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.
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.
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.
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.
For Australian investors, the banking sector, particularly the four major banks, form a significant part of their investment strategy and exposure to Australian economic activity. However, only investing in Australian banks even with the franked dividend income, is definitely a suboptimal approach to investing.
Let’s compare Australian banks with global competitors in terms of valuation, capital sufficiency, and business positioning or resilience.
Australian banks have high dividend yields and low variability of EPS growth compared to global competitors. This would usually make them attractive. Although we like dividends as proof of cash flow, it appears to us that Australian banks are overdistributing earnings as dividends, and not sufficiently acknowledging the risk in their loan books. In other words, their EPS resilience is somewhat masked by ‘highly managed’ bad debt recognition.
In terms of capital sufficiency, the Australian banks are average. It appears to be a form of financial arbitrage to us that the Australian banks pay out franked dividends and then raise capital in the markets to meet regulatory capital ratios. If management wanted to avoid this ‘distribute capital and then raise capital’ merry go round they would cut the ordinary dividends and wouldn’t need to raise capital since the capital buffers would be built by retained earnings. However, there would be an outcry from investors desperate for dividend income. When companies are hooked on dividend amounts which they shouldn’t be paying, it strikes us as risky.
Price/book ratios may be a better guide to valuation given the latitude which all banks have in their EPS reports? In the table below we show the Australian banks look expensive on this measure compared to other developed market banks.
Australian banks tend to copy and follow each other’s business strategies and this is clearly shown in the very high correlation of the bank’s total returns with each, not offering investors a reasonable level of asset diversification. They rushed into expensive wealth management platforms and ‘fund management’ (multi-manager offerings) and all now appear to be exiting simultaneously? They all rushed into mortgage lending in NSW, Victoria and Queensland and are now being told by APRA, their regulator, to ‘cool it’. Further, to increased limits around mortgage lending, the regulator has now indicated they are reviewing further changes to the risk weightings the banks use (for details on this, please see The Lazy Dog blog post). None have cracked Asia; none have cracked investment banking as have the USA majors.
You can see the result of this ‘tack and cover’ strategy in the table below. This compares the price behaviour of the Australian banks to each other where a figure near 1 means they are al the same and a figure of -1 means they are all different.
Correlation figures of 0.8 or higher show very close similarity in asset returns. Investing in Australian banks is essentially investing in one big bank. This is not ideal for your portfolio.
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.
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:
There are many reasons why we like companies with strong balance sheets including:
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.
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:
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:
