The Australian Share Market Is Shrinking

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In this week's Weekly Insights:

– The Australian Share Market Is Shrinking
– Commodities: Not All Equally Bullish
– Mineral Sands: Take A Guess
– Navitas And The Unforeseen Risk
– Rudi On Tour Visits Brisbane In September

The Australian Share Market Is Shrinking

By Rudi Filapek-Vandyck, Editor FNArena

Two terms have featured prominently in analyses of US equity market performance since March 2009: de-equitisation and corporate share buy-backs.

In layman's terms: US share markets have shrunk over the past three years amidst all the other available levers pulled by Corporate America determined to please investors (and thus keep those share prices in demand).

By contrast in Australia, total supply of equities has expanded by some 3.9% on average each year since 2006. Since demand-supply dynamics also work in financial markets, this should be part of everyone's response to the question: why have US markets done so much better?

Even more so because data analysis for the past five years shows buying equity in companies buying their own shares has proved the number one best performing strategy throughout the period.

The graph below, going back to 1990, from a recent BA-ML quant report, illustrates the core premise for investors via two diverging price lines. Buying companies that buy in their own shares: profitable strategy. Buying companies that issue additional equity: losing strategy.

While putting it into two extremes might not necessarily always be correct, as companies do manage to pull off successful acquisitions via capital raisings, the underlying premise is nevertheless backed up by numerous analyst reports: buying shrinking equities has been a successful investment strategy over the past five years.

The bad news, for Australian investors, is that companies listed on the ASX prefer to lift their dividends instead of buying in their own stock. This, incidentally, has also delivered investors with a profitable strategy: buying companies that lift their dividends has proven a better strategy than buying companies with rising profits (offering both is best – see banks).

And buying in your own stock works in Australia too as shown by CSL ((CSL)) who has been buying in own stock on numerous occasions since 2009.

The good news is analysts are predicting more buy-backs in Australia.

Three weeks ago, strategy analysts at Credit Suisse published a report in which they predicted the Australian share market is about to shrink this calendar year. At face value, this seems odd in the face of ever bigger numbers of IPOs hitting the market, as well as the newest trend of company spin-offs. But there's also an ever larger number of companies disappearing from the market. David Jones ((DJS)) will soon be gone. So should be SAI Global ((SAI)). And ROC Oil ((ROC)). And Wotif.com ((WTF)).

On Credit Suisse's estimations, already $17.4bn in corporate acquisitions have been announced thus far this year and the total tally by year-end is believed to rise to $22bn in shares that will no longer be available to Australian investors. Note: CS' research has limited itself to the ASX200. In addition, more capital is disappearing through de-listings with 21 Century Fox alone removing $8.8bn. CS thinks a total of $13bn in capital will de-list by year-end. These numbers will blow out further if the Lowy family follows the Murdoch strategy and decides to take Westfield ((WDF)) post Scentre-demerger to Wall Street (my suggestion, not CS's).

Companies have already started to indicate their preference of paying for acquisitions through new debt rather than equity – see Ramsay Healthcare's ((RHC)) latest acquisition in France. Credit Suisse suggests some might start using the low cost of debt to buy in their own shares, as has become common practice on Wall Street. Thus far, however, buying in own shares is not happening in large numbers in Australia. Woodside Petroleum ((WPL)) is doing it but other large cap stocks in the oil & gas sector with large LNG cash flows upcoming are likely to pay down debt first, lift dividends and invest more in future opportunities, as shown by Origin Energy ((ORG)) recently.

Downer EDI ((DOW)) is rumoured soon to be balance sheet debt-free and might consider buying in own shares? I wouldn't be surprised, however, if management prefers to buy UGL ((UGL)) instead (or another target). BHP Billiton ((BHP)) and Rio Tinto ((RIO)) looked like a shoe-in earlier this year for some serious reductions in listed capital, but a lower iron ore price might have a bigger-than-thought impact on such plans. Other candidates include Automotive Holdings ((AHE)), NRW Holdings ((NWH)), Bradken ((BKN)), Seven West Media ((SWM)), Sonic Healthcare ((SHL)), STW Communications ((SGN)) and the latest addition from the oil & gas sector, Karoon Gas ((KAR)) post its Poseidon sell-out to Origin Energy.

In most cases, however, corporate managers and their boards are likely to look around for acquisitions first, or to lift dividends, rather than buying in their own stock. A fact readily acknowledged by analysts at Credit Suisse. So maybe investors should simply keep an eye open for those companies who do announce a buyback in August or in February next year?

Consider, for example, that for a company such as McMillan Shakespeare ((MMS)), whose share price remains depressed and arguably too low according to its own standards, deciding on a share buy-back can prove a savvy and profitable investment.

Another comment to make is that buybacks probably work best in combination with unquestionable growth. Glove maker Ansell ((ANN)) is currently buying in its own shares, but in light of internal restructuring and ongoing tough market dynamics, this is more likely to limit the downside rather than propelling the shares back above $20 in a rush.

Two other straightforward options to try to benefit from all of this is via companies that are known as being on the acquisition path and assume they will use debt to finance new deals and make any additional profit contributions more accretive, as did Ramsay Healthcare. Well-known candidates include Amcom Telecom ((AMM)), Amcor ((AMC)), Carsales.com ((CRZ)), CSR ((CSR)), IOOF ((IFL)), Flexigroup ((FXL)), Macquarie Group ((MQG)), Oakton ((OKN)), Premier Investments ((PMV)), Transpacific Industries ((TPI)) and Vocus ((VOC)). The latter just announced yet another acquisition in New Zealand, partially funded with debt.

Following on from this theme, maybe this could be the right time to revisit some of the rumours that never seem to die. Why wouldn't iiNet ((IIN)) and TPG Telecom ((TPM)) finally decide to combine forces? What about AP Eagers ((APE)) and Automotive Holdings? Amcom and Big Air ((BGA)) anyone? Or Amcom and Vocus? Vocus and Big Air? Macquarie buying ING Direct? GPT Group ((GPT)) buying Investa Office Fund ((IOF))?

On the other end of potential opportunities, analysts remain of the view that Myer ((MYR)) might remain a target now that David Jones has been snapped up, but so too should be OrotonGroup ((ORL)). But so could be Adelaide Brighton ((ABC)), and Ten Network ((TEN)), and The Reject Shop ((TRS)), and Echo Entertainment ((EGP)), and Nufarm ((NUF)), and STW Communications.

Even for those investors who do not wish to target the theme specifically, there could still be benefits. Credit Suisse believes the switch from expanding equity to a shrinking base will lead to more funds chasing fewer assets and this should push up the index. This is why CS strategists have raised their year-end target for the ASX200 to 6000 from 5600 while many other strategists went the other way (there appears a common bandwidth between 5600-5800).

On CS' estimates, Australian companies issued in total $24bn in new capital in 2013. This year should see the total base shrink for the first time in a long while. Has to be a good thing, all else remaining equal.

Commodities: Not All Equally Bullish

Commodities have made a come-back on investor radars in 2014 and funds flow data are suggesting a sustainable trend is in the making. Remember my Commodities Investment Clock from two weeks ago?

As I have been at pains in trying to point out, this new bull market for base materials won't be a repeat of the period 2003-2008 when pretty much everything that comes out of mother earth was a good buy, for as long as it lasted. The performance of commodities as an asset class to invest in has nevertheless already taken one or two steps back, from number one performing asset earlier in the year to underperforming equities in recent times. This probably shows us all how much of the asset class's performance is dependent on crude oil support and recently there has been none.

The table below shows the divergent performances across the commodities space over the first six months of the calendar year. It's somewhat of a fresh breath after 2013 ended with losses for pretty much everything in the space.

The main discussion doing the rounds among analysts and investors in the space is whether copper is to genuinely participate as well? A sceptic could read from the table above that copper is still down for the year, but only just. An optimist can compare this to the much bigger losses earlier in the year and see improvement as encouraging. Overall, it is my observation that much of the renewed optimism for copper is at least partially based upon (expectations of) disappointment on the supply side. Macquarie analysts have been emphasising though there should be a wall of supply entering the market in 2015.

Assuming Macquarie is correct, this means any gains for copper, and for copper-related stocks in the share market, will have little sustainability and investors should thus not forget to sell (instead of thinking it'll last and last, just like it did last time). Another interesting chart was found in a recent report by Credit Suisse, showing copper recently was trading below the trading range that has been in place since early 2013. Again, optimists can turn enthusiastic about the fact that copper may still be inside a broader trading range, but it is near the bottom of the range!

Mineral Sands: Take A Guess

Mineral sands are nowadays influenced by too many moving parts to make any predictions with conviction, argued commodity analysts at Goldman Sachs in a recent update on the sector. At last they're honest about it. Most analysts had taken a more enthusiastic stance after major producer Rio Tinto ((RIO)) signaled at recent analyst presentations the industry might be welcoming better supply-demand dynamics from here onwards, in particular for zircon.

But then Macquarie releases an in-depth sector study and blows all enthusiasm away. Argue Macquarie analysts, the mineral sands industry predominantly consists of titanium dioxide producers who sell zircon as a by-product and since the race is on for TiO2, one simply should not get too excited about zircon's prospects. Macquarie is also sombre about Iluka's ((ILU)) prospects, estimating the company's global market shares have dropped to 27% and to 5% for zircon and TiO2 respectively, with the company now desperately searching for a new strategy.

This, of course, explains the recent attempt to acquire a troubled ilmenite asset in Mozambique. Failed attempt. It also explains why Macquarie downgraded the shares to Underperform with a $7.50 price target. Most analysts are anticipating a gradual recovery in zircon prices and a delayed recovery for TiO2. Which is why the consensus target sits at $10.29 and the share price around $8.30. Iluka's investment proposition might be similar as for copper (see above); don't automatically assume any gains will stick or last. At least, if Macquarie's study can be taken as our guide.

Navitas And The Unforeseen Risk

Believers in "the share market is already correct" dogma had another tough day at the office last week when market darling Navitas ((NVT)) revealed its relationship of 18 years with Macquarie University was not going to last beyond 2016. Entrepreneurial Macquarie Uni had now discovered it had the tools and the nous to take matters in its own hands. A reset of the Navitas share price around the $5.30 price level has since taken place and that's a big pill to swallow given the share price was hovering around the $7 mark before the admission.

That's one way of looking at it.

Another angle is that Navitas has been on my personal list of All-Weather Performers because the market certainly had treated it as such and analysts have -post reset- done exactly that. So woll growth simply continue and experience no more than a temporary blip once the contract with Macquarie Uni ends? It's what most analysts think will be the case. Unless proven otherwise.

Bottom line: All-Weather stocks may be better, and safer, than most of their peers on the exchange, but they are by no means 100% bullet proof. Investors should already know this given ongoing troubles and uncertainties at Coca-Cola Amatil ((CCL)) and at Ansell ((ANN)), while private equity hasn't cast an eye over SAI Global ((SAI)) for nothing. But a mutually beneficial relationship of 18 years? Who would've thought?

Rudi On Tour Visits Brisbane In September

I have yet to book accommodation and flights, but on Wednesday, September 3, I will be presenting in Brisbane twice, in the afternoon and in the evening, on behalf of the local chapters of the Australian Investors' Association (AIA) and the Australian Technical Analysts Association (ATAA)) respectively. More details to follow.

(This story was written on Monday, 14 July 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(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)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

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