Dilemmas Galore

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In this week's Weekly Insights:

– Dilemmas Galore
– The Question Of The Real Aldi Impact
– Coming Up: The Woodside Dividend Cut
– Small Caps Pain (Lots Of It) For Goldman Sachs
– All-Weather Performers: Strong Track Record
– FNArena Sponsors ASX Investor Series
– Rudi On TV
– Rudi On Tour

Dilemmas Galore

By Rudi Filapek-Vandyck, Editor FNArena

Experienced funds manager Geoff Wilson knows how to recognise an opportunity when one presents itself.

Managed funds operating under the wings of Wilson Asset Management are usually focused on finding undervalued industrial growth stocks, mostly in the small caps space. But when the tide turned towards additional RBA rate cuts, and Australian banks started a strong 12-day rally, WAM's team of market traders jumped on the bandwagon and let their profits run.

Since 2008, WAM's two flagship managed funds are accompanied by WAM Active Limited, which offers investors the option of exposure to an active style for extracting gains out of the local share market. It is unclear whether Wilson's traders were solely acting on behalf of WAM Active, or whether the performance of both small cap-oriented funds has now been boosted by riding the latest re-rate for the local banking sector.

Assuming the latter, some will argue WAM joining the rally in banks is akin to cheating, but Wilson, and his peers across the industry, know full well that by mid-year all that matters are the stats and how high on the comparative performance tables funds managers find themselves.

At least one of Wilson's small cap favourites, Amalgamated Holdings ((AHD)), has managed to keep pace with the banks' stellar performance these past two weeks.

Many active funds managers in Australia would have been underweight, or even without exposure to, Australia's major banks at the start of the new calendar year. Now THAT's a real dilemma today. How does one catch up?

Scenario number one is praying for a share market correction. This appears rather unlikely. Not only does history suggest strong share market performances like we just witnessed since mid-January are more often than not a precursor for more gains yet to follow, the RBA has dropped enough hints by now that more rate cuts should be expected.

This prospect is going to keep a strong bid under share prices of the banks and Telstra ((TLS)) and infrastructure yield stocks such as APA ((APA)) and Sydney Airport ((SYD)).

A second scenario is by being overweight the strongest performing index weights. Yes, I know, this may well become extremely interesting for those who are under no pressure to outperform. I wouldn't bet against the current momentum for blue chip yield stocks anytime soon and that's not even including foreign funds that quickly have rediscovered Telstra and the major banks on the Australian stock exchange.

Morgan Stanley Sticks To Its Guns

Market strategists at Morgan Stanley have been among the more cautious on the outlook for Australian shares in 2015. Their recent update revealed remarkably little change, despite a shift in central bank policies globally. To set the tone: Morgan Stanley sticks to its ASX200 target of 5350 by year-end. This is below the level at which the index started 2015, not to mention where the index is now.

The strategists hold two main gripes: valuations are stretched and earnings growth remains largely elusive. Only a change in profit growth momentum will bring about a target review.

In terms of portfolio positioning, Morgan Stanley remains Underweight banks, Market-weight Insurers, but Overweight Diversified Financials and Real Estate. This suggests their performance has lagged the market recently. Some changes have been made to sector allocations: Telcos, Infra & Utilities was downgraded to Market-weight from Overweight while stocks linked to the Housing sector and Consumer non-staples stocks have been upgraded to Overweight.

This suggests Morgan Stanley is banking on second round impact from RBA rate cuts (and cheaper fuel) to benefit and encourage outperformance of the broader market, instead of focusing on the re-rating of the banks and Telstra.

Within this context, BlueScope Steel ((BSL)) and JB Hi-Fi ((JBH)) have now been added, accompanying Domino's Pizza ((DMP)), Navitas ((NVT)), Super Retail Group ((SUL)), Tabcorp ((TAH)), DuluxGroup ((DLX)) and James Hardie ((JHX)).

Macquarie Atlas Roads ((MQA)) has been removed from the portfolio. Morgan Stanley has elected to stay Underweight Metals & Mining and Energy.

One addition worth mentioning here is that strategists at Credit Suisse, who have not received enough recognition for the fact they have been predicting RBA rate cuts well before anyone else, essentially share a similarly cautious approach towards the Australian economy and corporate profits.

