Market Update – March 2009 Cautious Optimism The Month in Review Market Performance Early March saw the downward trend in equity markets Key Economic Indicators continue, with the S&P/ASX 200 Index hitting a new bear market low of 3121 on 10 March, representing a fall of 54.4% Indicator 28 Feb 31 Mar Change from the November 2007 peak. The market then staged a All Ordinaries 3296.9 3532.3 strong rally into the end of the month with the benchmark $AUD US64.54 US68.73 finishing up 14.7% at 3582. This was a clear demonstration of how economic viewpoints can at times be at complete Oil (crude) US$45/b US$48/b odds with market sentiment – despite the bulk of ‘historical’ Gold US$940oz US$918oz economic news appearing dire, markets still took the view RBA Cash 3.25% 3.25% - that economies may be beyond their worst and likely to improve over the next six to nine months. No doubt this thesis is going to be tested many times over in coming Best and Worst Stocks and Sectors months. Measure Sector/Stock Month Return Why the turn in March? There were a number of factors Market Return S&P/ASX 300 Accum +8.07% driving the change in sentiment including 1) the large US Best Sectors Information Technology +24.6% banks reporting trading profits for the first two months of 2009, 2) perceived ‘positive outcomes’ from the G20 Financials, ex Property +19.9% meeting, 3) a supportive view of US Treasury Secretary Tim Worst Sectors Telecoms - 4.8% Geithner’s latest plan to deal with toxic US bank assets, and Healthcare - 4.7% 4) an improvement in the credit markets. Best Stocks Macq. Communications +175.9% Have we seen the bottom of this bear market? March could FKP Property Group +174.0% well have been the low point, however, this downturn has been unprecedented in so many ways that we would not be APN European Retail +136.8% surprised to see new “left field” events emerge. Our instinct Worst Stocks Hastings Diversified (52.7%) tells us, given the signs coming through, that we have seen Albidon Limited (45.8%) the worst for the global economy, with governments and central banks finally appearing to get ahead of the curve – Centro Retail Group (28.2%) plans are in place and we are now in the implementation phase. Some $2.5trn of the planned $12.5trn in spending is now on its way. Further, should more surprises emerge in the US, they now have a president with a strong mandate Recent Global Events (Democrats control both the house and senate) which means As we have mentioned in the past, one of the keys to an more decisive and timely action can be taken if required. In improvement in global economic growth and a sustainable addition, there are strong signs that the Chinese stimulus recovery in the Australian share market is a recovery in the package is beginning to have an impact. credit markets. A number of recent steps at the international As we have mentioned for some months, we have been level have assisted in improving sentiment in credit markets. slowly reducing the defensive bias of the Ralton portfolios US Bank Sector maintained throughout most of 2008. This is very much a stock picker’s market in our view. We are currently focused There were three key steps taken in March to resolve on adding companies expected to benefit from an economic problems in the US banking system. Firstly, the US Federal recovery, as well as those representing good value relative to Reserve announced its plan to “stress test” major bank the risk we are taking on. balance sheets to determine those requiring further capital. The release of positive results would provide more comfort to market participants about the health of banks at the centre of the US financial system. However, banks failing the Fed’s test will be required to arrange re-capitalisation with further US government assistance provided if required. Secondly, US Treasury Secretary Tim Geithner announced the nation’s lifestyles had to change in order to settle these Public Private Investment Partnership (PPIP) program which global imbalances, as it would have moved the polls in an will provide a mechanism for the acquisition of toxic assets unfavourable manner! Rather, it is much easier to argue the from banks using a combination of public and private funds. fault of evil bankers, ignoring the fact that bankers needed a The initial reaction from some of the US managers suggests it borrower in the first place! will be lucrative enough for “vulture funds” to participate – We have seen positive announcements recently from China this should ensure it is successful in creating a market for the regarding changes to the structure of its economy in an debt. Again, cleaning up bank balance sheets will provide effort to drive domestic demand and, as a result, reduce them with the capacity to make loans. The freeing up of saving. The key to lifting domestic demand for China is to credit to households and business is critical to restoring provide retirement income and healthcare to its citizens (i.e. economic growth in the US. by socialising the cost of retirement and ill health rather than Thirdly, the ‘mark-to-market’ accounting rules have been having people rely on their own savings). Tentative steps on modified to be less onerous on the banks. In fact, the rules both these fronts have recently been announced, but will now more accurately represent reality as opposed to take many years to implement. accounting ‘myth’. The mark-to-market rule has in the past Further, households in Australia and the US are showing exacerbated problems for banks - the ‘market’ price for an signs of lifting their savings rates. This is bad for politicians asset in a highly illiquid was actually that of the distressed trying to stimulate a