the door. The food retailers are currently better at this. Tastings and samplings, price discounts on a seasonal basis, and recipe ideas, all help to create excitement. Why for example do Myers in Australia not hold lunchtime “fashion shows” in their stores to showcase this seasons’ looks and to create additional visits? If you travel and want to see how a UK department store is adapting its space to meet a changing market then go to Fortnum and Masons in Piccadilly in London. The 3rd floor has been transformed from menswear (which is offered in overabundance in other local outlets) to a cocktail bar.

A destination for a quiet drink perhaps while some shopping is done? We did a bit of digging and it transpires it is quite profitable AND popular as a starting point for an evening out.
Macy’s is trying to generate more visitors with its Backstage format and value shoppers are able to shop for discounted clothes and help Macy’s improve stock turn. We anticipate more concepts being rolled out.

External change is occurring – All USA malls are adapting to the online impact (finally) so the 50% of leased space that Macy’s have is likely to piggy back that. Macy’s has stores in over 70% of malls categorised as A grade so since these will survive and fight back…Macy’s should do alright. We would be concerned if they were predominantly in B and C grade malls.

The metrics to measure management success are no longer total sales growth or like for like sales growth, but sales per employee and free cash flow to pay dividends and invest in digital platform.

Lacklustre sales growth on a like for like basis is spooking some investors but it shouldn’t be the metric to define success. We continue to judge the transition as being successful if we see the following continue:

  1. Continued asset disposals producing net gains to the profit and loss statement, thereby maintaining the strength of the balance sheet and proving the conservative carrying value of the real estate in the books.
  2. Free cash generation net of continued investment in the digital platform
  3. Sales per employee continuing to rise

The Lendlease Income Opportunity

by | Jul 12, 2017 | Stock Insight

Following on from our previous discussion of income versus capital as a source of portfolio return Scott Maddock and the team at CBG, of the TAMIM Australian Equity Income IMA, look at Lendlease (LLC.ASX).
The Lendlease income opportunity
Scott Maddock

LLC is a leading development, construction and investment management business, operating in 9 countries. We believe the company is positively leveraged to global economic activity. Operationally the company has been on a path of continuous improvement since their last major construction losses in 2004. Delivering a strong operational track record, generating 14% ROE. We expect LLC to have net cash within 18 months (5% gearing currently).

The current dividend does not seem high at first glance; however, LLC has a history of paying excess cash to shareholders – notably following the sale of a major Shopping Centre development for $1.3bn in the UK in 2014. We feel LLC will have the opportunity to deliver more cash to shareholders as current projects mature.

The Australian housing cycle is a fixation for most of us and we assume all our readers have a strong view regarding the near-term path of housing prices. We feel it’s clear that as housing construction activity peaks in Sydney and Melbourne this year, that housing prices will also peak. This process is assisted by controls on bank lending – both internal and those imposed by the bank regulator, APRA.
In this context, many would say LLC is a risky investment – and that’s true to an extent – contracting and construction businesses have inherent risks which we do consider. However, the housing cycle is less of a risk than you would think at first glance;
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  • LLC’s exposure to Australian apartment earnings peaks this year at only 20% of group earnings.
  • Developments are 80-90% (and higher) pre-sold and most purchasers (especially from overseas) are holding a significant unrealised profit. This suggests there will be a low final payment default rate as buildings are completed.
  • Even during the GFC both LLC and Mirvac Group observed less than a 3% default rate, recently defaults are running at less than 1%.
  • Lend Lease’s apartment construction business includes projects in the UK and USA, further diversifying the sources of likely cash flow.

In summary, our investment thesis is that LLC has invested ahead of the economic cycle, has significant pre-sold revenue for work in progress, with buyers having paid 10% deposits and sitting on capital gains – therefore significant defaults or losses for LLC are unlikely. We expect that as most projects are finalized during the next twelve months (see table) we will see significant cash generated. Since LLC has relatively low levels of debt, cash should be available to increase dividends or potentially allow a capital return.

Source: Lend Lease company filings

Source: Lend Lease company filings
Just as importantly LLC earnings will benefit from growth in construction activity in Australia – particularly in road-building and related infrastructure. The company has also been increasing capital employed offshore. Capital allocated internationally is expected to increase from 23% of total to 30-50% as LLC apply their expertise in Urban Renewal projects around the world.
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We believe valuation remains attractive vs. history and global peers, on a 12x forward PE vs 17x for similar global listed construction companies. LLC is likely to deliver more cash to shareholders along with a positive share price return.