The difference is Credit Suisse is projecting a more positive contribution from additional RBA rate cuts on local share prices and as such CS's year-end target for the ASX200 is 6000.

Initial indications are that Credit Suisse has a better feel for the market pulse than Morgan Stanley.

Stick To The Trend

The recent 12-day rally for local equities has made some market participants nervous. I spotted a number of "take profits" recommendations which, until Monday, proved in contradiction to the strong underlying trend.

I have no opinion on who should do what and when, but I do note that whenever analysts go through historical data, whether it's here or in the US, they always come to the conclusion that strong rallies like the one we just witnessed are usually a precursor to further gains. I think it's but a fair assumption current momentum is not going to evaporate easily given just about everyone remains convinced the RBA is going to cut again (exact timing unknown).

The recent rally has once again reminded me of the distinct differences in attitude between gamblers and investors in Western cultures and the Chinese. What do Westies do when they see the same colour coming up repeatedly on the roulette? They start speculating on the opposite colour. In other words: they start anticipating the end of the trend.

Chinese are different. They stick to the trend.

Think about the following. The longest same colour streak at the roulette in a US casino happened in 1943; 32 consecutive times the ball landed on red.

Now imagine how much money the casino would have made from all those punters doubling their bet, and again, and again, on the fact that next time, surely, it cannot be red again?

In China, however, the casino would have gone bankrupt.

I'm more than happy to stick to the Chinese approach. Don't fight the trend. Don't get spooked too soon.

"Meeting Is The New Beating"

Straight up: I think the local reporting season will be of less importance than in past years. This is because the strong emphasis on yield and income means investors will be more focused on the security and continuation of dividend payments, and less so on whether there's strong growth on offer.

In other words: Mr Market will be wearing rose tinted glasses this season, in particular for yield stocks. The onus will be on companies not to come out with big disappointments.

Having said so, companies that do manage to surprise to the upside will still be rewarded handsomely and those that require punishment will receive exactly that. I sense many more companies will enjoy the benefit of the doubt this month. Strategist at Morgan Stanley agree. They call it "meeting [expectations] is the new beating".

Further supporting this view is the fact that earnings estimates have been steadily falling prior to this month. Offsetting this is the observation many stocks are trading on elevated PE multiples and thus a relatively small reduction can have larger consequences for the share price.

In addition, a recent analysis conducted by JP Morgan suggests the risk for downside surprises seems unusually low this month (based upon a combination of fundamental and quant screens).

I have thus read through dozens of reports and previews with the focus on finding which stocks are expected to disappoint this month. I left out those candidates with both supporters and critics.

Stocks that have been nominated for potential negative surprises include:

– Ardent Leisure ((AAD)) – potential impact on Main Events (Texas) and slowing momentum Health Clubs

– BHP Billiton ((BHP)) – not enough room for capital management?

– Brambles ((BXB)) – oil sector exposure

– Carsales.com ((CRZ)) – slowing momentum in new and used car sales

– Coca Cola Amatil ((CCL)) – core business still rebasing

– CSL ((CSL)) – currency impacts

– iiNet ((IIN)) – slowing ARPU in combination with growing opex

– Imdex ((IMD)) – oil exposure

– Insurance Australia Group ((IAG)) – insurance cycle peaks causing falling premium rates

– Origin Energy ((ORG)) – oil exposure and ongoing churn retail power

– PAS Group ((PGR)) – retail exposure

– QBE Insurance ((QBE)) – remains messy with many moving parts

– Suncorp ((SUN)) – pressure on margins as insurance cycle peaks and competition increases

– Tatts ((TTS)) – industry laggard

– Transpacific Industries ((TPI)) – exposure to oil sector

– Treasury Wine Estates ((TWE)) – messy result expected

– Woolworths ((WOW)) – weak momentum and Masters' ongoing slow progress

As has been the case in recent reporting seasons, any positive surprise regarding dividends is likely to be well-received (see Tabcorp).

The Question Of The Real Aldi Impact

Australia is not always at the forefront of new developments, ahem, and thus analysts regularly look offshore for new trends and developments that are about to hit Australian companies.