recovery in domestic spending, but it is a seller, rather than the price that would prevail in a more very important step in reducing the excessive gearing of the rational market. A more appropriate measure of the assets a household sector in each country. bank intends to hold to maturity is based on the expected future cash flows from the asset over the term to maturity. Failure to address the global imbalances is only going to lay Whilst this may be a subjective number, it is more useful the foundations for the next crisis in our opinion. This is as than a price determined in a market with sellers and no important as improving the regulation of the financial buyers, and will serve to reduce write-offs and balance sheet system. Overall for the global economy in the short term the reductions, increasing banks’ capacity to make loans. fact that world leaders failed to materially disagree and did leave the two day summit with some tangible policy benefits G20 Meeting – London suggests that the conference was more success than failure. Financial markets were relieved. Looking beyond political rhetoric and disputes over the need for greater financial regulation (which the Europeans favour), or the need for further economic stimulus (which the US was Domestic Building – Housing & Schools pushing), the G-20 did successfully address two major issues. A key ingredient to a recovery in the Australian economy in Firstly, the G-20 substantially increased funding for the IMF – this cycle will be a lift in housing starts and public this should allow the IMF to deal with the problems in some infrastructure initiatives. The first home buyers’ grant and of the Eastern European economies (which we flagged as a the dramatic fall in interest rates over the past 6 months serious risk last month). This should provide some relief for (with its favourable impact on housing affordability) are the Western European banks with loans into those markets. beginning to have the desired impact with new housing In turn, this should also assist in stabilising many European finance beginning to lift. banks. Further, our industry sources suggest that at least in Victoria Secondly, the G-20 sought to directly fund global trade with the State government is moving swiftly to implement the $250bn directed toward trade credit. This was a very school construction program funded by the federal positive step, and as a “circulating” amount it represents a government. This will provide an additional boost to far bigger boost to the financial system than the face value domestic construction. suggests. On the downside, a major cause of the financial crisis not Debt – What Level of Gearing is Appropriate? addressed by the G-20 was that households, particularly We were recently asked by a client how we consider the from Anglo-Saxon countries, have been living well beyond capital structure of companies we include in the Ralton their means for many years. This problem has manifested portfolios. In particular, our client felt that gearing below itself into massive current account deficits in countries such 30% would be viewed as conservative, and therefore, should as the UK, US, Ireland, NZ and Australia, with these be considered good. The answer to a question of this type is imbalances funded largely through borrowings from Asian complex as there are many issues analysed in assessing the and Middle Eastern investors. appropriate capital structure for a business. Politicians returning home from the G-20 would have been reticent to share the news with their voters that their To start with an extreme example, using any debt funding to companies during this downturn. The dramatic movement finance mining exploration in a company with no income of the Australian dollar against the US dollar (over 30%) in a generating assets would be inappropriate. At the same time, very short space of time last year caught some companies off having 30% debt in company with a very stable income guard. This included companies which had made offshore stream (say a fully operational toll road with many years of acquisitions without adequate consideration of the potential operating history) would be considered very conservative. exposures arising from the currency risk and companies with business models built around importing goods from Our investment process involves a consideration of the overseas. Further, the sharp fall in commodity prices will no capital structure (both debt and equity) for the companies doubt have hurt some companies. An understanding of we invest in. Our emphasis is on what is appropriate for the these exposures is important when assessing a company’s industry and company under consideration. We felt it would capital structure. be useful to provide a snapshot of the type of issues that need to be considered. Debt Maturity Profile: This has been a real issue for many companies, including banks. As a general rule shorter dated Cyclical Sectors debt usually costs less than longer dated debt. As such, For companies with earnings and cash flow that vary widely companies tend to have a shorter dated maturity profile on with the economic cycle, banks are more comfortable with their debt. The global financial crisis has changed that and gearing levels that ensure commitments can be met through companies (and analysts) will be far more focused on the the cycle. By implication this means stocks in cyclical term structure of a companies funding in future. industries should have a lower level of gearing than those Interestingly, Rupert Murdoch learned from the near death with more defensive incomes streams. For instance, housing experience of Newscorp in the early 1990’s and has a very construction