The RBA’s Conundrum
Guy Carson

​Earlier this week the RBA remained on hold for the 7th consecutive month. However, when we look at economists’ forecasts for the remainder of the year there is significant divergence. Some believe that the economy needs further stimulus whilst others believe we are through the worst and will eventually follow the US Federal Reserve in raising rates. The interesting thing is that both cases have some merit when looking at the overall data and it’s only when we delve down to a state level that we can really understand why.

Firstly, let’s examine the rational for a rate cut. The RBA has a dual mandate to maintain full employment and the stability of the currency. The stability of the currency is seen as achieving an inflation target of 2-3%. As can be seen from the chart below, the Consumer Price Index fell below this targeted band in June 2015 and has remained there ever since.

​So currently the RBA is not achieving its price stability target. What about full employment? After seeing the unemployment rate improve from 2015 through to mid last year, we are now starting to see job growth slow. In fact the unemployment rate since the last RBA cut in August last year has gone from 5.7% to 5.9%, which isn’t exactly what they would have wanted. In addition the underlying quality of the jobs created in recent times has been poor with a large shift towards part-time employment meaning that underemployment has risen as well:

​Adding to this weak employment picture, wage growth is at record lows and this indicates that plenty of “slack” remains in the labour force. The Wage Price Index (WPI) is currently running at 1.9% year on year and has fallen steadily since 2012:

​It’s not until you look under the headline unemployment rate that you will notice some significant divergence in trends between states:

​If we look at the period of improvement in the unemployment rate from 2015 through to mid last year, it was largely driven by New South Wales and Victoria (as well as South Australia improving from a very high level). New South Wales currently has the lowest unemployment rate in the country at 5.2% which is near recent lows. Victoria has seen its unemployment rate tick up slightly to 6.1% but this is slightly misleading given the state has been the primary driver of job growth in the last year. The below chart looks at net jobs growth in each state over the last year and Victoria has represented a staggering 98% of the Australian total. The unemployment rate in the state has been impacted by high migration and it should be no surprise that people are moving to Melbourne given it’s the only place with jobs growth. Immigration tends to be pro-cyclical, i.e. people will move to where the jobs are.

On the other end of the spectrum, a few of the states are struggling. In terms of job growth, Queensland has gone backwards by 38.6k in the last 12 months. Western Australia, whilst having stabilised in recent months has seen a worrying longer term trend in unemployment from a low of 3.5% in 2012 to 6.0% currently.

There are two major reasons for the divergence between states and that has been the end of the mining construction boom and the transition to the residential construction boom (we wrote about this extensively in our 2017 Outlook). Essentially in an attempt to see off a recession in the face of a significant fall in mining investment, the RBA has cut interest rates from 4.75% to 1.50%. This has led to is an unprecedented construction boom in housing, particularly along the East Coast and most notably in apartments.

The chart below looks at building approvals for apartments across New South Wales, Victoria, Queensland and WA (data is rolling annual). This is a leading indicator of construction activity and we can see all four states have recently reached all-time highs.

Western Australia saw building approvals peak in June 2015 and hence is dealing with the end of a residential construction boom now as well as the ongoing falls in mining investment. The major concern now is Queensland where the annual number has rolled over, and on the volatile monthly basis it looks disastrous, as can be seen in the chart here:

This is a significant headwind that the Queensland economy faces over the next 12-18 months. It is likely going to put further pressure on the current employment situation. So you could argue that Queensland is in need of further stimulus.

Moving across to Western Australia and whilst the employment situation has improved slightly in recent months, unemployment still remains elevated and households are struggling. We have talked previously about how mortgage arrears for the banks in WA on a 90 day basis have moved up significantly over the last 12 months (again, see our 2017 Outlook). We can now see, via Moody’s, that 30 day arrears are shooting higher for the entire country. This is being driven by the 2013 vintage of loans which is not overly surprising given it corresponds with the mining investment peak of 2012. This vintage is the purple line in the chart below.

Further evidence of household stress can be seen in the Retail Sales data where WA has seen very little growth since the beginning of 2016. Quite clearly WA households could use a further interest rate cut.

​Overall, there are arguments for both directions in rates. WA and Queensland are both in need of stimulus; an interest cut rate can easily be justified in both states. Meanwhile, the unemployment rate in New South Wales is sitting near decade lows at 5.1% and Victoria is recording strong jobs growth. Both of these states are in the midst of a record residential construction boom and have large infrastructure projects in progress or due to start. One could argue that interest rate rises would be more appropriate for these states.

The conundrum the RBA faces is that interest rates are a blunt tool. To provide stimulus to WA and Queensland, they need to provide stimulus to the rest of the country, there isn’t a way of differentiating.

Thankfully there is a solution but unfortunately it relies on a functional political system. Too often in recent years, central banks have been the only port of call for stimulus globally. Monetary stimulus (interest rate cuts and quantitative easing) has been the dominant force whilst fiscal stimulus (government spending) has been non-existent. On a global basis, there is hope that this might change, a big part of the Trump rally is based upon expectations of increased infrastructure spend in the US (whether Trump lives up to these expectations is another story altogether). Unfortunately in Australia, we have a government fixated on reducing its deficit and focused on the corporate tax rates. These tax cuts are more likely to just flow through to corporate profits and are unlikely to lead to the job gains and wage increases that the government is trumpeting.

