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Cost Reductions Versus Top Line Stasis

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Aug 31 2016

This story features REGIS HEALTHCARE LIMITED, and other companies. For more info SHARE ANALYSIS: REG

 In this week's Weekly Insights:

– Cost Reductions Versus Top Line Stasis
– Reporting Season: The Final Verdict
– Aged Care: Cheap For A Reason
– Most Highly Rated Stocks
– Rudi On Tour (note change of date)
– Nothing Ever Changes, Or Does It?
– Rudi On TV

Cost Reductions Versus Top Line Stasis

By Rudi Filapek-Vandyck, Editor FNArena

Quant analysts at Credit Suisse made two interesting observations during the local August reporting season. One is most companies find it hard to improve on their revenues, which by now might as well be considered an established trend in Australia. Number two is average cost for operating the business and making sales seems to be increasing faster than increasing sales.

The two observations combined have major ramifications for investors considering their investments and exposures.

One is cost reduction is losing out as a major source of profit growth. Two: it pays to be a master in cost reduction, with more potential in the pipeline.

The Quant analysts have done some research into this matter and, no surprise, their conclusion is the market rewards those companies who manage their costs best.

Here's the paragraph that sums it all up: "In particular, we find that low-cost growth stocks tend to outperform in periods of low economic growth and underperform in more buoyant economic environments, while the converse occurs for high-cost growth stocks. Both findings are consistent with what you would intuitively expect."

To further support their thesis, the analysts have come to the conclusion that concentrating on the best cost managers in the Australian share market has been the best performing investment style over the past seven years (since the GFC), including the first eight months of 2016, and also including this year's August reporting season.

Trend In Acceleration

It goes without saying, the CS Quant analysis is only of real value if you agree the seven year trend of tepid top line growth is not about to disappear on us. I think my eBook published last year(*) pointed firmly towards such conclusion. There doesn't appear to be any doubt in the CS Quant report.

But things are not necessarily as straightforward. On the analysis done, picking the best cost controllers only leads to a mildly market outperforming basket of stocks. A far more lucrative strategy is to pick those who cannot contain their costs, and then taking short positions. The latter strategy has significantly outperformed the ASX200 over the past seven years, as well as during 2000-2002.

Anyone looking for more evidence the current period carries many characteristics typical for an equities bear market? Call it a bear market in disguise, if you like.

This is where things get genuinely interesting: on the Quant analysts observation, investor demand for the best cost managers has grown thus far in 2016. In other words: with companies finding it increasingly more challenging to keep cost inflation below growth in revenues, the performance gap between the good and the not so good has widened this year.

Equally important, on the Quant analysts general assessment, the better cost controllers are currently, as a group, trading one standard deviation above historical valuation compared with two standard deviation for Australian shares in general.

An Important New Tool For Investors

CS Quant analysts have compiled a list of companies that appear good cost managers right now plus a second list of companies that appear not very good at it. But they are quick on their feet in admitting their rough data-analysis may not take into account all the twists, quirks and turns, and exceptions that can only be discovered through more detailed analysis.

So their prime advice is for investors to absorb this important piece of information, and conduct their own detailed analysis. Probably good to start with all companies held in portfolio, and those on your radar.

When reviewing both lists (see below), the Quant analysts warn not to take anything at face value. Controlling costs is but one component when judging an investment, and it should be considered as only one input factor when conducting analysis and calibrating one's investment strategy, the report stresses.

One easy to make observation is that a number of companies included on the aggregated "short" list has no problems whatsoever in achieving top line growth, which makes the need for cost control a lot less necessary. Au contraire, if management teams at, say, Bellamy's, Domino's Pizza and Aristocrat Leisure would start focusing on reducing costs and thereby neglecting their growth opportunity, I have little doubt the market would punish them severely, irrespective of any achievements in controlling costs.

In the Quant analysts own words: "This report shows that at different points in the economic cycle direct focus on cost growth will likely be rewarded with positive alpha.

"Given the outlook for a continuation of low economic growth for the foreseeable future, we would argue that investors should be placing more weight on analysis of cost growth, than they possibly have been, in their investment processes."

(*) Change. Investing in a Low Growth World. Published in December 2015. Paying subscribers to FNArena receive a free copy as part of their membership. All other investors can purchase their copy through Amazon or most other online channels.

Reporting Season: The Final Verdict

FNArena is currently wrapping up the August reporting season. Expect more updates of the Daily Monitor as well as a broad, general assessment throughout the remainder of this week.

Aged Care: Cheap For A Reason

Last year providers of accommodation services to Australia's aging population could do no wrong. This year it appears there's very little coming from and towards the sector that has the ability to excite.

My suspicion to date is investors fell in love with the broader theme, ignoring any negatives while share prices kept climbing to ever higher highs. Not every operator is of high quality. Analysts don't like to emphasise this fact, for understandable reasons, but reading in between factual comments and observations reveals an undisputed ranking between the three listed sector-leveraged entities, with Regis Healthcare ((REG)) believed to be of the highest quality, Estia Health ((EHE)) of the lowest, and Japara ((JHC)) sitting in between.

