This week Guy Carson, manager of the TAMIM Australian Equity All Cap Value IMA, takes a look at the Australian supermarkets, the prevailing duopoly, incoming competition from ALDI, Costco and Amazon and how the future looks for this sector.
Australian Supermarkets: The death of a duopoly Guy Carson
If you were to travel back in time five or ten years ago and asked Australian fund managers to name some of the highest quality companies listed on the ASX, there would be very good chance that a number of them would name Woolworths. For a long period of time the company was so consistent with its store roll-out, earnings growth and returns on capital that it was hard to go wrong buying the shares. Unfortunately that has all changed. Fast forward to today and ask some of the same fund managers to name one of their favourite turnaround plays and you might get the same answer, Woolworths.
What caused this dramatic change in investors thinking? For the answer we need to look through recent history. Back in 2007, the industry structure was a cosy duopoly of Coles and Woolworths with a third player, Metcash, carving out a niche. Life was easy for Woolworths, particularly as their management stayed one step ahead of Coles in store layout design. The Coles share price was suffering and Woolworths was booming. However, the first major change to the industry was close and after rejecting two bids from private equity firm Kohlberg Kravis Roberts & Co, Coles was bought by Wesfarmers for $22bn. This was the largest ever takeover in Australian corporate history and many fund managers wrote the price off as too high and believed Wesfarmers would fail.
The initial share price reaction was negative for Wesfarmers (WES) whilst Woolworths (WOW), seen as “recession proof” by many, held up remarkably well during the GFC. Wesfarmers raised capital initially at $29 for the acquisition then was forced into another raising at $13.50. Investors in those capital raisings have done well with the share price sitting at $43 now.
Source: Thomson Reuters
Meanwhile in 2014, Woolworths share price started to take a turn for the worse. They had begun to lose to market share. After years of mismanagement, Coles had become a legitimate competitor (arguably by copying the Woolworth’s model). In addition a new threat had emerged. After opening its first store in Australia in 2001, Aldi has opened a further 456 stores and has grown to be a significant presence with close to $7bn worth of sales last year. In comparison, Woolworth’s food division had close to $35bn of sales, and Coles had $32.5bn.
The main loser to date from Aldi’s rise has been Woolworths with Coles more or less maintaining their market share after gaining ground between 2009 and 2015. The reason behind Cole’s success during this period was twofold. Firstly under new ownership, the company spent a lot of money on store revamps to make their offering more appealable. In recent years the company has spent a significant amount of growth capex in order to catch Woolworths. The below chart compares their capex spend to their depreciation charge (a proxy for sustaining capex) to show how aggressive their spend has been.
Source: Thomson Reuters
With more appealable stores they closed the quality gap between themselves and Woolworths. The second aspect of their success was undercutting Woolworths with regards to price. Coles typically ran EBIT margins of below 5% versus Woolworths above 6%. Hence, consumers started to migrate to the cheaper option. Woolworth’s margins (which were the highest of any supermarket in the world) were simply unsustainable. The company has now realised this and has started to compete with Coles on price as can be seen by the fall in margins below.
Source: Thomson Reuters
The problem for Woolworths and Coles is that they are likely fighting for a smaller pool. The rise of Aldi is unlikely to be halted any time soon with an aggressive rollout plan. They continue to have significantly lower margins with lower grocery prices and smaller store areas (meaning lower overhead costs such as rent). EBIT margins for Aldi in Australia were 4% last year according to the ATO.
Another competitor set to gain market share is Costco, where their unique business sees them run EBIT margins of sub 3%. Costco make over three quarters of their profit from their annual membership fees (currently $55 per annum in Australia) and as a result can sell the goods to consumers near cost, hence the name.
Source: Thomson Reuters
Then there is the imminent arrival of Amazon into Australia. This is less of a worry than the above threats. Amazon has struggled to make meaningful headwinds into the US market with consumers still preferring physical stores for groceries. Their market share currently stands at around 1% of the US market and in attempt to grow that, the company is experimenting with physical stores in Seattle.
