Have You Been Paying Attention?

This story features CSL LIMITED, and other companies. For more info SHARE ANALYSIS: CSL

In this week's Weekly Insights (published in two separate parts):

-Have You Been Paying Attention?
–More Snippets Post Feb Reporting Season
-Conviction Calls
-Harvester Pain (Lots Of It)

[Note the non-highlighted items appear in part two on the website on Thursday]

Have You Been Paying Attention?

By Rudi Filapek-Vandyck, Editor FNArena

This story started in 2012. Back then the world looked a much scarier place with Greece and the broader European Union regularly capturing the financial market's attention.

The eurozone was printing negative economic growth numbers. The US economy appeared weak and vulnerable, unable to sustain a lot of momentum. The price for a barrel of crude oil was swinging between US$100 and US$120/bbl. To many it seemed too high a price might prove yet another burden for the global economy. The Federal Reserve decided more stimulus was prudent. It announced QE3 later that year.

Global equities, understandably, found it difficult to sustain positive momentum; the path of least resistance was down, with lots of gyrations along the way. In July, ECB President Mario Draghi assured Europe's central bank would do "whatever it takes" to save the euro and the eurozone. Equities rediscovered their mojo. The rest, as they say, is now history. Global equities are still enjoying one of the longest and most powerful up-trends in history.

Something has changed…

But underneath the surface here in Australia, something fundamentally had changed. It wasn't clear at that time what exactly was happening, and very few would have been paying attention, but as time went by the characteristics have become obvious and visible to everyone. The past five years have seen the Australian share market generate positive returns, but behind the public facade hides an unspoken of, widespread dissatisfaction carried by large parts of the Australian investor community.

Returns from Australian shares have been noticeably lower than those generated in offshore markets, not the least on Wall Street. Also noticeable is the fact local banks are no longer the strong pillars they had been for almost two decades, GFC not included. Since 2012, banks have been weighing down the performance of local indices, exacerbating the performance gap with foreign markets.

It's not just the banks. Large caps in general are structurally underperforming vis-a-vis smaller cap peers in Australia. Over the past five years, there have been temporary hiccups, when money flowed back into large cap stocks, but these have proven but a fleeting push back. Overall, the trend has been very much in favour of smaller cap, mid-sized stocks with the ASX20 and ASX50 unable to keep up, even with historically large dividends and franking included.

Also noticeable is that value-oriented investment strategies have found it hard to consistently make their mark. The past five years have very much favoured "growth" stocks instead, as illustrated by the significant outperformance of CSL ((CSL)) among the Top 50. CSL never trades on a low PE, yet the shares are up more than 170% since mid-2012, ex-dividends.

In comparison, the ASX200 went up less than 30% over the same period, ex-dividends. CommBank ((CBA)) has managed to more or less keep track while paying out an above average yield, but all of ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) only managed share price gains between 14-19%, or a very much sub-par 2.5-3.5% per annum, ex dividends.

Macquarie Group ((MQG)), on the other hand, is up 190% since mid-2012 and pays out a dividend that is able to compete with the Big Four. You don't really want me to line up the performance of smaller cap industrials such as a2 Milk ((A2M)), NextDC ((NXT)), or Altium ((ALU)) over the period. It'll break your heart, unless you own these stocks in your portfolio, in which case you know all about the sheer difference in performance.

The most important question is: what is causing this tectonic shift in Australia, that favours smaller sized companies over blue chips, growth over value, offshore over domestic?

The Cause Of Changing Dynamics

I believe the answer lies with "disruption". The Australian economy has long operated as a basket of close-knit, powerful duopolies/oligopolies. Investors have unknowingly benefited from this over a long period, as companies in control of their destiny generated consistent and reliable rewards for shareholders, but now dynamics and market forces have become less supportive, and the local share market is simply reflective of that.

The key difference between a2 Milk and Wesfarmers ((WES))?

The latter has a suite of maturing businesses that are trying to cope with changing consumer spending, as well as with increasing competition. The former is young, dynamic, smaller in size and carving out its own niche by grabbing market share from incumbents.

A similar comparison can be drawn between CSL and Cochlear ((COH)), Aristocrat Leisure ((ALL)), Xero ((XRO)), ARB corp ((ARB)) and Corporate Travel Management ((CTD)) to name but a few in the same position as a2 Milk, and on the other side AMP ((AMP)), Brambles ((BXB)), FlexiGroup ((FXL)), Harvey Norman ((HVN)), Fortescue Metals ((FMG)), Japara Healthcare ((JHC)), G8 Education ((GEM)), Mayne Pharma ((MYX)), and Healthscope ((HSO)), among many others in the same position as Wesfarmers today.