At 5 July 2017

Mid-year Australian Update – Have we turned the corner?

by | Jul 12, 2017 | Stock Insight

This week Guy Carson provides a mid-year-update to his 2017 Outlook for the Australian economy. Have things been playing out as expected in the two-speed economy or is there more yet to come?
Mid-year Australian Update – Have we turned the corner?
Guy Carson
At the start of the year, in our 2017 Outlook, we wrote about our concerns over the two speed nature of the Australian economy. Our fears seem to be largely playing out through the first quarter as GDP came in at a very soft +0.3% q/q and +1.7% y/y.  However, as the year has progressed a few things have surprised us, primarily the strength of the Australian job market and as a result the recent rebound in consumer activity. The strength of the Western Australian job market in particular has been a significant surprise. Given this new information at hand, it seems worthwhile to revisit our views.
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The change of course for the Australian economy seems to have started around March when the employment data took a significant turn for the better. Over the three months starting March we saw employment gains of 60k, 46k and 42k. For a steady unemployment rate a figure of around 15k is needed to keep pace with population growth. As a result the unemployment rate has fallen from 5.9% to 5.5%. The biggest improver somewhat surprisingly has been Western Australia where the unemployment rate has fallen from 6.5% to 5.5%. The other main improver is New South Wales which continues to have the lowest unemployment in the country.

Source: ABS
With lower unemployment, we have started to see an improvement in retail sales over the last two months. After a steady decline since 2014, national retail sales have rebounded significantly in the last two months up 1.6%. Western Australian continues to lag the other states but there is some sign of life.

Source: ABS

These are positive turnarounds, more people with jobs leads to increased consumer spending and increased economic activity. Whilst GDP is a near impossible number to predict, we can say the foundations are there for a rebound in the June quarter. Hence the question we get is have we turned the corner? Are we out of the woods yet again?

At this point, we are not confident that these positive signs will be maintained. Yes, near term economic signals are positive but for us three key structural challenges remain. These challenges are:

  1. Record low wage growth.
  2. Record high household debt.
  3. An unprecedented building boom that appears to be softening.

Despite the strength in the labour market over the last three months, we are yet to see signs of wage pressures. In fact wage growth has declined steadily in Australia since 2012 and is currently running at its lowest level on record at 1.9% year on year. During this period we did see a significant decline in unemployment in 2015 but even this did little to stop the wage trend. The current bounce in the employment numbers would therefore, in our opinion, need to last significantly longer to have an impact.

Source: ABS
​Low wage growth is a major problem. This is particularly true when combined with record household debt. Recently the cost of that debt has started to rise. Due to the intervention of regulators, the banks have announced significant interest rate hikes for interest only loans (due to come into effect this month). The intention of these hikes is to get property investors to switch from interest only to principal and interest. The net effect will be slightly increased total payments. A small increase on a large amount can have a big impact and, as we have written about previously, Australian household debt to GDP levels are currently the second highest in the world (according to the Bank of International Settlements) and above the peak that the likes of Ireland and Spain saw before the GFC.

Source: Bank of International Settlements

A majority of this debt sits against residential property which has been a key driver of the Australian economy in recent years. In response to the end of the mining construction boom, the RBA began to cut interest rates in 2011. All up they have cut rates from 4.75% to 1.50% and have seen off a recession we most likely would have had otherwise.

The interest rate cuts have enabled households to borrow more. In turn this has led to house price increases and higher house prices have led to greater incentive to build. The residential construction industry has as a result boomed, primarily across the East Coast and primarily in apartments. The RBA has effectively replaced a mining boom with a property boom.

There is a considerable amount of research around about the impact of residential construction booms. The Bank of International Settlements has warned against cutting interest rates to boost asset prices and the consequences that it can have. Regular readers of ours will also know about Edward E. Leamer’s paper “Housing IS the business cycle” where he paints residential construction as the major cause of economic recessions. One of the key points that Leamer makes is that “house prices are very inflexible downward, and when demand softens as it has in 2005 and 2006 [in the US], we get very little price adjustment but a huge volume drop. For GDP and for employment, it’s the volume that matters.“ So whilst most of the commentary and focus remains on Sydney and Melbourne house prices, we would suggest that people need to be more focused on the volume and here we are starting to see potential signs of a decline in construction activity.
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The chart below looks at residential building approvals, commencements and completions on a national level. From this data we can see that building approvals act as an excellent indicator of building activity and they are showing signs of rolling over. If we were to see a continued decline in approvals from here we will start to get very nervous. Typically commencements follow approvals closely and completions tend to peak 6-9 months thereafter.

Whilst the decline is a on a national level, there are certain areas that are leading the fall. The below chart looks at apartment approvals on a rolling annual basis. There are two interesting things to note. Firstly all of the four states that experienced booms are off their peaks, and secondly there is real pain set to come for apartment developers in Queensland.

Source: ABS

With the residential construction boom potentially coming to an end, there will be a growth hole to fill. The RBA cut interest rates by 3.25% to fill the hole from the mining boom, but now with interest rates at 1.5% they have significantly less fire power. Which begs the question of how the RBA would deal with a prolonged slowdown?

The counter argument to our assessment of the residential boom is that due to record immigration levels, current building levels are rational and must be maintained. We take a slightly different view and would suggest that immigration may have a component that is pro-cyclical, i.e. people will move to where there is work. On that basis, it’s the building work drawing people here and not the people moving here that is forcing the building work. On this point we would highlight that Iceland, Ireland and Spain all had record immigration in 2007 and we probably don’t need to remind people what happened in 2008. For Australia, whilst immigration has remained high over the last decade or so, there are three clear surges. These surges occur with both stages of the mining boom (pre GFC and post) as well as the recent residential construction boom.

In summary, the last few months has seen renewed energy from the Australian consumer and that could provide some short term relief to sectors such as retail and financials. However, when we invest we take a longer term view and believe the risks to the downside outweigh the upside for these sectors. As a result, we continue to focus our efforts on finding companies with structural tailwinds, global earnings and strong value propositions. These companies should be able to grow and prosper despite an uncertain domestic economic environment.

New financial year – Asset allocation update

by | Jul 3, 2017 | Market Insight

Robert Swift provides an update on his stance on asset allocation having just ticked over into the new financial year.

An update from our asset allocation models.

One of the most important decisions is how to allocate your money across different asset classes – property, bonds, equities, or cash. This is because a combination of these assets will be less volatile than simply holding equities, and the returns, although lower, will be safer and reduce the chances of a nasty surprise to your pension pot.

Summer in the Northern hemisphere often brings with it dull markets – the “sell in May and go away” expression is routinely trotted out for a good reason! Fewer investors at work, fewer company announcements and a long break for politicians, makes for a lack of news flow.

In the absence of news, markets tend to drift lower. Will it be the same this year?

We first wrote on asset allocation four months ago and thought it was time to revisit the landscape using our asset allocation models.

Our conclusions then were:
Equities – overweight especially Value
Bonds – underweight especially net debtor countries such as Australia, Turkey, Spain
Property – residential is overpriced and liable to be taxed by governments keen to spend more of your money. Be careful of yield hunting.

How did we do?

We did ok and you would have made money following the recommendation.

Most European equity markets have drifted a little over the last month, after a strong few months, but the US has continued upwards, as has Japan and a number of Emerging markets like China. We have held a strong Value bias in equities for a few months now and have been wrong in this regard.

​Growth styles, and the ‘sexy six’ have performed exceptionally well. We aren’t changing our view on this and still recommend a Value tilt in an overweight equities position.

Our Tactical Asset Allocation model continues to like equities overall, and still prefers them to Bonds.

Other asset classes to consider currently are:

Overweight Equities

  • Prefer Value style, with dividends and high free cashflow yield
  • Prefer Financials, Cheap Tech, Telecoms

Underweight Advanced Economy Government bonds.

Equal weight Emerging Market bonds (China, Asian & Middle East issuers) but avoid South Africa & Brazil

Underweight commodities especially oil

Underweight residential property (including Australian banks). Prefer industrial and retail in Asia

Given the inexorable rise in debt (see the chart above) over the last decade, and the decline in interest payable on it, as a consequence of central bank intervention in fixed income markets, the question you have to ask yourself with bonds is: – “Why should I lend money to governments at 2-3% when there is so much debt already outstanding?”

We wouldn’t! We might at 6%.
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Looking at the charts below it appears to us that the only value in bond markets is to be found in certain emerging market bonds. These are bonds issued by net creditor emerging market countries and they still offer returns of 5-6% (LH Scale on left chart) which is a reasonable return. Avoid bonds with negative yields and those issued by governments which are heavily indebted already. (Right Hand chart)

Central bankers and politicians are the greatest larcenists of all time and will use inflation to erode your purchasing power. The chart above tracks cumulative inflation over the last 100+ years. Most has occurred since the rapid issuance of government debt for ‘welfare states’ and the constant temptation to monetise this and reduce the liabilities aka your savings!
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Inflation hurts bonds more than equities where companies can, usually, pass on cost price increases and whose asset values rise in line with inflation.

Near term risks and what to watch

Purchasing Managers Indices – widely followed data as an indication of near term economic activity – have recently showed slowing activity. If this continues over the Summer this may see medium and long term interest rates move down and bond prices move up.

After a good first half of the year we may well see some pause or setback in equities, but they continue to be the preferred major asset class for now, given that we are currently in a broad synchronised global upswing in global economic activity.
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Within equities, across the regions we continue to prefer Europe which is exhibiting its best growth since the financial crisis in 2008. Emerging markets are also now looking attractive both in terms of valuation and price action. The USA is the market where we continue to struggle to find value in stocks. The rally there has been very narrow there in the top hot tech stocks – Apple, Facebook, Google, Amazon – when you strip those out – the US market advance has not been widespread.

From the chart above you can see that Value stock returns have fallen relative to Growth stocks.

Value stocks have been disappointing for sure this year but we continue to believe that the focus on just a few big stocks in major indices has been excessive. Meanwhile some very good companies such as Daimler, Glaxo SmithKline, China Mobile, Legal & General, JP Morgan, Itochu are on modest PE ratings and with dividend yields in excess of 4%, will find favour.
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The market may be a voting machine in the short run, but it’s a weighing machine in the long run. Now is the time to favour companies paying sustainable dividends, with asset backing. Now is the time to ensure your portfolio is set to take advantage of these coming market changes!

Positioned for Brexit

by | Jun 28, 2017 | Stock Insight

Robert Swift talks about how the TAMIM Global Equity High Conviction IMA is positioned heading into the Brexit vote and in particular reviews our 3 London listed investments.
This week we republish an article written by Robert Swift, the Chief Investment Officer of the TAMIM Global Equity High Conviction Individually Managed Account (IMA).
Can we immunize the portfolio from Brexit or Bremain risk?
Robert Swift – Head of Global Equity Strategies
Much has been written on the referendum on June 23rd when eligible UK citizens will be able to vote on whether to remain in, or begin to negotiate an exit from, the EU. You’ll be glad to know we won’t be making arguments for either choice in this article, and that this article will be brief.

It is a fascinating, and unprecedented, spectacle not least because the protagonists on either side transcend their traditional divisions. There has been much nonsense spouted, but by the Remain side in particular, and it is perhaps some of their insulting and patronising drivel that has caused the outcome to become closer than initially thought? We don’t trust polls but the bookies, who tend to be better predictors, have certainly shortened the odds on a Brexit. Consequently, if markets are sort of efficient, the closeness of the vote predicted by the bookies, should be discounted in the equity markets? Theoretically what only remains as a risk is if the vote is a resounding victory for one side or the other?

We’re not so sure and a narrow victory either way as well a resounding victory either way needs to be considered. While the numbers don’t warrant a big reaction (Total value of ALL trade and services between the UK and the EU accounts for around 1% of global GDP. Nobody for one minute is suggesting this will disappear overnight) there may well be one since markets love to overreact. Since we can’t predict what will happen we need to try and reduce portfolio exposure to a deleterious outcome. We think we can do this without going to cash by selling all UK exposure.

Here is what we have done. We own 3 UK stocks of which only one may be exposed to a shock in the UK economy and changes in interest rates and legislation. Two of the companies we own are multinational businesses, Glaxo, and HSBC which happen to have their main listing in the UK. They could just as easily be listed in New York, Shanghai, or indeed Frankfurt. If Sterling falls on a vote to Brexit they should benefit. Their US$ earnings are substantial so they are also a hedge against Euro risk. On a decision to Remain, they are quite likely to be favoured if investors wish to take on equity risk in a relief rally. Given the UK’s very large twin deficits we don’t think a vote for Remain causes a permanent and painful increase in the value of Sterling. Any such relief rally in Sterling is likely to be short lived.

The ‘pure’ UK company is National Grid which owns regulated electric and gas transmission assets. It also owns assets in the USA which actually comprise about 1/3rd of its asset base but it is overwhelmingly considered a UK company and its shareholders are predominantly UK based.

We find the company attractive because it has a stable and strategically important business, and has a high and growing dividend yield. This is a much better investment option than a UK bond or gilt at current interest rates. National Grid is unlikely to be affected by a close vote or an overwhelming vote either way. The UK is running seriously close to full utilisation in energy; NG is investing, and is being encouraged to invest by the regulator. The dividend yield will become really attractive if the Bank of England has to cut interest rates on a Brexit vote, to boost the economy. On the other hand if there is capital flight and an increase in interest rates to protect the pound Sterling, funding for capex is more likely to be directed TO this company than removed given the UK’s imminent energy shortages.

We believe these kinds of companies are attractive regardless of the outcome on June 23rd. We will be watching and relaxed doing so!

Happy Investing,

​The team at TAMIM