Last year, a UK supermarket sector in turmoil caught the attention of local analysts as discounters such as Lidl and Aldi started to make an impact with devastating results for already troubled operators such as the once mighty Tesco.

Since Aldi is steadily growing bigger on the Australian East Coast, nowadays flanked by America's Costco, the logical question to ask was: how long before the UK experience starts to transpire in Australia?

Immediately after various local stockbrokerages started asking that question, sometimes supported by specific sector research reports, investors decided not to wait until the first signs of fundamental change were about to show up. Soon after, shares in Woolworths ((WOW)) traded closer to $30 than to $38 while Metcash ((MTS)) now trades around $1.50 instead of just under $3.00.

Wesfarmers ((WES)), owner and operator of Coles, did not feel much of an impact since both analysts and investors believed it would remain relatively insulated and the big impact would instead be felt by Woolworths, owner of the world's fattest profit margins among supermarkets, and by Metcash, the weakest of the local operators desperately trying to find a second breath.

Analysts at Macquarie question the validity of these movements and knee-jerk conclusions. They believe Aldi is indeed poised for a bigger share of the local market in years ahead, but also that both Coles and Woolworths will continue growing their own businesses, albeit at a slower pace.

This then raises the obvious question: if Macquarie's analysis is correct, should Woolworths be re-rated again? Or maybe this remains dependent on how well the company executes on its Masters' home improvement market invasion?

Metcash, on the other hand, looks like it will be the main victim of Aldi's growing market pressure.

Until 2013, Metcash shares were relatively popular among yield-seekers, but growing market pressure has forced dividend cuts and a strategic reorientation, which is still ongoing. Last financial year, dividends were cut by approximately one third, and the same is again anticipated for the present financial year until April 30. Thus far, analysts are expecting further cuts next year, albeit not of the same magnitude.

This will be one company that will be closely watched for signs of stabilisation. But with Aldi's pressure only to grow further in the years ahead, what can realistically be expected from Metcash management?

Coming Up: The Woodside Dividend Cut

In August 2013, the board of Woodside Petroleum ((WPL)) turned the stock into a dividend play when the promise was made to pay out 80% of operational profits under the condition that no better usage for the cash can be identified.

That transformation has worked well. Woodside shares continued to range-trade between $38-$39 for no less than eight months before shooting up above $40 and even touching $44 in August last year.

On my observation, financial planners, stockbrokers and SMSF advisors have been guiding their clientele towards Woodside shares since with the shares offering a healthy, above market yield. Needless to remind everyone, but dividends from a resources company, even if it is the country's largest oil and gas producer, don't come with the same reliability and solidity as from our trusted financials.

And the proof came with the share price tumbling from $40+ to $32 in the space of a few weeks when oil prices fell out of bed between November and January. Now Woodside shares are trading on an implied yield of no less than 9%+ and the final part of those dividends shall be paid out after the release of the 2014 financials, scheduled for 16 February.

However, and this is the "surprise" many of its yield hungry shareholders may yet have to catch on to, Woodside's profit outlook this year is for a significant fall in earnings and thus 80% of a significant fall in earnings is going to represent a significant fall in dividends.

How much of a fall exactly remains to be seen and analysts will try to get some indication from the board and management from the release and accompanying briefings. Already many have sharply reduced estimates and as things stand right now (see Stock Analysis on the website) consensus forecast is for profits to deteriorate by some 60% and dividends to be cut by more than half this year.

Probably a fair assumption to make that without any support from a recovering crude oil price, Woodside shares might be facing some pressure once that final dividend has been paid out as the prospect of an unusually high yield pay-out (potentially 4.5% in one go) will be followed up by the realisation the yield going forward is going to be a lot less.

Assuming current forecasts stand (which remains one big question mark) Woodside's yield outlook for the year sits around 4.4% plus franking and that still remains an attractive proposition, I would wager. It's just that if the market decides that's a bit rich for such a volatile resources stock, the share price might fail to recover 2014's monster final payout, and, post ex-dividend, reset at a lower price level instead.

Note BHP Billiton ((BHP)) shares are currently offering 5.1% (plus 100% franking) and Rio Tinto ((RIO)) shares 4.9% (plus franking and a general anticipation of a share buy-back). Both BHP and RIO are expected to increase, not decrease, their dividends this month as well as in the year ahead.