The key factor for investors to understand is it is a lot easier for skilled management teams to generate positive rewards for loyal shareholders when their businesses are not encumbered by lots of extra barriers and obstacles.

"Disruption" is not solely linked to emerging new technologies and online competition. Today, rising costs and low growth in wages are putting pressure on household budgets, which leads to changes in consumer spending. More populist politicians and governments are becoming less predictable, with more direct interference. Increased scrutiny from APRA, ASIC and the RBA is heavily impacting on insurance and mortgages being sold locally. Lower share market returns, and rising popularity of passive investment tools and products are putting pressure on active managers to show performance, and reduce their costs and fees. Et cetera.

Many of today's "disruptions" were quite embryonic five years ago, but they are increasingly growing in importance, and nowhere near running out of puff.

The all-important question that needs to be asked therefore is not whether Wesfarmers shares look "cheap" or "undervalued", but whether management has transformed the business sufficiently in order to cope with, and to re-conquer successfully, a market place that is now dominated by different dynamics.

At best, I think, this challenge will take time. But until that key question can be answered in the affirmative, any consideration about "cheap" or "undervalued" will be short term only. I note Wesfarmers shares have been inside a sideways tracking pattern since early 2013. Given the broader context, is anyone surprised?

'Value' Is Not The Same Anymore

Share market dynamics over the past five years make a lot more sense when viewed through the prism of "disruption". This also explains as to why I have been a lot more sanguine about owning High PE stocks, unencumbered and fast growing, than many other experts and commentators, even in the face of rising bond yields.

Sure, the share market is constantly exposed to excessive greed and irrational fear, and disasters can happen, with or without bond market conniptions, but until these business models lose access to end users, or they are being disrupted themselves, my view is investors should watch out for excessive exuberance rather than the next interest rate hike by the Federal Reserve to assess their exposure and share market strategies.

FlexiGroup does not all of a sudden become a better company because shares in AfterPay Touch ((APT)) might surge too close to the sun. Nor does Primary Health Care ((PRY)) become a better investment because ResMed ((RMD)) might temporarily face headwinds from a weakening USD.

One of the unmentioned truths about the Australian share market in the past five years is that lower valued stocks simply generated lower returns in comparison with their higher valued peers, with the occasional exception attracting way too much attention. Compare Macquarie Group and CommBank; a2 Milk and Murray Goulburn ((MGC)); Aristocrat Leisure and Ainsworth Gaming ((AGI)); Xero, Reckon ((RKN)) and MYOB ((MYO)). NextDC, TPG Telecom ((TPG)) and Vocus Communications ((VOC)).

The answer lies in the fact that traditional sectors and old economy stalwarts are being upstaged, and the share market is taking notice. A company like Xero might be trading on a PE ratio well above the market average, but when investors look three years out, they see a substantially larger company with substantially more customers, sales and profits. They simply cannot be that confident about AMP, Myer, CommBank, or IPH ltd.

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The composition of the FNArena/Vested Equities All-Weather Model Portfolio is very much in line with all of the above. All-Weather stocks are not 100% guaranteed fully immune from all forms of disruption, as proven in recent months through companies including InvoCare ((IVC)) and Ramsay Health Care ((RHC)), but most remain unencumbered, and are among the beneficiaries from shifting market dynamics.

This key characteristic has trampolined many into the basket of High PE stocks; not necessarily as high as Domino's Pizza ((DMP)) and WiseTech Global ((WTC)) at the peak of their popularity, but usually well above market average. Pushed onward and upward by high quality business models at CSL, Orora ((ORA)), REA Group ((REA)) and the likes, carried by healthy margins, healthy balance sheets and solid growth performances, the portfolio performance beat many, including the ASX200 Accumulation index throughout 2017.

The outperformance has thus far continued into 2018, with the February reporting season the best thus far since December 2014, when the All-Weather Portfolio first started breathing. Outperformance to date has been helped by the resurgence in the likes of Bapcor ((BAP)), Hansen Technologies ((HSN)), and TechnologyOne ((TNE)); high PE stocks that temporarily fell out of favour last year but that are once again proving intrinsic quality never stays out of fashion for long.

The FNArena/Vested Equities All-Weather Model Portfolio combines my personal research into All-Weather stocks in the Australian share market with emerging new business models that seem to have all the necessary hallmarks for non-cyclical, multi-year, high quality growth and value creation. Paying subscribers at FNArena have access to my stock selection, my research and my past writings via a dedicated section on the website.

For the financial year running, total performance for the portfolio excluding fees is 12.55% versus 7.76% for the ASX200 Accumulation index. Calendar year-to-date the portfolio is positive 3.15% versus negative -0.56% for the index.

Harvester Pain (Lots Of It)

Ever since Betashares launched the Australian Dividend Harvester Fund ETF, commonly referred to as "Harvester", this yield-oriented derivative has not been without controversy, or public debate. In essence, Harvester is an attempt to satisfy domestic investors' hunger for yield via an automated intelligent system which involves hopping on and off dividend paying stocks in the domestic equity market, all year long.

The system includes some filters to avoid obvious yield traps, as well as an automated protection against share market volatility through ASX futures.

From the onset it was clear that Harvester might be providing regular yield, but a certain portion of it might come hand in hand with capital loss, something Betashares has always acknowledged.

The latter is never a major problem when the yield received is superior to the capital loss that comes with it, but that certainly has not been the case over the past twelve months with investors holding on to the Harvester ETF losing about -20% of their capital. One does not need to be a mathematical genius to figure out the income paid out over the period has been nothing but a band aid for a large, gaping flesh wound.

So what happened exactly? Is Harvester a yield trap of its own?

Firstly, the easy and commonly understood factor in play: bond yields are on the rise, bond proxies in the share market have fallen out of favour in response. One need not look further than share price graphs for Vicinity Centres ((VCX)), Transurban ((TCL)), Sydney Airport ((SYD)) and the likes to underline that statement.

Not helping either is the fact Australian banks have pretty much consistently underperformed the broader market in 2017, and thus far this trend has not yet changed in 2018. Love them or loath them, when it comes to any dividend yield product and Australian equities, the major banks are always a key ingredient.

These key problems are further enlarged by the fact Harvester only buys and sells dividend paying stocks, so portfolio weightings for stocks like AMP, the banks, Telstra, etc are typically larger than their respective weightings in the ASX200. This is why the yield on offer can be superior, but it also translates into potentially outsized capital losses.

Now that I've mentioned Telstra… Part of the automated intelligence that helps Harvester perform at best practice is a filter that should ensure no obvious yield traps are part of the buy, hold, then sell strategy, but this has not prevented heavyweight Telstra being part of the team. The Telstra share price lost some -26% over the past year, which does not translate fully into capital loss for Harvester owners, as the ETF only buys when dividends are due, but Telstra also cut its dividend and the shares have tended to lose more in capital than the dividends paid out to shareholders over the period.

Lastly, when overall share market volatility picks up, Harvester attempts to protect itself through the futures market, an insurance policy that should pay off when the market does whirl into a downward spiral, but so far it has been mostly false alarms and rapidly recovering indices. This means the portfolio insurance has simply added to the downside.

Investors who owned the Harvester ETF since February 2015 (it only started trading on the ASX in November 2014) endured a capital loss of circa -33% by April last year, for an average of roughly -10% per annum for a product that promised 10%+ payout in yield ex franking.

The message for yield hungry investors is pretty straightforward: always understand what you are investing in. The disappointing performance of Harvester since April last year also illustrates how difficult it has been for yield seeking investors to avoid capital losses in the share market.

I have little doubt many are left licking their wounds today. Hopefully some valuable lessons have been learned.

Rudi On TV

This week my appearances on the Sky Business channel are scheduled as follows:

-Tuesday, 11.15am Skype-link to discuss broker calls
-Thursday, noon-2pm
-Friday, 11am Skype-link to discuss broker calls

Rudi On Tour

-An Evening With Rudi, Paddington, 11 April
-Presentations to ASA members and guests Gold Coast and Brisbane (2x), on 12 & 13 June
-ATAA members presentation Newcastle, 15 July
-AIA National Conference, Gold Coast QLD, late June-August 1
-Presentation to ASA members and guests Wollongong, in September

(This story was written on Monday 12th March and the second part on Wednesday 14th March. This first part was published on the Monday in the form of an email to paying subscribers at FNArena, and will be published again on Wednesday as a story on the website. Part two shall be published on Thursday).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
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