Cautious Optimism by lindash


Cautious Optimism

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									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.
                                                                   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.
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:
20 years. Prior to Ralton, he held senior positions with major                             Web:
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.

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