Whilst Amazon is currently grabbing headlines, the major threat for the major supermarkets remains Aldi. The constant of an aggressive low cost competitor means life will remain difficult. Despite that pressure we have seen a significant rally in the Woolworths share price since June last year. The rerating has been driven by two consecutive quarters of solid sales growth and a rerating in the Price to Earnings ratio from around 16x to 23x. Meanwhile, Wesfarmers has gone the other way and seen their P/E ratio fall from over 20x to 16x (driven by a flat share price and rising earnings from their coal division).
Source: Thomson Reuters
The rerating in Woolworth’s Price to Book valuation multiple has been to a similar scale, going from around 3x to 4.1x. A level similar to what the company traded on between 2009 and 2014.
Source: Thomson Reuters
This is despite Return on Equity (which is the return on the book value that should justify the above multiple) having fallen significantly in recent years.
Source: Thomson Reuters
From the above valuation metrics, it appears the popular trade right now is to bet on a Woolworths turnaround. If we were running an index aware strategy, we would much prefer to take the 16x on Wesfarmers instead of paying 23x for Woolworths. In addition to a cheaper valuation, Wesfarmers has the added advantage of owning Bunnings. Bunnings is a very high quality business that represents 34% of Wesfarmers EBIT, is currently growing at a double digit rate and has a return on capital employed of above 35%.
One of the great aspects of our strategy is that we aren’t benchmark aware. A company that comes into our portfolio has to stand on its own two feet and not just be a better alternative that its competitor. Whilst we would be more likely to invest in Wesfarmers than Woolworths at this point of time, we don’t due to concerns that the market is underestimating the ongoing growth of Aldi on both businesses.
Karl Hunt, of the TAMIM Global High Conviction strategy, spent a month living in a district in Shenzhen, in an attempt to better understand what was happening in the world’s second-largest economy, and to gauge what the locals were doing. Here is his report.
The Shenzhen Special Economic Zone bordering Hong Kong is the epitome of the Chinese economic “miracle”. First established by Deng Xiaoping in 1980 as China sought to establish economic reform, Shenzhen, once a fishing village of 30,000 people, has grown to have a population of 12m+ covering an area of 790 sq.miles, and a GDP of USD $284bn and GDP per capita of USD $27,230. By comparison the USA has a US$GDP per capita of $51,638 (2015, Source: Trading Economics).
It is the “Silicon Valley of China” with the Shenzhen stock exchange akin to NASDAQ, home to hi-tech stocks such as Tencent (internet search, payment, chat,etc) , ZTE (telecom equipment), Huawei (electrical goods), and BYD (electric cars). It is estimated that over 20% of China’s PhD holders work in Shenzhen.
Economic success produces asset price and wage increases. Shenzhen property prices have now surpassed Beijing as being the highest in China, with areas like Nanshang (new hi-tech central business district) boasting prices of RMB 150,000 per sq. metre (psm) – USD $2,016 per sq,ft.. To put this in to a London perspective only Knightsbridge would be higher at USD $2,430 psf and on a par with Chelsea! Reminiscent of the boom times in the West, in the suburb of Shenzhen in which I stayed, nearly every shop was a real estate agency, staffed by smartly dressed eager youngsters!
The prevalence of ostentatious wealth with premium European cars on the road (Ferrari, Maybach, Porsche, etc) abounds and puts most Middle Eastern cities like Abu Dhabi in the shade. (Though you will have to pay double the European prices for these cars due to hefty import duties).
The well-heeled also do their grocery shopping at foreign branded supermarkets like Walmart, Metro, etc where prices are above those in the West given that most of the produce is imported – it appears the middle classes often mistrust Chinese food quality/standards. Western brands and quality for everything from cars, clothes, electrical items and food are highly desirable for locals – an encouraging sign for Western companies and their aspirations to grow in China.
There is more to come. As you move from the coastal areas of Shenzhen to the interior, and the manufacturing areas, there is a stark contrast. Infrastructure becomes notably inferior – poor roads, street lighting, housing, etc. Factory workers live in rundown properties next door to chemical and plastic manufacturing plants. Here the most common form of transport is scooters (I didn’t see one person wear a helmet) or bicycle. Here you are in no doubt that you are in a 3rd world country.
Inequality is high with many professional occupations, anecdotally, appearing to earn salaries higher than those in the West in Shenzhen. By contrast semi and unskilled salaries still remain low – though they have been rising. They still have one big advantage over the West – they don’t have much of a welfare system to fund!
The question of course is, are the high growth rates and exorbitant property prices sustainable? Will capitalism continue to penetrate the interior or will government intervention and/or a crash in asset values cause a reappraisal? Even if the growth continues how can we make money as investors?
As always there are nuances to consider. A number of factors have come together to create this massive boom in house prices. The main driver is the wealthy speculating on property in the belief that the government will back stop any fall and that the migration from rural to urban areas will continue. How could this be?
This is a country that has never seen a property price crash and people have come to view property as a one-way bet. In a country where they believe the government controls everything, so too they believe that the government won’t allow property prices to fall.
China has strict currency controls and it is difficult for most people to buy overseas assets so they are forced to invest locally. They have seen volatility in stock markets and many have been burnt; so property is the staple investment for most. It is not uncommon to see large numbers of apartments, and houses that remain empty in China – they are simply bought for speculative investment.
The government has tried to curb the speculative nature of the property market so that now people can no longer buy outside their residency permit area. It hasn’t stopped prices rising so the government may need to introduce more measures. But the speculative nature of the market clearly is a cause for major concern should some event trigger a rush for the exit. Household debts are not too high at 40% of GDP, and home buyers still needing a substantial deposit to buy a house, so this may continue to persist for now.
Arguably, a more worrying near term risk is in the corporate sector where the debt has been piled up. China’s gross total debts (government, corporate and personal) now stand at an eye watering 277% of GDP at the end of 2016 up from 254% in 2015 according to UBS. The Debt/GDP ratio of the corporate sector is estimated to be 160%+ alone.
The massive increase in the number of companies, the factories – capital formation – has been financed by debt. Each industry in the West – railways, cars, chemicals, tech, etc – emerged and evolved at different times in history and the debt was accumulated across many years in lock step with GDP growth. But in China since the introduction of private enterprise in the 1970s, all sectors have seen a simultaneous expansion in the number of companies and total production capacity. So when you look at each sector, there are many more car companies, chemical companies, tech companies etc than currently exist in Western Europe for example. With cheap and plentiful availability of capital there have been far too many companies being set up and too much capacity.
When this happens, returns invariably fall.
Much of the debt is likely to turn bad. Some companies go bust, weaker ones get swallowed up, industries consolidate and a far fewer number of bigger companies emerge at the end. This process took decades to achieve in the West in most industries. But just like the rapid expansion in China the consolidation may be equally dramatic. When this disruption happens – the fallout – people lose their jobs, confidence falls, investment declines, uncertainty rises and this invariably affects property prices. Which would then have 2nd round effects as wealth falls and consumer spending gets reined in.
Ironically, without this capacity write down and consequent debt write-off, the situation for many industries looks poor because with so much capacity, there is no pricing power.
We are aware that pundits have called the “top” on China’s economy many times over the last 10 years. Although Chinese policy makers seemingly evade the question of excess capacity and continue to meddle and muddle, the government does have over $3tn in reserves which can substantially help to smooth over future bumps in the road and help to fill in “black holes” created by losses in either local government or State Owned Enterprises (SOEs). There are also fiscal programmes now in place such as “One belt one road” to improve connectivity in China and help the interior to grow and provide cheaper labour.
However, with so much over-investment, returns on capital can only come down. No government in history has yet stopped market forces eventually taking control of asset prices. It seems to me then that it’s case of “damned if you do and damned if you don’t”. Chinese companies may restructure but cause some closures and defaults or they don’t, but endure sub-par profitability for a while.
Consequently, this side of that restructuring we are staying out of cyclical basic industries in China. Without any restructuring, we are definitely staying away from Chinese companies and also those that compete against them since global pricing is likely to remain irrational. This is also known as ‘dumping’ and has been a major impediment to Western companies’ profitability and a source of political friction.
Following on from a previous article – Australian Banks: The death of a 25 year bull market – last week, this week we highlight an article from Sam Ferraro on APRA and the impact their macro-prudential changes will have on the banks. While the article is slightly more technical, it may be one of the more important reads on the banks this year.
– Evidente –
APRA’s quest for an unquestionably strong financial system continues Penned April 6, 2017
It has been a good week for APRA and the RBA. Their announcements surrounding the expansion of the use of macro-prudential policy tools and warnings around slow growth in rents and the outlook for property prices have had the initial desired effect of maximum media coverage. They would hope that lenders and potential property investors are getting the message.
The head of APRA yesterday, further weighed in on the debate surrounding banks’ loss absorbing capital buffers. Mr Wayne Byres had already bought into the key recommendation from the Financial System Inquiry (FSI) that Australia’s financial system should be unquestionably strong due to the fact that Australia has historically been a net importer of financial capital, and the high concentration of residential mortgages on banks’ loan books. To that end, the FSI suggested that Australia’s banks’ capital positions should be in the top quartile globally. APRA hasn’t committed to this hard edged quantitative aspiration or target and it is at their discretion which capital ratios they focus on.
In mid-2016, APRA lifted the risk weights used by banks with internal risk based models (ie. larger banks) by 50%, from 17% to 25%. In yesterday’s speech however, Mr Byres took a more glass half empty approach by drawing attention to the fact that Australia’s banks had indeed lifted their risk weighted capital ratios since the financial crisis, but their leverage ratios had remained little changed during this time. The leverage ratio, the ratio of total assets funded by shareholders’ equity, has increased marginally to around 6.5% from 6% in 2007 (see chart).
The Tier 1 capital ratio – which represents the ratio of shareholders’ equity to total risk weighted assets – has increased to 12% from 8% over the past decade (see chart). Risk weighted assets assign lower risk weights to loans that are considered less risky (eg. residential mortgages) and higher risk weights to more risky loans such as commercial lending. The key implication is that a bank must therefore must use more shareholders’ equity to fund a commercial loan than a residential mortgage.
Because housing loans attract low risk weights, growth in risk weighted assets has been slower than growth in total assets as banks have lifted the share of residential mortgages in their loan books (see chart). A cynical interpretation is that the banks have gamed the risk weights; a more generous interpretation is that a lift in mortgage lending has helped to offset the persistently weak demand for corporate lending since the crisis.
Against this backdrop, Mr Byers announced that it would release an issues paper later this year, outlining a road-map on how it intends to further strengthen banks’ loss absorbing capital ratios, and hinted at the prospect of a further lift in the risk weight for residential mortgages used by the larger banks.
The key development in Evidente’s view is the focus on the leverage ratio. APRA has left itself plenty of flexibility at this stage, and I am not suggesting that that APRA intends to target a desired leverage ratio. But as a guide only, we undertake a global comparison of leverage ratios and a sensitivity analysis. At present, the leverage ratios for the Australian majors range from 6% to 6.5%, which puts them below the median of the largest 100 developed market banks by over 100 basis points (see chart).
Assuming that the sector’s assets remain unchanged from current levels, the majors would need to top up their shareholders equity base by 18% or $40 billion to reach the global median of 7.6%. To get to the top quartile would require an additional $70 billion or a 30% more equity. These are large numbers and I suspect for this reason, APRA won’t be imposing a hard edged target on the leverage ratio.
Finally, it is not just possible but likely that the path to stronger capital positions will involve some contraction of assets. This has already been evolving, with annual asset growth in the sector turning negative for the first time in over two decades recently (see chart). ANZ and NAB have been seeking to ‘shrink to greatness’ by shedding low return international businesses, and Evidente expects this process to continue with ANZ and CBA looking to sell their wealth management businesses.
Evidente is an independent financial consulting firm managed by Sam Ferraro that delivers innovative financial advice to wholesale investors, including active long only funds, hedge funds, pension funds, and sovereign wealth funds, in Australia and globally. Drawing on academic research in asset pricing, behavioural finance and portfolio construction, Evidente provides wholesale investors with commercial solutions to stock selection and asset allocation decisions across equities and other asset classes.
Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.
We take a look at accessing IPO’s and Capital raisings. Small investors tend to be locked out of these raisings. In most instances, this is not an issue as the quality of the capital raisings tend to be poor. However, in the case of a strong IPO, you can benefit from a relationship with an investment manager who provides access to these IPO’s and Capital raisings.
Summary:
Gaining access to the best IPOs and Capital Raisings appears to remain the preserve of institutional and high net worth individuals at present. Whilst this plays to our advantage at TAMIM Asset Management we would like to see the market playing field level over time to allow fairer access to retail investors. However, in the meantime we continue to take advantage of opportunities to access the highest quality IPOs and Capital Raisings within the ASX smaller companies universe. In this article we discuss the ins and outs of gaining access to stock.
Not all IPOs and Capital Raisings are created equal…
IPOs and Capital Raisings are a sensitive subject for many retail investors who often view them as “closed doors” for smaller investors. And of course the more a door appears closed, the more it is natural for human psychology to want it to be opened.
However, we believe this way of thinking warrants caution since not all IPOs and Capital Raisings are created equal. In our opinion the vast majority should be avoided due to their lack of track record and evidence of sustainable moats, and their often unproven business models. We have previously written about our high quality shopping list, and we find the majority of IPO and Capital Raising opportunities fail to meet our criteria of a high quality investment.
We recently saw a cautionary tale when it comes to IPOs, as covered on The Lazy Dog blog.
STOCK EXAMPLE: Zenitas (ASX:ZNT) is a good example of a recent Capital Raising which ticks all our high quality boxes. ZNT now operates from 54 locations throughout Australia, employing 700+ health professionals, providing services across allied health, home care and primary care; making it a significant player in the community healthcare in the Australian market. Community healthcare is expected to benefit from supportive government policy, as community-based health services represent a cost effective solution compared to high cost hospital care. We like ZNT as it is in a sector supported by strong tailwinds and encouraging thematics, it is priced on an undemanding multiple, has multiple and credible pathways to grow, and is run by an experienced management team. That said, the business still has work to do prove itself to the market, and to build out its model. As it does, there is ample room for the share price to re-rate.
Once you have identified the right ones – how to gain access?
We have generally found that competition is intense for stock if an IPO or Capital Raising does indeed tick all our high quality boxes. In small Capital Raisings that are in high demand, it is often the case that the stock available is bid for multiple times over by institutional and sophisticated investors, before retail investors are even offered an opportunity. As a result, it can be very challenging for retail investors to pick up stock in these cases. Conversely, it is often easier for retail investors to pick up stock in the lower quality IPOs we are aiming to avoid.
At this point it is worth mentioning that the IPO market largely remains under the control of the larger brokers who still generate very high fees for handling IPOs. So the main route to IPO or Capital Raising stock supply is through the broking community.
For smaller investors this means leveraging existing broker relationships, and showing yourself as a potential longer term client for that broker rather than an “IPO flipper”. If an IPO is in hot demand brokers will be very focused on the clients they believe will help build their business longer term rather than short term focused traders.
This is one of the areas where it is a major advantage to be invested through a long term focused smaller companies investment manager since these funds tend to move to the front of the queue for the reasons mentioned.
STOCK EXAMPLE: In the above mentioned example of Zenitas (ASX:ZNT), there was no public float or ability for retail investors to participate. And even sophisticated investors had their bids substantially scaled. However, we were able to use our existing relationship with the company through our long term shareholding in BGD Corporation to secure a strong allocation.
What is being done about it by the ASX?
The short answer is the ASX are doing nothing about this. They recently released a consultation paper on listing rules reform, which made it clear they don’t intend to address the fair participation in IPO issue at all. This effectively means the IPO (and Capital Raising) markets will remain the preserve of bankers, brokers and high net wealth individuals, at least in the short term.
Alternative strategy to gain access to IPOs: Onmarket Bookbuilds
It is positive to see the emergence of onmarket bookbuilds, a relatively new business model which aims to provide IPO access to retail investors. At present, this type of business is generally the secondary IPO broker behind a traditional primary broker so is generally only contributing a relatively small portion of the IPO fund raisings it in involved in. However, the key point is that this business is providing IPO access to retail investors who were previously locked out of the market, which is a clear step in the right direction.
We hope these bookbuilding models succeed in building their business longer term as their success will lead to greater access to the higher quality IPOs which remain largely inaccessible for retail investors at present. And hopefully other alternative access points for retail investors will emerge in the coming years.
Conclusion:
We rarely participate in IPOs and generally only participate in the highest quality Capital Raising opportunities. However, fair access to stock is a debate which will rage on. We believe a move towards fairer access to stock for retail investors is likely longer term despite the ASX’s recent lack of reform action.