and media are traditionally viewed as being long duration on his debt. Having a long dated debt profile cyclical sectors, and therefore, the revenue streams are or ‘manageable’ refinance needs is a key focus and attraction subject to the vagaries of the economic cycle. When you for Ralton. have a cyclical revenue stream and a fixed cost base, the Takeovers: Debt funded acquisitions at the end of the cycle earnings and cash flow of the company are likely to swing which were financed by short term debt have caused widely in an economic downturn. Therefore, gearing levels problems, in our opinion, for a couple of companies (eg need to be lower than companies with more stable income Wesfarmers and Incitec Pivot). Further, some of the debt streams. Companies that we have seen that do need to raise funded acquisitions strategies have unravelled (eg Babcock & capital under the current environment are not necessarily Brown, Allco Finance and ABC Learning). bad companies – their level of gearing was just too high given Covenants: Banks impose a range of covenants on a the relative depth of the downturn. company which borrows money. This might include total Defensive Sectors levels of debt relative to earnings, debt to total assets, etc. However, one that took some people by surprise was the We have seen companies like Coca-Cola Amatil (Beverage concept of a market cap covenant (i.e. debt may become sector) and Ramsay Healthcare (Healthcare sector) perform repayable if the market cap of the company falls below a very strongly relatively to the market over the past 12 certain level). This one proved a great target for hedge months, yet both have relatively high debt levels. This is funds. There will be more focus on debt covenants as well by explained by the fact that revenue streams are not driven by investment analysts in future. the economic cycle. For Ramsay, government policy around healthcare funding is a far more critical issue and the rate at Reflecting on this discussion we hope it becomes clear that which people get sick. Coca-Cola’s earnings, in contrast, are debt and gearing levels are a multi-factorial consideration more a function of our taste for their product range which and that part of our role as managers is to choose does not seem to vary much over time. Both of these investments with due consideration to appropriate capital companies can sustain higher gearing levels than more structures. There are also a range of other issues which need cyclical stocks that may appear ‘high’ if assessed based on a to be considered when one considers banks, utilities, straight percentage of debt levels. infrastructure and property assets. Other Capital Structure Issues There are other factors which need to be considered around a company’s financial profile – some of which have been exacerbated by the global financial crisis. Hedging: The hedging of currency and commodity exposures (or lack thereof) has been an area which has tripped up many Ralton Portfolio Positioning Although the stock market lifted solidly in March and there are early signs of economic recovery (or at least a floor developing on the downside) we remain cautious. Risks to the downside still exist. We continue to reposition the portfolios in the well positioned cyclical stocks that offer good value for the risk we are taking. Our thoughts for how this cycle will unfold remain largely unchanged and many of the key steps required for an eventual recovery have been taken by governments and central banks. Now we just need to allow the economies to go through the healing process which just takes time. About the Author For Further Information Andrew Stanley, Director & Head of Investments Financial advisers seeking additional information can contact Andrew leads the Ralton investment team and is responsible Ralton Adviser Services at: for the day-to-day management of our model portfolios as well as the economics & thematics strategy. Andrew’s career Phone: 03 9674 0600 in funds management and investment banking spans almost Email: firstname.lastname@example.org 20 years. Prior to Ralton, he held senior positions with major Web: www.raltonam.com.au investment banks around the world, most recently as an Executive Director within the Financial Structuring Group of UBS in Hong Kong. He started his career at Arthur Andersen in Melbourne, where he spent four years as a tax adviser. Andrew holds degrees in Economics and Law from Monash University, a Masters of Applied Finance from Macquarie University, and is a qualified Chartered Accountant. The views and opinions expressed in the report are currently held by Ralton Asset Management and are accurate as at the date of the report, however, they may change without notice. This report provides general information only and does not take into account the investment objectives, financial circumstances or needs of any person. To the maximum extent permitted by law, Ralton, its directors, employees and agents accept no liability for any loss or damage incurred as a result of any action taken or not taken on the basis of the information contained in the report or any omissions or errors within it. Before making an investment decision you should consider the latest PDS or FSG and assess whether the product and/or service is appropriate for you. It is advisable that you obtain professional independent financial, legal and taxation advice before making any financial investment decision. Ralton does not guarantee the repayment of capital, the payment of income, or the performance of its investments. Further, past performance is not indicative of future performance.
Pages to are hidden for
"Cautious Optimism"Please download to view full document