Rudi’s View: Telstra, Iress, NextDC And That Grand Delusion

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

In this week's Weekly Insights:

-Data, Statistics, Indices And… Lies?
-The Telstra Turn-Around
-Iress Rejected
-Share Buybacks And Franking Benefits
-NextDC And The Relative Proposition
-Conviction Calls
-All-Weather Model Portfolio
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Data, Statistics, Indices And… Lies?

We are all familiar with the Vanguard chart of indices suggesting equities are but a profitable investment, as long as investors stay the course. Don't try to time the market, it's time in the market that counts!

Or as Vanguard itself puts it: History shows, despite the peaks and troughs, average market returns will trend upwards over time.

When the 30-year charts were being updated, as at 30 June 2021, the numbers were there for all to see (all % per annum):

-Investment return for Australian shares: 30.2% over one year, 11.5% over 5 years, 9.4% over 10 years, 8.4% over 20 years and 9.7% over 30 years
-Investment return for international shares: 27.5% over one year, 14.7% over 5 years, 14.8% over 10 years, 5.1% over 20 years and 8.3% over 30 years
-Investment return for US shares: 29.1% over one year, 17.5% over 5 years, 19% over 10 years, 6.5% over 20 years and 10.8% over 30 years

It's a fine amalgamation of market data and many inside the finance industry absolutely love it because of its underlying implication: stick with shares long enough, and you cannot lose.

But, of course, that's where the trouble starts because we all know, or should know, there are many important details hiding underneath those generalised calculations. Such as the fact that in the long run, which is what Vanguard's exercise is trying to embody, only a minority of stocks can truly hold its own and continue creating shareholder value that is sustainable.

Or, to put that statement in practical terms, everyone who bought CSL ((CSL)), ResMed ((RMD)), REA Group ((REA)) and the likes back in 2011 has since enjoyed an absolutely tremendous return, simply by holding on and not selling through periods of turmoil. Thanks for the advice, Vanguard!

Now try googling Woodside Petroleum ((WPL)), or Westpac Bank ((WBC)), or Telstra ((TLS)) and those returns calculated by Vanguard seem like from a galaxy, far, far away.

If anything, the real underlying implication from Vanguard's 30-year investment returns overview seems to be that investors might simply be best off when buying an index instead of individual shares, which makes all the sense as this is what Vanguard does: marketing and selling index-oriented investment products.

But wait, we haven't yet uncovered the real twist in this narrative.

As I never tire to explain to aspiring investors: to become a great and successful investor, one has to be a reader. And when you read a lot, you come across some genuinely interesting and surprising information.

Last week it was David Rosenberg's turn. Once upon a time, Rosenberg made his mark through self-confident, anti-consensus market calls as chief economist and strategist for Merrill Lynch. Nowadays, he runs his own service and newsletter through Rosenberg Research.

Last week, Rosenberg had asked the question: with the Dow Jones Industrial Average (DJIA) not that far off anymore from the 36,000 level as predicted by the book written by authors James Glassman and Kevin Hassett in the late 1990s, what would have happened if the index had not been updated and refreshed regularly along the way?

The answer will surprise you.

Had it not been for the many deletions and new additions post 1997, the index would today be a full -65% lower than where it is – 12,500 instead of 35,000.

How's that for an optical illusion to inspire the masses?!

Those Vanguard index charts are as much about getting rid of the losers and taking on board new winners regularly as they show the long term value of investing in equities, through regular changes made to indices.

The Vanguard chart can be downloaded here:

https://www.fnarena.com/downloadfile.php?p=w&n=158BDFBA-BC1B-F83E-E5ACEB30453B7A59

The Telstra Turn-Around

It has taken five long years since Telstra's ((TLS)) earnings per share peaked at 32.7c which, at that time, supported an annual dividend of 31c.

Today, Telstra's FY22 EPS is forecast to be 13.3c, but higher cash flows and ongoing payments from the NBN should support a promised dividend of 16c for shareholders.

To state that the past six years have marked a painful trajectory for loyal Telstra shareholders is one big understatement. It's hard to imagine today, but the Telstra share price back in 2015 at times threatened to break through its ceiling at $6, only to slide towards $2.50 over the subsequent five years.

And that (apparently) attractive dividend equally halved over the period.

But on Friday, upon returning from this year's 'T25 Investor Day', analysts at Goldman Sachs could hardly contain their enthusiasm, reporting management's confidence in the telco's "strong" earnings outlook was evident throughout the presentations.

I cannot even remember the last time one such research report was released upon investors with Telstra the main subject in it, though I am sure it must have happened long time ago.

The human brain is not the most reliable source when it comes to such things.

Post-investor day, earnings estimates have still fallen, but analysts are now looking forward to better times ahead. Some are even considering the dividend might start to rise again within 2-3 years or so. There is potential for share buybacks, and for acquisitions. Telstra even has expressed the ambition to become a major party in Australia's energy distribution sector.

Some have read this as: AGL Energy ((AGL)) is a target, once those coal assets have been separated.

Before we all get too excited, it's good to keep things within their context. Telstra is not all of a sudden transforming itself into the next reborn, high growth stock and when time has come to, potentially, lift its dividend, it'll be to 17c or 18c, nothing exceptionally spectacular.

What has supported the Telstra share price since earlier this year, is the prospect of asset sales, and here Telstra has thus far only traveled half the journey by partially monetising the value in its telecommunication towers. There still remains the promise of selling off part of what is now called InfraCo, essentially the telco's fibre and fixed network sites.

As communicated earlier, the FNArena/Vested Equities All-Weather Model Portfolio added Telstra shares early in 2021 on anticipated benefits from these asset sales, as well as a recognition that an overall changing macro-environment would be most beneficial to industrials paying a dividend, rather than REITs and/or landlords.

So the Portfolio bought because of the asset sales and ended up owning the shares during a period of improving market dynamics for Telstra, allowing the shares to rise to circa $3.89 from circa $3.10. Never underestimate the importance of pure plain luck when making investment decisions.

With most analysts setting valuations/price targets of $4.35 or higher for the year ahead, a solid looking dividend, no longer under threat of being cut, in combination with further asset sales and the promise of growing market share and profits should keep the medium-term outlook for Telstra shareholders promising indeed.

But we're not getting carried away. Telstra has not all of a sudden become a long-term investment for the Portfolio, just for now, and until we see better dividend leverage elsewhere.

Iress Rejected

At face value, local finance technology company Iress ((IRE)) shares some of the core characteristics that have turned the likes of Amcor ((AMC)) and TechnologyOne ((TNE)) into the solid, reliable and dependable All-Weather Performers that they have proved to be for loyal shareholders over the past decade and beyond: "Our software is used by more than 10,000 businesses and 500,000 users globally", reports the company proudly via its website and annual reports.

As many of those businesses and users involve stockbrokers, asset managers, financial planners and SMSF investors, the company's mantra has always been that of a quality service provider with rather sticky customers, but Swedish private equity group EQT could not make that thesis work, apparently.

Having been forced by Iress to lift its indicative offer, twice, before being granted due diligence access, EQT ultimately decided there was nothing untoward in the business or its finances, but the suitor's plan simply didn't stack up. Iress's fault or should EQT have done its home-work more thoroughly?

We will probably never find out.

What investors are left with is Iress' management's plan to double profits by FY25, expressed with confidence and -apparently- with further room for upside surprise. Plus the intention to sell off its mortgage servicing business in the UK, and return excess cash from the proceeds to shareholders.

This is where things get interesting because the past six years have not been great for Iress or its shareholders. Up until 2016, this was broadly regarded as one of few quality, unassuming performers among smaller cap stocks on the ASX. Never doing anything spectacular, but great at lifting profits and dividends steadily, with here and there a regular acquisition in between.

From 2016 onwards, the shares have essentially range-traded while the annual dividend increased from 42.7c to 46c but earnings per share went nowhere (well, EPS went sideways) despite annual revenues increasing in each year. The problem for Iress has been a constantly declining profit margin as more and more investments were required to develop new products and integrate those acquisitions.

The solution thus has to be that those margins can be stabilised and improved, and I have little doubt management has similar ideas, which is why they appear so confident in their double-by-FY25 projection.

Meanwhile, it's going to take another year or so before new products can start having genuine impact, as well as acquisitions such as OneVue. So what's a shareholder, like the FNArena/Vested Equities All-Weather Model Portfolio, to decide?

Let's first take a step back to when the Iress share price jumped from $10-something to $15, in two stages, once the market was made aware of the EQT approach, non-binding as it was.

Out of risk management, the Portfolio had decided to sell half of its shares, but should we sell the other half too?

Having thought about it, and this all happened before the news came out that EQT had abandoned its intention, I had come to the conclusion that were no takeover to proceed, the odds remain in favour of a better outlook for Iress in the years ahead, as per management's confidence.

Even if Iress doesn't exactly double its profits over the next four years, once the internal flywheel starts turning in its favour, I reckon the results can quickly become very profitable indeed. But as per always, the ultimate proof will need to be delivered by management at the helm.

Investors are likely to take a wait-and-see approach first, just as they're doing with Brambles ((BXB)), given Brambles made so many promises in the past, and so many years of no real progress made have since passed. There are similarities between Iress and Brambles, but I reckon the odds for success look better at Iress.

The post-event sell-off has pushed the prospective dividend yield for Iress shares back up to 4%, with the promise of an extra or bonus once a buyer for Mortgage, Sales and Originations (MSO) has been found. Iress has resumed its on-market share buyback.

Those will be the extra-rewards for waiting until management can show some tangible results coming through.

In the meantime, I'll simply quote EQT chairman of Asia-Pacific, Thomas Van Koch: "During our work we have been able to confirm that Iress is an impressive, technology-focused business with strong market share and a very loyal customer base driven by its market-leading software solutions.

"We have not come across any red flags during our due diligence but were not able to sufficiently confirm our investment hypothesis. We wish management and the company well and have every confidence Iress will continue to be a leader in its field."

Share Buybacks And Franking Benefits

What's in it for me?

The question is often received here at FNArena when widely held ASX-companies announce a share buyback: Why don't they simply increase the dividend?

The answer can usually be found in the accumulation or the lack thereof of franking credits on the corporate balance sheet.

Starting with the standard on-market share buyback, which is in particular proving to be very popular in the USA; when a company buys in its own shares, its profits and dividend are subsequently shared by fewer outstanding shares, essentially creating artificial growth, but effective nevertheless.

Consider the following proposition: a company intends to pay out $100 in total dividends next year and it reduces its outstanding shares from 50 to 40. $100 divided over 50 shares means every shareholder received $2. Divided over 40 shares, however, that same dividend becomes $2.50 or an increase of 25% without increasing the actual dividend payout.

And, of course, the same principle applies for earnings per share, one of key measures for shareholders.

But then some companies have an abundance in franking credits accumulated, and those can be used in a more creative manner, with a lot more benefit for long-time shareholders in Australia.

Licensed investment advisor George Cochrane used the example of the Woolworths ((WOW)) off-market share buyback in the Sun Herald on Sunday, and I am liberally quoting from his writings on Sunday last.

Woolworths has invited shareholders to tender in their shares at a discount of between -10%-14%. This sounds like one helluva discount, until one realises the benefits for all involved. Woolworths estimates the 'capital component' of the buyback price to be just $4.31 per share, with the remainder made up by franked income.

As Woolworths shares are trading around $40, the potential tax benefit for a no longer tax paying retiree are simply enormous. Consider the following:

-share price of $40 at discount of -14% becomes $34.40
-because $4.31 is less than the purchase price, the investor can take the difference as a 'loss' which can be carried forward for tax reasons
-the remainder, which is $34.40 minus $4.31 becomes franked income and as such triggers a tax claw back claim of 30%, even if no tax is being paid

In Sunday's newspaper, Cochrane uses the example of a canny self-funded retiree who, having bought Woolworths shares in the 1990s for $5.31 a piece, ends up with a benefit of $47.21 per share plus a capital loss for future use. Sounds like a big win-win for everyone involved!

This also easily explains why Harvey Norman ((HVN)) is regularly targeted for the excess in franking credits on the balance sheet. Good ole Gerry Harvey, as chairman of the board, is not having a bar of it however.

Always keep in mind: FNArena does not provide investment or tax advice. Investors should seek proper advice in these matters, preferably through a professional accountant.

NextDC And The Relative Proposition

The NextDC ((NXT)) share price has come to life again, though that hasn't stopped the public debate among investors whether Australian investors are over-paying or even how to properly value the local number one owner and builder of data centre infrastructure.

One way for trying to answer the question is by comparing valuation and growth with international peers. One of the arguments is, after all, that when it comes to emerging new, technology-driven business models, Australian investors are always over-paying for exposure in comparison with investors elsewhere.

Turns out, when taking into account the much faster growth at NextDC, its valuation does not seem out of kilter with valuations elsewhere. Also thanks to Canaccord Genuity for helping to bust yet another popular myth.

Conviction Calls

Wilsons' Focus List has undergone two changes recently. Aventus Group ((AVN)) has been removed as the share price is no longer considered cheap or undervalued, but merely fairly valued, and total weighting for CSL ((CSL)) has increased further.

Wilsons remains confident momentum in the core blood plasma business will improve throughout the two years ahead. The Focus List is Overweight Healthcare in general.

There have been no changes to Wilsons' Conviction List which thus still comprises of: ARB Corp ((ARB)), Collins Foods ((CKF)), Pacific Smiles ((PSQ)), Aroa Biosurgery ((ARX)), ReadyTech ((RDY)), and Plenti ((PLT)).

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It turns out, the Australian Focus Portfolio Ex-20 at Evans & Partners has had a tough time since inception six months ago. Exposure to the Energy sector seems to have been the major culprit, while small cap disappointment from the likes of Electro Optic Systems ((EOS)) and a sharply falling iron ore price haven't helped either.

The portfolio's five largest holdings as at the end of August were (in order of magnitude starting on 3.1% and ending on 2.9%): NextDC ((NXT)), Star Entertainment ((SGR)), James Hardie ((JHX)), Johns Lyng ((JLG)) and Mineral Resources ((MIN)).

The portfolio sold out of GUD Holdings ((GUD)) as potential benefits were perceived to be better elsewhere. AUB Group ((AUB)) has been added.

Potentially of more interest is that small cap specialists at Evans & Partners have tried to distinguish between three baskets of companies with specific characteristics:

–Set & Forget; well-managed, delivering consistent growth and probably higher valued, this selection contains AUB Group, Johns Lyng, Lovisa Holdings ((LOV)) Pro Medicus ((PME)), and PSC Insurance Group ((PSI)).

–Growth; companies offering the big picture dream, often still loss-making, this selection includes Atomos ((AMS)), Life 360 ((360)), Catapult ((CAT)), Nearmap ((NEA)) and Nitro Software ((NTO)).

–Staple; well-established businesses with attractive fundamentals, but timing remains of the essence, the broker assures. This basket currently includes Accent Group ((AX1)), Blackmores ((BKL)), BWX Ltd ((BWX)), Enero Group ((EGG)), Kathmandu ((KMD)), and Universal Store ((UNI)).

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Portfolio managers at stockbroker Morgans have decided to lighten the Core Model Portfolio's exposure to Amcor ((AMC)) and Sonic Healthcare ((SHL)), in both cases following strong performances.

Instead Tabcorp Holdings ((TAH)) has been added and exposure to Santos ((STO)) has increased.

The Growth Model Portfolio also increased exposure to Santos, while selling ANZ Bank ((ANZ)) and buying TPG Group ((TPG)).

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Share market strategists at JP Morgan remain convinced the best strategy remains to be exposed to cyclical equities – they upgraded both Mining and Energy last month, and are sticking by that decision.

JP Morgan is of the view that all the worries that have kept momentum with the more defensive companies are by now largely priced-in, and might even be turning less worrisome.

The strategists believe momentum into year-end is likely to favour cyclicals, as well as Developing Markets (or EMs) over Developed Markets.

The defensives in the market have done their bit, while bond yields have bottomed are two of the popular predictions at JP Morgan.

All-Weather Model Portfolio

August update for the All-Weather Portfolio:

https://www.fnarena.com/downloadfile.php?p=w&n=3D34B41F-A924-08CA-4FCB4623B55F2F44

FNArena Talks

Last week I was interviewed by The Australian's James Kirby for the newspaper's regular podcast The Money Cafe. The audio-only broadcast sits behind a paywall at the newspaper, but it can be accessed through other channels, such as Apple Podcasts:

https://podcasts.apple.com/au/podcast/the-australians-money-cafe/id1201031401

Alternatively, look for James Kirby in Google Podcasts: https://podcasts.google.com/

Research To Download

RaaS on PropTech ((PTG)):

https://www.fnarena.com/downloadfile.php?p=w&n=0AEE9E35-E5DC-75F2-97AB34BB6A441C3D

(This story was written on Monday 20th September, 2021. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story 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.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $450 (incl GST) for twelve months or $250 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index.php/sign-up/

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