Looking at the above state of play, we believe targeted fiscal stimulus in the form of infrastructure spending into Western Australia and Queensland would be the best option for the Australian economy. This would take pressure off the RBA, improve job prospects in those areas and potentially slow interstate migration to Victoria and New South Wales. The current government should be considering some sort of action, after all the WA voters recently showed their thinking on the matter by overwhelmingly going against the incumbent Liberal government. This (in addition with the rise of One Nation in Queensland) is a function of an unpleasant economic reality. It is similar to the trends seen globally which have seen the UK leave the EU, Donald Trump’s rise to power in the US and the popularity of Marine Le Pen in France. If things don’t improve, people will vote for change.

Within our team we are focused upon investing in under-valued, high quality smaller companies. We are often asked how we define high quality so in this article we present our shopping list of attributes we look for in high quality businesses which we can invest in for the long term to generate superior returns for our clients.

The first deal breaker for us in the high quality search is whether a company is profitable and cash flow positive. In our minds profitability and positive cash flow generation are both core to what a business should be about, and thus we are not willing to speculate on loss-making companies which are aiming to more than cover their costs in the future. And it is not just the short term risks we are aware of: loss-making companies carry longer term risks far beyond the headline losses in our opinion. If a business is loss-making it often indicates an “empire building” mindset in management, poor strategic choices, structural problems with the business model, and cost mismanagement issues. This is obviously not always the case but in our experience the hit rate with these issues is high, and we are not willing to risk shareholders’ funds where these risks are high.

When looking at profitability we are interested in comparing a company’s reported earnings with its reported cash flows. In our experience, it is common to come across companies where their reported earnings are significantly higher than their reported cash flows. The difference is usually explained by the company’s accounting choices. For example, we recently did some work on a retirement village owner and operator which looks very cheap on statutory earnings at around 8x this year’s earnings. However, when we analysed the company’s accounts it became apparent that much of this year’s earnings are coming from expected property revaluations and thus the company’s cash flows, and the profitability of the underlying business, are likely to be significantly lower. We decided the stock was expensive as a result. We are looking for the contrary scenario whereby reported earnings are below reported cash flows reflecting conservative accounting strategies. Companies which fall into this category tend to be led by management teams focused upon under-promising and over-delivering.

STOCK EXAMPLE: Fiducian (ASX:FID) is a good example of a highly profitable stock in the TAMIM small cap portfolio which tends to report higher cash flows than statutory net profit reflecting its highly experienced and conservative management team. In its recent half yearly report operating cash flows was $3.6m versus a statutory net profit of $3.4m.

Next on our shopping list is companies which have clear and visible organic growth drivers which management can articulate.

We often come across businesses which are focused upon capturing a macro theme or trend. When we read through their presentations we generally find many inspiring charts highlighting the enormous growth potential of this macro trend/theme. However, after reading such presentations we are often left wondering what the company actually does and why it will benefit from these macro drivers. This is not what we are looking for.

We are looking for companies which have clear strategies in place to grow their businesses independent of macro trends. We’ll discuss business tailwinds later in this article (these are also on our high quality list) but we need to see clear organic growth strategies from management. And we also need to understand exactly what a company’s growth strategies mean in terms of day to day business activities.
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STOCK EXAMPLE: Joyce Corp (ASX:JYC) is an example from the TAMIM small cap portfolio of a stock with clear growth drivers looking forward. The following slide from the company’s recent half yearly presentation highlights 6 clear and visible earnings growth drivers in the year ahead – a big tick on our high quality list:

We have previously written of our preference for companies in which management are personally invested, of which family/founder companies are a great example. Having “skin in the game” is a highly effective means of ensuring management are thinking of shareholders’ best interests at all times. The evidence is compelling:

There are many reasons why we like companies with strong balance sheets including:

1. Lower financial risks – Companies with net cash surpluses don’t need to pay interest and are thus far less exposed to financial risks in the event of a business slowdown, rising interest rates, etc.
2. More earnings to distribute as dividends – Management of debt free companies only need to think of equity holders since there are no debt holders ahead of them in the queue waiting to be paid. This means shareholders are well placed to receive attractive dividends payouts, and it also means management thinking is all about shareholders which in our experience is a good thing.
3. Greater flexibility to expand when opportunities arise – Companies with strong balance sheets are well placed to make opportunistic investments when the opportunities present themselves. This is a significant advantage in our opinion since it is often hard to predict when acquisition opportunities are likely to arise.

STOCK EXAMPLE:  A powerful example of a company with a strong balance sheet within the TAMIM small cap portfolio is Reverse Corp (ASX:REF). As at 31st December 2016 the company held $7.42m in net cash versus its current market cap of $8.6m. The market is currently valuing the company’s reverse calling and online contact lens businesses at a lowly $1.2m. We believe these two businesses are worth far more than this, and the company has the benefit of an extremely strong balance sheet which can be used to build the online contact lens business whilst paying very high fully franked dividends to shareholders.