Looking at share price performances for all three thus far this year supports my observation. Regis Healthcare shares are down some -19% since December 31st; Japara shares are down in excess of -29%; while for Estia the losses ballooned on Monday's sell-off to circa -44%.

There is one very important lesson to draw from this: when conditions for the whole sector deteriorate significantly, don't get blinded by the apparent cheap valuation(s) or larger upside potential for the weaker or lower quality industry participants. It is under such circumstances that "quality" makes its presence felt.

Put in another way: you need a bull market for the lower quality stocks to generate better returns than their higher quality peers. In a bear market the principle works the other way around.

There's no denying these three stocks have fallen out of favour since the Turnbull government suggested the sector was probably over-earning at a time when budget repair and containing healthcare costs still are front of mind. One conclusion to draw from the fact Regis Healthcare ranks among the highest rated stocks in the share market is that most analysts (if not all of them) think management should cope when confronted with sector headwinds. See also further below.

Even then, investors should still heed the obvious, as expressed by Moelis on Monday: "We remain cautious on the aged care sector near term given the regulatory uncertainty, rising debt levels and complexity of managing a large pipeline of development work". Current expectations for FY17 are likely to be met, but it's projections for FY18 and FY19 that are less certain.

Estia Health reported as last on Monday and its release was not well received, judging from the double-digit sell-off that ensued. FNArena subscribers will be able to view brokers responses on Tuesday-Wednesday, but an initial assessment by stockbroker Moelis indicates Estia's FY17 guidance on top of a disappointing FY16 implies market consensus has to fall by some 15%.

As they call it in the trade: cheap for a reason.

Most Highly Rated Stocks

As one would expect, the tsunami of rating downgrades and upgrades that hit the Australian share market during the August reporting season has reshuffled analysts' collective preferences for individual stocks.

Take it as a given that overall sentiment towards Qantas ((QAN)) remains buoyant, carried by wide and wildly varied expectations about cash flowing into shareholders pockets in the year(s) ahead. No wonder thus, Qantas has remained as the sole ASX-listed stock with a perfect 1.0 score on the FNArena Sentiment Indicator. A perfect score indicates every broker covering the stock rates it Buy, or an equivalent.

Of course, it helps when the shares entered 2016 with a 4 in front and they are now, even after a meaty rally off the July lows, still trading closer to $3.00.

The old rule of thumb is the FNArena Sentiment Indicator isn't genuinely positive unless the score is 0.7 or higher. On this rule, there are only 21 stocks left in the complete FNArena database (400+ stocks) that carry positive sentiment as signalled by individual stockbroker stock ratings. The full list is included below.

Investors looking to integrate this info into their own market research and strategies should always keep in mind there's a difference between stocks being too cheaply valued, and thus receiving Buy ratings, and stocks carrying robust growth potential which is not yet fully priced in. Admittedly, the latter are harder to find in a stock market trading on elevated Price-Earnings multiples, but I think at least half of the stocks listed falls under that category.

Can you spot them too?


Rudi On Tour

Please note the date change for upcoming presentation in Chatswood.

I will be presenting:

– To Chatswood chapter of Australian Investors' Association (AIA) on September 14, 7.15pm, Chatswood RSL

– Christmas Special for Chatswood members of Australian Investors' Association (AIA), December 14, 7pm

– To Perth chapters of Australian Investors' Association (AIA) and Australian Shareholders' Association (ASA) on 7 February 2017

Nothing Ever Changes, Or Does It?

Yes, of course, investing in the share market is never really different and best working strategies today are the same that worked pre-GFC. Seriously. I tell you, seriously.

Now that we had a good laugh about it, let's get straight to business. This is a low growth environment. Has been since 2010 (it was masked at the time because of the V-shaped recovery from the global recession) and it is not likely to change fundamentally in the near term. I wrote a book about this (see below). This means investment strategies must adapt. You'll be turning your portfolio into a wish list for dinosaurs otherwise (and your returns will be a reflection of it).

Those not afraid to contemplate "this time is different" can subscribe to FNArena and read all about it in our bonus eBooklets 'Make Risk Your Friend' (free with a paid 6 or 12 months subscription) plus the freshly published eBook 'Change. Investing in a low growth world' (equally free with subscription, or available through Amazon and other online distributors).

Here's the link to Amazon:

See also further below.

Rudi On TV

– On Tuesday, around 11.15am, on Sky Business, I shall make a brief appearance through Skype-link to discuss broker ratings for less than ten minutes
– On Wednesday I will appear as market guest commentator, Sky Business, 12.30-2.30pm
– On Friday, around 11.05am, on Sky Business, I shall make a brief appearance through Skype-link to discuss broker ratings for less than ten minutes

(This story was written on Monday 29th August 2016. 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.

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: or via Editor Direct on the website).



Paid subscribers to FNArena 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. This book should transform your views and your investment strategies. Can you afford not to read it?

Subscriptions cost $380 for twelve months or $210 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): 

FNArena has reformatted its monthly price tracker file for All-Weather Performers. Last updated until July 31st. Paying subscribers can request a copy at

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