Robert Swift takes a look at the sideshow that is North Korea. We do not believe that North Korea impacts global economic fundamentals and that any short term dips that it may create in markets are good opportunities for us to purchase assets we would like to hold over the long term.
North Korea – “Buy on the cannons; sell on the trumpets” Robert Swift
The saying was attributed to Nathan Rothschild from 1810 when Europe was plagued by periodic outbreaks of war which obviously needed financing, and which might end in change of government or, catastrophically, an invasion by foreign power and confiscation of assets. The anticipation of this turmoil led to falls in bond and equity prices which offered an opportunity to invest at cheaper prices. Fortunes are typically made by buying on dips when others panic.
Source: Wall Street Journal
With all eyes on North Korea and growing tension in the region is this such a time? Is the current selling, particularly in Asia, offering a chance to repeat Rothschild’s success?
It is hard to argue that equities are in ‘bargain basement’ territory – or at least that USA equities are. Over the last several years they have risen substantially and depending on the definition of the earnings number you use trade between 18 and 22 x next year’s earnings.
Source: Thomson Reuters Datastream
On the other hand earnings volatility has been reduced and is likely to remain low, and it is unlikely that 10 year Treasury Note yields, from which we can estimate the fair price of equities, will go much above 3%. (They are currently just over 2%) Both of these help underpin USA equities at current levels and make selling frenzies attractive entry points.
So while not bargain basement they aren’t a bubble either. Looking at the average PE is misleading anyway in such a diverse universe of stocks. It’s a bit like saying “if I put my head in the oven and my feet in the fridge, then on average I’m comfortable”. It’s nonsense. Focus on stocks and try to pick those whose prospects are strong but whose share prices have fallen to where PE multiples are reasonable.
How can we be so sanguine?
North Korea is a side show and has done this shakedown before. Once it gets paid out then tensions ease.
Trump might refuse to payout on such a shakedown, unlike past Presidents, and make bellicose gestures, but he has shown more restraint than expected.
This tension gives him a chance to backtrack on his ‘abandonment of the region’ which should do wonders for its long term prosperity and stability.
We can tell you from our connections in the USA that there is so much firepower trained on North Korea that it will be cinders in a second should it do something stupid. They aren’t stupid. Part of the opportunity to ramp up tension was created by the political corruption scandal currently engulfing the South and a perceived subsequent political vacuum. Clever stuff by the North in one respect?
A much more interesting line of conjecture is what should you do as investors if North Korea re-engages with the South as East and West Germany did in 1990. We won’t do that here but can suggest unification would cost South Korea a lot more than it cost West Germany. Japan would also need to reconsider its source of unofficial cheap labour.
In what should you invest?
Meanwhile back in the real world, certain USA financials we like have mostly reported good earnings and indicate stability ahead. JP Morgan beat (carefully massaged) expectations and with plenty of risk capital buffers is now starting to reduce risky loans.
Another financial stock we like, AFLAC, trades on a PE multiple of 11.5 and grows slowly but steadily in the USA and Japan by selling policies to supplement health and medical care and loss of income protection.
Part of our investment thesis for USA financials is that they are not the beasts of 2002 – 2008 and have much more control over what loans are being made, and are much more closely supervised. If anything, the problem is in hitting growth targets which was the root cause of the Wells Fargo accounts fabrication scandal? The next crisis won’t be caused by financial stocks.
Directly in the ‘firing line’ in Asia is another cheap financial stock Sumitomo Mitsui Financial Group which trades on a PE of just over 9x. It has fallen about 10% in the last month and represents an attractive entry point now. Those of you who have been to our seminars or read anything we publish will know that Japan is not the economic basket case that the conventional wisdom would have you believe. The economy won’t implode and there is lots of innovation.
Now is not the time to reduce equity risk. If you are heavily invested in Australian equities then try to become more diversified. Be wary of the financial sector here which although not badly managed represents a single exposure to residential real estate. More legislation is likely which will reduce the potential for growth of that loan book and then where is the growth going to come from? Not overseas where NAB and ANZ have conspicuously failed and are now withdrawing, nor from investment banking. It won’t take much of a PE derating to make the franked dividends look a forlorn reason to own so much of the Australian financial sector.