In addition to the organic business drivers already mentioned, we like to invest in companies with industry tailwinds behind them. In our experience, being in the right industry at the right time often makes it easier for a company to exceed the market’s earnings expectations.

STOCK EXAMPLE: Paragon Healthcare (ASX:PGC) is a standout example within the portfolio. Paragon is a leading provider of medical equipment, devices and consumables to the healthcare market, and provides excellent exposure to the ageing population thematic. We believe the company’s organic growth drivers will be complemented and supplemented by this powerful tailwind in the years to come.

We spend a lot of time getting to know management in order to tick this final box on all our investments. We believe high quality management are even more important when investing in smaller companies than larger companies because each strategic decision tends to carry a higher relative weight in a smaller business.

As a result, we will only invest in businesses with management who are:

1. Capable – We are looking for management teams who know the ins and outs of their business and industry. When talking with management we want to come away interested and inspired by what they are doing, not confused and bored.
2. Trustworthy – We view this one as a deal-breaker. We need to be able to trust what management are saying at all times. This includes all financial accounts.
3. Shareholder friendly – By this we mean management who will always act in shareholders’ best interests. For example, given the choice of making an expensive acquisition for the sake of empire building or paying shareholders a healthy dividend, we would aim to be invested with the management team which chooses the latter option.

STOCK EXAMPLE:  Elanor Investors (ASX:ENN) is an example of TAMIM small cap stock with highly capable, trustworthy and shareholder friendly management who are very conscious of total shareholder returns as per this slide from the recent half yearly results presentation:

​It’s a long shopping list and we are very picky. However, we believe ticking all these high quality boxes at the right valuation is why our clients invest with us. The lower the hit rate, the more repeatable and sustainable the process in our opinion. We will remain disciplined in our search for under-valued high quality smaller companies looking forward.

​This piece is on Japan. It covers Japanese demography, a much misunderstood influence on GDP, robotics (a labour saving device or a threat to everyone’s livelihood?) and technology which is typically adopted by the young but has a much bigger wealthier market if the elderly were to “get on board”. We will stay focussed and address only a couple of trends in Japan and technology you can use to make money!

Please click and watch the video clip below from the Nikkei news company. – it takes 3 minutes or so. Nikkei is a Japanese media business which owns the Financial Times of London, the Nikkei, the world’s largest circulation business newspaper, and various stakes in Japanese TV broadcasting companies. It also calculates the Nikkei 225 and Nikkei 300 indices which you may use to follow Japanese share prices.

​Fascinating? We think so and it strikes us that robotics is a useful tool and not to be feared or rejected.

Japanese demography is aging and the workforce shrinking. Such a pattern is not conducive to GDP growth but it doesn’t matter from an investor’s perspective. On a per head of population basis Japan has outperformed Germany a little and most definitely the USA, the UK and Australia over the last 20 years. In other words its citizens are more productive and getting wealthier even though the total pie is not growing that fast. Think about it. Australian working age population has grown about 2% p.a. for many years and general price increases (ignoring property) have averaged about the same. These two together make 4% p.a. and account for nearly all of the annual nominal GDP growth p.a. in Australia, leaving very little real improvement in living standards per head of population. This explains both the frustration of the average family here and the RBA which correctly worries about a lack of productivity growth.

Japan is a better performing economy than Australia. This is not the point we want to make here. What we do want to emphasise is that aging demography is feared but shouldn’t be. It may result in lower nominal GDP numbers but the spending power per person may remain strong and the spending patterns change and it is that change that provides the new investment opportunity. Medical care, aging and robotics in Japan looks one such trend.

It also struck us that a ‘virtual’ interaction like we see on the video is not so different with the ‘virtual’ interactions we all witness with our children’s “social” lives. Our children will have “friends” on Facebook or gaming sites, they have never, and may never, meet! How different is that from having a robot help folks exercise, provide comfort and company by responding to touch or voice, or even cleaning bed pans? Not much if at all. Consequently we see no moral or ethical barriers to widespread adoption in Japan and ultimately, elsewhere.

This also reminds us that Japan was a technology innovator and although Japanese technology may not grab the headlines like USA technology which tends to be more software and advertising focussed, if we do see a return to more acceptable levels of public and private sector capital investment, then Japanese companies are well placed. We are reminded of this technological prowess by the current coverage of the sad demise of Toshiba which is facing a breakup after poor acquisitions and some business cultural failings (a common Japanese problem) but which at one time was the global leader in memory chip technology.

It also shows us that Japan is wealthy and is able to provide dignity to its elderly. Analysts focus on Japan’s gross debt but this is misleading since it is also a very significant creditor nation having had years of current account surpluses to build a very strong Net Foreign Assets (NFA) position. Anyone care to think what the UK or Australian NFA position looks like?

Japan may not be leading the way in the use of robotics but it is up there and many of its companies will be successful internationally. We are currently evaluating SMC, Fanuc, Omron, Keyence, HitachI High-Tech, JTEKT and Terumo. There is a rich seam to be mined if the price is right.

In conclusion we emphasise that Japan is a market rich in stock opportunities but surrounded by misperceptions of its economic performance.