Investors should also note at present analysts' estimates for Woodside really are all over the shop. JP Morgan is the low marker, having argued since late last year the market is underestimating the impact from the lower oil price environment.

JP Morgan has penciled in no more than a 55c total payout in 2015, which would reduce the yield to a measly 2%. In that case, I'd agree with analysts predicting an exodus of yield-oriented investors post the upcoming results release.

Small Caps Pain (Lots Of It) For Goldman Sachs

It has been several years since stockbrokers started to concede their ratings system for simply slapping Buy-Hold-Sell labels on individual stocks came with some serious limitations, regardless of the exact terminologies applied (some prefer Add, Accumulate, Outperform or Overweight instead).

What we have seen since are releases of Conviction Lists and Top Pick Lists whereby stock pickers and market strategists at investment banks and stockbrokerages can differentiate and explain why one Buy does not equal the next one.

It's favouritism to the max and -honest is honest- most of these stock selections end up outperforming the broader market. Which is also why FNArena regularly reports on these lists.

None of these lists come without failures, which is always a good thing to remember. Maybe we should all collectively spare some thought for the team of small caps stock pickers at Goldman Sachs. Their so-called "Australia Small and Mid Cap Focus List", with a track record for outperforming the market, has been hit particularly hard these past few weeks.

Imagine selecting 12 high conviction stocks and then seeing the likes of Austbrokers ((AUB)), Kathmandu ((KMD)), Nine Entertainment ((NEC)), iiNet ((IIN)), OzForex ((OFX)), PanAust ((PNA)) and Skilled Group ((SKE)) getting clobbered on company specific news (profit warning, CEO leaving) or on a broader sector sell-down.

The fact that Flexigroup ((FXL)) and Genworth Mortgages Insurance Australia ((GMA)) put in a strong rally recently hardly soothes the pain.

Now that the outperformance has come to a brisk halt, it's going to be interesting to see what kind of soul-searching is taking place. The next list update has my attention, this much is certain.

P.S. the remaining stocks on the list are Dick Smith ((DSH)), SAI Global ((SAI)) and Super Retail ((SUL)).

All-Weather Performers: Strong Track Record

The February reporting season is still young, but already a handful companies have made their mark. Blackmores ((BKL)), REA Group ((REA)) and Ansell ((ANN)) all forced analysts to upgrade forecasts and valuations and share prices have responded accordingly.

All three companies have in common that they form part of my selection of All-Weather Performers in the Australian share market. I have said this before, in fact I have been saying this since 2008: the share market is NOT only about yield.

There is a chronic shortage out there of reliable, solid growth opportunities with a lower risk profile and companies such as Blackmores, REA Group and Ansell fulfill the necessary requirements.

Paying subscribers have access to eBooklets on the theme (see below), as well as to a regularly updated excel overview showing share price performances. Send requests to info@fnarena.com

FNArena Sponsors ASX Investor Series, Sydney February 17, 12:30pm-2pm

Don’t miss the next opportunity to hear from CEOs over lunch with an informal meet and greet session at the conclusion of presentations. Speaking at this event are Starpharma Holdings, Whitehaven Coal, Charter Hall Holdings and TTG Fintech.

These events are free to attend however registration is required as seating is limited. Register here

(Or use the following link: http://www.asx.com.au/education/investor-series.htm )

Rudi On TV

– Wednesday, Market Moves, Sky Business, 5.30-6pm
– Thursday, Lunch Money, Sky Business, 12-12.45pm
– Thursday, Switzer TV, Sky Business, 7-8pm

Rudi On Tour

I have accepted invitations to present:

– Wednesday, 18 February to members of CPA Australia's SMSF Discussion Group in Sydney (evening)
– Wednesday, 11 March to members of Chatswood section of AIA, in Chatswood (evening)
– August 2-5, AIA National Conference, Surfers Paradise Marriott Resort and Spa, Queensland

(This story was written on Monday, 9 February 2015. 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).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Odd as it may seem, but today's share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

Making Risk Your Friend. Finding All-Weather Performers, in both eBooklet versions, is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of January available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms